Family investment companies (FICs) are becoming increasingly common among high-net-worth families. An FIC is typically a family-held LLC or family limited partnership (FLP) in which a wealthy founder transfers assets into the company, and other family members become partners or members in the business.
Creating an FIC can be a good way to protect and manage assets, pass on wealth to future generations, and reduce tax liabilities. However, over the years the IRS has cottoned on to the fact that some FICs exist for the sole purpose of reducing or avoiding taxes. This has led to increased scrutiny.
If you have an FIC, or are thinking about creating one for your family, here’s what you should know.
You Need a Legitimate Non-Tax Reason to Operate a Family Investment Company
The purpose of the FIC cannot be to reduce or avoid taxes. There must be a legitimate non-tax reason for the family investment company to exist in the first place.
For many families, centralized asset management is reason enough. FICs allow for assets to be pooled, managed, and overseen by multiple family members, rather than keeping those assets in separate trusts or an individual’s account(s).
Other potential legitimate reasons for creating and maintaining an FIC include:
- Asset protection (from creditors, family members, impending divorce, etc.)
- Business succession planning
- Preservation of larger assets by avoiding fractionalization
These are just some of the possible legitimate reasons to have an FIC; discuss your unique situation with your tax preparer, wealth advisor, business attorney, and/or estate planning attorney.
If the IRS determines that the FIC exists solely to evade paying taxes, it may be able to disregard the transfer of certain assets under Internal Revenue Code Section 2036 and count them in the estate of the donor/founder at death – a bigger topic we may cover in the future. For now, just remember that an FIC must have a non-tax purpose for existing.
You Must Respect the Business Entity and the Business
The IRS may look to see if the company is being run like a company or if it’s only “on paper.” A business that’s just on paper will have little to no activity and may serve solely as a place for assets to sit and generate income passively.
In contrast, a legitimate business in the eyes of the IRS is one that has a clear structure, maintains formalities such as holding meetings and keeping minutes, and engages in substantial economic activity such as managing and investing assets.
In addition, members/partners must respect the business entity itself and avoid piercing the corporate veil (read more about this on our blog).
Watch Out for Fractional Gifts
Why did the IRS start looking at family investment companies more closely over the past decade or so? Because some people got a little too greedy. Here’s what happened.
High-net-worth individuals discovered that the use of fractional gifts was a good way to handle the logistics of passing on assets to future generations, and it provided a tax benefit, too. A fractional gift in the context of an FIC typically involves a founder transferring a partial ownership interest in the FIC to a family member who is also a member/partner of the FIC.
This partial interest is eligible for discounts, often a discount for lack of control (when the stake in the business is under 50%) and a discount for marketability (because it’s harder to find buyers for a smaller, non-controlling share of a business). These discounts lower its value and, consequently, reduce the amount of gift taxes the donor is liable for. (Read more about discounts and on valuation of closely held companies here on our blog.)
But pigs get fat, hogs get slaughtered, as we often say. Not too long ago, some people tried to push the limit on these discounts, reducing the value beyond what the IRS found reasonable. This is what led to the IRS cracking down on families using FICs and fractional gifts, in particular, as tax evasion tools.
What’s a reasonable discount? There is no set number. This is something that needs to be determined on a case-by-case basis, ideally with the advice of an attorney, tax professional, and/or financial advisor.
Legal Advice on Business Matters and Estate Planning
For help with short-term and long-term estate planning and business planning, including succession planning, speak with Gem McDowell. Gem and his team help individuals and business professionals protect their interests and plan for the future with customized estate plans, corporate governance documents, and strategic advice. Gem also has many years of experience in tax law and holds a master’s degree in tax law from Emory University, and he is ready to help advise you on your tax issues.
Call the Gem McDowell Law Group, with offices in Myrtle Beach and Mt. Pleasant, SC, today at 843-284-1021 to schedule your free consultation.
