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BY: Deidre S. Waltz, CFP®, CIMA®
Vice President, Relationship Manager
(405) 608-8002
Families seeking a better way to manage their wealth may want to consider a strategy that is commonly used by family offices: utilizing “side pockets” in a family investment partnership (FIP) to create customized portfolios that are tailored to investor needs.
Family wealth professionals have long advised using investment partnerships to manage wealth and provide for the financial needs of current and future family members. Common assets held in an FIP include ownership interest in the family business or investments in stocks, bonds, real estate and alternative investments (such as private equity or hedge funds).
By pooling their assets into an FIP, families have more control over investment management decisions and can tap into the expertise of professional money managers. Additionally, for federal tax purposes, income generated from the FIP is not taxed at the partnership level, but instead flows to the individual investors, which simplifies reporting to the IRS.
But there is one important drawback to the traditional FIP structure: partners do not get to choose what types of investments they want to own because everyone in the partnership is treated equally. That’s where side pockets can help.
What is a side pocket?
In simple terms, side pockets are separate accounts or groups of accounts held within an FIP. They are not separate legal entities, and each side pocket has its own investment mandate.
3 ways a family investment partnership can benefit using side pockets
1| Customized and flexible asset allocation for each family member: Typically, all assets in an FIP are commingled into one portfolio and family members own a percentage of the partnership. That is an important consideration because the management of the partnership’s assets do not take into account the different risk tolerance and income needs of each investor. With side pockets, investors choose which investment strategies (i.e., the side pockets) they want as part of their portfolio.
Think of it this way: With side pockets, grandma and grandpa can have their own conservative investment portfolio (more fixed income securities, less exposure to equities) that is tailored to meet their income needs. Their grandchildren, on the other hand, can have a more aggressive, equity-heavy portfolio. And those portfolios can be periodically rebalanced as the grandparents and grandchildren age.
The ability to manage risk tolerance and asset allocation for partner needs is one of the main reasons why family offices rely on side pockets. It also allows them, for example, to segregate liquid assets (such as publicly traded equity and fixed income securities) from illiquid hard-to-value assets (such as ownership interests in a business, speculative real estate or oil and gas investments).
2| Cost-efficient tax reporting: Because side pockets are not considered separate legal entities, the FIP only needs to file one federal tax return. Without side pockets, advisors would likely have to set up individual legal entities (such as limited liability companies) for each investment mandate in order for each investor to choose which investment strategies best fit their investment goals – an undertaking that would result in a host of complex tax and reporting issues.
3| Equitable allocation of gains and losses: Many FIP operating agreements include what is known as a “stuffing” provision to address how gains or losses are allocated to investors who withdraw funds from the partnership. The language in the stuffing provision determines how realized gains or losses are allocated when an investor sells assets in the side pocket. (The tax implications on FIP withdrawals is a topic unto itself, so please talk with your CPA before acting.)
Investment partnerships have traditionally been an ideal way for families to manage their wealth. By taking it one step further and utilizing side pockets, your family can build customized portfolios that protect and grow their assets for future generations.
If you would like to learn more about family investment partnerships and side pockets, please contact one of our financial advisors. We are ready to help.
