In a recent case, Lender Management, LLC versus Commissioner, The U.S. Tax Court found a family office* to be engaged in the trade or business of providing investment management services. As a result, the family office was entitled to deduct all of the ordinary and necessary expenses paid or incurred in carrying on that trade or business as business expenses under IRC section 162. If the family office was found to be merely an investor or family members were found to be managing money solely for themselves, these expenses would be characterized as nonbusiness expenses for the production of income under IRC section 212. Prior to 2018, the nonbusiness expenses would be deductible as an itemized deduction subject to adjusted gross income limitations. Under the 2017 Tax Act, commonly referred to as the Tax Cuts and Jobs Act, these nonbusiness expenses are nondeductible for tax years 2018-2025.
This article reviews the key facts and conclusions in this case and also provides an overview of the benefits of family office planning.
Key case points
The Court’s conclusion was based upon all of the facts and circumstances specific to this case. The key factors the Court considered when determining if the family office was engaged in a trade or business were the activities performed by the family office, how the family office was compensated for the services it provided, and the relationship to the family. These are summarized below.
1. Activities of the family office
The family office is designated as the sole manager of three investment limited liability companies (LLCs) owned by three generations of the family. The chief investment officer (CIO) of the family office is also a member of the family. The services provided by the family office included sourcing, investigating, negotiating and monitoring investments; managing cash flow; preparing asset allocations; and providing investment and financial advice to the investment LLCs. The LLCs invested in private equities, hedge funds, and public equities. The Court concluded these activities went beyond those of an investor and were comparable to services a hedge fund manager would provide.
It is important to note that the family office engaged an outside firm for investment advisory, accounting,tax preparation services and reporting. tThe family office was primarily engaged in investment management, advisory and financial planning services.
2. Compensation of the family office
The family office shifted from a cost center to a profit center over the prior years. The family office was compensated for its services through the receipt of a profits interest or carried interest. The Court considered the profits interest as a legitimate form of compensation for services rendered. Specific facts considered are outlined below.
- Compensation through profit interest: To the extent that it successfully managed its clients' investments and the net assets under management increased in value, the family office received an allocation of net profit. This compensation structure can be differentiated from Beals versus Commissioner. In that case, the taxpayer actively investigated and followed the investments made by him and his family, but he did not receive compensation attributable to his services for overseeing his family member's accounts. He benefited solely from his share of dividends, which constituted a normal investor's return.
- Disproportionate capital and profits interests: The family office held a relatively small capital interest in the underlying investment LLCs. However, the profits interests were the primary incentive for the family office to maximize the funds' success and thereby increasing the compensation to the family office. The disproportion between the capital and the profits interests is an important reason for concluding that the predominant activity of the family office was management of investments for others rather than investing for its own account.
- Absence of a management fee based on capital: The family office did not receive guaranteed management fees based on capital; it received payment for its services only if the investment LLCs earned net profits. Therefore, the absence of guaranteed fees motivated the family office to increase the net value of the investment LLCs.
3. Family relationship
Managing investments for yourself and members of your family is generally not a trade or business. The Court concluded that the family office, Lender Management, was providing investment management services to its clients, not to itself. Specific facts considered are outlined below.
- The management company was not managing its own money. As previously stated, the CIO of the family office was also a family member. Furthermore, the CIO was the managing member of the family office and owned 99 percent of the family office. A key consideration by the Court is the CIO owned less than 10 percent of certain underlying investment LLCs. Therefore, most of the assets under management were owned by members of the Lender family that had no ownership interest in the family office.
- Investment choices and related activities were driven by the needs of clients. There was a tailored investment strategy, asset allocation analysis, and other related financial services performed to specifically meet the needs of each client. The clients could withdraw funds if they were dissatisfied with the investment services.
- The clients within the three investment LLCs (members of the Lender family) did not act collectively or with a single mindset. They were geographically dispersed and their needs as investors did not necessarily coincide. The family office did not simply make investments on behalf of the family group; it provided investment advisory services for each of its clients individually, regardless of the clients' relationship to each other or to the managing member of the family office.
Benefits of family office restructuring as a trade or business
The 2017 Tax Act coupled with this Court case has led family offices to consider the benefits and potential issues associated with adopting a profits interest or carried interest structure. Key considerations include:
1. Income tax deduction for family office expenses
- Historically, families receive little or no benefit for investment fee deductions due to adjusted gross income (AGI) limitations and the alternative minimum tax (AMT). Under the new law, families can no longer deduct investment fees paid in 2018-2025.
- Treating investment fees as trade/business fees within an active trade or business eliminates these limitations and may provide a significant annual tax savings.
2. Estate tax savings
- Creative use of dynasty trusts that own key entities can provide for significant estate tax benefits over multiple generations. As the family office is compensated for the services it provides, those profits are allocated to the dynasty trusts. The combination of the legal entity structure and pooled assets create increased wealth preservation.
3. Tax efficient investment rebalancing
- With proper structuring, individuals or entities can change their asset allocation or rebalance their portfolios without selling assets.
- This approach can effectively eliminate the tax cost of rebalancing or reallocating the portfolio.
4. State tax savings
- Utilization of the activity of the family office to source income to more tax-beneficial states
1. Centralize the operations and procedures within the family office
2. Formulize asset allocation and investment options for clients/family members by providing flexible vehicles
3. Shifting to a profit focused family office can positively impact employee satisfaction and length of tenure
4. Enhanced opportunities for the family’s next generation to become more involved with the family’s businesses or charitable endeavors
Issues to consider for restructuring a family office as a trade or business include but are not limited to the following:
1. Size, complexity and asset classifications of the asset investment pools
2. Projected cash flow and income/gain amounts anticipated from the asset investment pools, including growth and appreciation potential of the investment pools
3. Expertise and qualifications of family office personnel with respect to providing investment management and advisory services to the clients/family members
4. Structure requires thorough and competent modeling, documentation of the risk factors and review of all legal documents for family enterprises that will become clients of the family office. Competent legal advice is required in creating and structuring the family office enterprise, investment entities and related investment and partnership agreements
5. Different economic arrangement for family office entity structure
Moving to a profits interest structure is only applicable in the right situation and requires significant tax and legal analysis as well as potentially significant operational and legal restructuring and substance. A thorough review is required before implementing a structure for a family office.
* What is a family office?
Family offices come in all shapes and sizes. They can range from a few single-generation members of a wealthy family with common investment and philanthropic goals, to a multigenerational family with contrasting interests and individual investment objectives. There are two types of family offices: single family offices and multi-family offices, sometimes referred to as SFOs and MFOs respectively. Single family offices usually begin by serving one ultra-affluent patriarch/matriarch and his or her family while multi-family offices are more closely related to traditional private wealth management practices, seeking to build their business upon serving many clients. In addition, many family offices also assist with, or in some cases lead, nonfinancial issues such as private schooling, travel arrangements and miscellaneous other household arrangements. Most family offices combine asset management, cash management, risk management, financial planning, tax, accounting, lifestyle management and other services to provide each family with the essential elements for addressing the pivotal issues it faces as it navigates the complex world of wealth management.