New Structures for Family Offices
December 13, 2018
Summary of Key Points
- Recent court cases and changes in the tax law have substantially changed the rules governing the structuring of family offices.
- Family offices have new guidance for the qualification of the office as a trade or business, entitled to deduction in full for all of its expenses.
- For family offices that don’t qualify as a trade or business, it may be worth considering restructuring as a C corporation.
- Regardless of the form chosen, family offices achieve the greatest tax efficiency by being compensated pursuant to a profits interest, as opposed to a management fee.
Read below to learn more about how best to structure your family office in this new and shifting landscape.
Historical Family Office Structuring
Prior to the end of 2017, most family offices were not able to structure themselves in a particularly tax-efficient manner. Usually, a family office would be structured as a limited partnership or limited liability company (“LLC“), and would provide investment management, tax, accounting and concierge services to family members and various family entities (partnerships, trusts, foundations, etc.). Often, the family office would be compensated by the family members and family entities (collectively, the “Family Clients“) in the form of management fees. However, those management fees were deductible by a Family Client only to the extent that the fees exceeded 2% of the Family Client’s adjusted gross income (“AGI“) for the tax year. For many family offices, deductions for operating expenses, including salaries, office rental and payments to third-party vendors, were likewise limited. Some family offices, if properly structured, were able to avoid most of the limitations on deductions by claiming that they were an active trade or business, and thereby taking their deductions in full. However, taking such a position was risky, as the IRS had often challenged attempts by single family offices to claim that they were a trade or business.
Sections 212 and 162
Historically, expenses of the type incurred by family offices were deductible under one of two provisions of the Internal Revenue Code (the “Code“): Section 162 and Section 212. Section 162 deductions are applicable to an active trade or business, and deductions taken under Section 162 are generally permitted in full. The IRS has traditionally viewed the active trade or business requirement somewhat strictly, demanding that entities claiming the deduction be engaged in a for-profit business through the provision of goods or services to third parties. In the 1930s, the family office of Eugene Higgins, the wealthy heir to a business fortune, attempted to claim the expenses of managing his fortune as trade or business deductions. The government successfully challenged this position, arguing that the management of one’s own wealth is not a valid trade or business. In response, Congress enacted Section 212, recognizing that expenses related to the management and enhancement of one’s own wealth were legitimate and should be deductible to some extent. Nevertheless, the Code limited those deductions to amounts in excess of 2% of AGI. Given the government’s historical antipathy towards family offices operating as a trade or business, most family offices weren’t willing to take the risk of an IRS challenge, and instead chose to claim their deductions solely under Section 212. As a result, the owners of many family offices and the Family Clients they served were unable to deduct their expenses in full.
Important Developments in 2017
As a result of two important developments at the end of 2017, traditional family office structures are less viable, but at the same time, new structures provide opportunities for much greater tax efficiency. The first involved the case of Lender Management v. Commissioner, in which the Tax Court ruled that a family office could be treated as a business so long as certain criteria were met. The second involved the passage of the Jobs and Tax Cut Act of 2017, which disallowed deductions under Code Section 212 and reduced the corporate tax rate from 35% to 21%.
Lender v. Commissioner
In Lender, the taxpayer was a family office that provided management services to a series of investment LLCs owned by the children, grandchildren and great-grandchildren of the founder of Lender’s Bagels.
In determining whether the family office was engaged in a trade or business (and could therefore fully deduct its expenses), the court noted that there is heightened scrutiny when a family relationship exists between the owners of the family office and the owners of the LLCs. Nevertheless, the court found that the family office should properly be considered a trade or business, noting several factors that differentiated the operation of Lender Management from activities conducted by an investor to manage and monitor his or her own investments:
- The family office was headed by Keith Lender, a third-generation family member, who was an expert money manager with an MBA in finance. Keith devoted approximately 50 hours a week to his work for the family office and was involved in researching investment opportunities, negotiating and executing new investments, monitoring existing positions and working with individual family member clients to understand their investment needs.
- In addition to Keith, the family office employed several full-time and part-time employees, and was assisted by a team of outside specialists and firms providing various advisory, accounting and legal services.
- The family office was compensated via a profits interest in the investment LLCs. The court noted as a helpful feature the fact that Lender Management’s ownership interest in the investment LLCs (it had small investments in each) was different from its right to a profits interest, showing that the family office was being compensated for the services it provided. As a result of this method of compensation, Lender Management had real entrepreneurial risk and in fact generated losses in certain years.
- The family office did not manage Family Clients’ money in a uniform manner. The Family Clients were geographically dispersed, many did not know each other, and a number were in conflict with each other sufficient to prevent them from attending the same investor meetings. (In those circumstances, Keith met with the Family Clients directly.) Lender Management managed each Family Client’s money on a bespoke basis according to the tailored needs of the individual or the entity.
In reviewing the facts discussed by the court that led it to rule in favor of Lender Management, some best practices for treating a Family Office as a trade or business can be divined:
- The family office should be owned in different percentages and by a different mix of people or entities than the assets being managed.
- The manager of the family office should be qualified to act as an investment advisor and should devote his or her full time to the family office.
- The family office should be operated to generate a profit.
- The family office should employ non-family full-time employees and maintain its own physical office space.
- Family members should be treated as clients, and written client advisory agreements setting forth the services to be rendered and the means of compensation should be executed.
- The family office should hold regular client meetings and should provide transparency to its clients, including regular accountings of its investments and other activities.
The Jobs and Tax Cut Act of 2017
The passage of the Jobs and Tax Cut Act of 2017 (the “Tax Act“) significantly reorganized the federal income tax system for both individuals and corporations. For corporations, the income tax rate was decreased from 35% to 21%. For individuals, an enormous number of changes were imposed, but the most significant one for purposes of this discussion is the elimination of the deduction for expenses under Code Section 212. As a result, the payment of management fees by Family Clients to a family office is no longer deductible, and family offices that fail to meet sufficient criteria to be categorized as a trade or business are faced with the unappealing prospect of not being able to take any deductions for their expenses, even if those expenses are in excess of the 2% of AGI floor.
Using C Corporations
However, the change in the corporate tax rate has made the use of a C corporation as a family office much more appealing. Unlike other entities, C corporations are generally considered to be conducting a trade or business as a matter of course, and C corporations can generally deduct their expenses under Code Section 162, so long as they are ordinary and necessary expenses of running the corporation. As a result, many families are considering converting their family office to a C corporation.
The downside of a C corporation is that any profits earned by the corporation in excess of expenses will be taxed at the 21% corporate tax rate, and there may be state or city income taxes applicable to the corporate profits. In addition, any funds remaining in the C corporation will be taxed at 20% when distributed to the owners in the form of a dividend, or alternately will be subject to either a tax on retained earnings or a tax on a personal holding company, such that the funds will be taxed at the income tax rate on dividends regardless. Therefore, it is imperative when using a C corporation that profits be generated (so as to legitimize its position as a trade or business), but that those profits be minimized (so as to limit the additional tax exposure resulting from the corporate form).
As noted earlier, there are two ways in which deductions are no longer permitted with respect to family offices: (1) the payment of management fees to the family office by Family Clients, and (2) the payment of expenses by the family office if not a trade or business. The second problem is addressed by structuring the family office as a C corporation. To avoid the first problem, the family office can be compensated by the Family Clients in the form of a profits interest in the family investment vehicles. Any such profits interest needs to be carefully drafted in order to provide sufficient funds for the family office to operate on an annual basis while avoiding the allocation of excess income to the family office. The profits interest can be structured in a variety of ways, for example as a percentage of the assets under management or using a percentage margin over the costs of the family office (similar to a “cost-plus” arrangement), in either case limited to the net profits of the investment vehicle