Prior to the 2017 Tax Cuts and Jobs Act (Act), individual taxpayers were able to reduce their taxable income by deducting various investment-related expenses as miscellaneous itemized deductions. The Act suspended miscellaneous itemized deductions beginning in 2018 through January 1, 2026. As a result, investment advisory fees and other expenses incurred for the production or collection of income are no longer deductible by individual taxpayers. The new tax law is a particularly unwelcome development for high-net-worth clients with a family office, as the costs incurred by these operations are often substantial.
However, expenses incurred by a taxpayer engaged in a "trade or business" are not considered miscellaneous itemized deductions and therefore remain available to reduce taxable income. With the continuing deductibility of trade or business expenses and the suspended deduction for investment expenses, characterizing the family office as a "trade or business" has become a valuable distinction. Unfortunately there is no clear definition of what constitutes a trade or business. Rather, whether a taxpayer is engaged in a trade or business or merely an investment activity is based on all of the facts and circumstances, and there had been very little guidance in the family office context until the Tax Court issued its December 3, 2017 decision in Lender Management v. Commissioner (Lender).
Lender addresses the distinction between investment activities and trade or business activities in the context of a family office. The Tax Court found that Lender Management LLC (Lender LLC), a family office providing management services to three separate investment entities owned by various members of the Lender family, was not an investor, but rather was actively engaged in a trade or business. The Tax Court found that Lender LLC provided investment management services for the benefit of its clients, rather than for its own enrichment. This distinction is key in separating personal investment activity from a trade or business.
In deciding that Lender LLC was engaged in a trade or business, the Tax Court noted that Lender LLC received a carried interest as compensation for its services, beyond the return on its own investments. The Tax Court's decision also focused on the fact that Lender LLC had multiple employees, both full- and part-time, that researched investment opportunities, negotiated and executed new investments, monitored existing positions, and worked with individual investment entity members providing one-on-one investment advisory and financial planning services to address such members' specific needs. The Tax Court found that the breadth of services Lender LLC provided to its clients was analogous to the services hedge fund managers provide to their clients, and that such services went far beyond those of a personal investor.
In light of the suspension of miscellaneous itemized deductions, Lender provides a road map for family offices to consider in establishing a new or restructuring an existing operation. Many family offices already engage in some of the activities favorably cited by the Tax Court in Lender, and others may need to reevaluate their particular structure in light of this recent decision.
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