In this Ropes & Gray podcast, Gabby Hirz, counsel in the tax controversy group, is joined by Loretta Richard, a partner in the tax and benefits group and co-founder of the tax controversy group, and Christi Lazo, counsel in the private client group, to discuss another notable Tax Court decision, Lender Management LLC v. Commissioner of Internal Revenue. Lender Management considered whether a family office was operating a trade or business and could therefore deduct investment expenses as business expenses.
Gabby Hirz: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Gabby Hirz, counsel in the tax controversy group. Joining me today are Loretta Richard, a partner in the tax and benefits group and co-founder of the firm's tax controversy group, and Christi Lazo, counsel in the private client group.
In today's podcast, we're going to discuss a notable Tax Court decision, which we've chosen as our case of the quarter. This case, Lender Management LLC v. Commissioner of Internal Revenue, dealt with the deductibility of a family office's expenses pursuant to Section 162 of the Internal Revenue Code. Specifically, despite the usual heightened scrutiny for family offices, the case determined that the family office of the Lender family, Lender Management, was carrying on a trade or business because it engaged in activities "far beyond those of an investor." As a result, Lender Management, a partnership for tax purposes, could deduct its investment expenses under Section 162 of the Code rather than as miscellaneous itemized deductions under Section 212 of the Code. That allowed its members to deduct them in their entirety without regard to the floors and limitations that applied to miscellaneous itemized deductions. As we will see, this was a particularly notable decision because it affirms the ability of a family office to be respected as a trade or business for federal income tax purposes. This is particularly important under the new tax reform legislation.
Before launching into more of the reasoning of the decision, Christi, could you explain briefly the purpose of family offices?
Christi Lazo: Before we start talking about the purposes that family offices serve, perhaps it's helpful to talk about some of the functions the family offices provide. Those functions of family offices vary widely depending on the needs and appetite of the particular family.
So, historically it has been common for family offices to fulfill administrative and bookkeeping functions for families. For example, a lot of family offices grow out of the need for family members to have assistance paying bills, organizing travel schedules, and managing household employees. They also started to frequently offer basic estate planning and tax services, including helping to administer charitable giving, and coordinate advice from outside professionals on more complex legal and tax matters.
Increasingly, however, we've started to see family offices have taken a more active role in the management of investments for family members and for the vehicles owned by or for the benefit of those family members. And, they've begun to do so in an increasingly sophisticated fashion. Many family offices now engage in direct investment activity comparable to private equity funds, hedge funds, and fund of funds. The trend was evident in the description of Lender Management's functions.
The case describes that Lender Management, in the tax years at issue, was a family office primarily devoted to managing investments for underlying investment LLCs held by family members. Lender Management's primary functions included advising on potential investment opportunities, monitoring investment positions, and determining appropriate investments based on the cash flow needs and investment tolerances of each of its advisees (the investment LLCs and their owners, the family members).
So with all of those varied functions that family offices serve, the take away is that no matter what the function the family office serves the purpose usually of a family office is to create economies of scale for the family, to reduce costs of services, to open up investment opportunities, to help to guarantee privacy, and to allow for greater family control over service providers.
Gabby Hirz: Christi, what are some of the primary structuring considerations which go into family offices?
Christi Lazo: Well as we just discussed Gabby, the functions of family offices vary widely and likewise family offices are formed in a variety of ways. The appropriate structure for a particular office will often depend on the office's principal functions, but also the dynamics of a particular family, the expected employee compensation structure for any employees of the family office, the tax planning motivations of the owners of the family office and any number of additional factors specific to a particular family.
For example, some of the questions a family will ask itself:
- Will the office primarily have an investment management function, or will it also handle administrative functions?
- If it will handle both, is the family intent on consolidating all functions in one entity, or could multiple entities be formed to bifurcate duties?
- Who will own and profit from the family office – all family members consistent with their ownership interests in the family's underlying wealth? Or will one family member take a lead role in managing the family office, and therefore be entitled to compensation above and beyond other family members for that role?
- Do all owners of the family office share exposure to tax in the same jurisdictions, or is the family a global family with different tax profiles for each owner?
- How many employees will the family office have, and how will those employees expect to be compensated?
- Is it expected that the family office will operate for a profit, or is break-even operation the goal?
- Is tax efficiency a primary motivator for the family, or are other concerns more important to prioritize?
These are just some of the factors to consider before settling on a particular structure for the family office.
Ultimately, some offices, like Lender Management, are structured as flow-through entities charging success-based fees for the management of investments for particular investment entities, allowing for different diversification among family members. But others are set up as corporations, not intended to generate a profit, and families contribute for the costs of operation on a pro rata basis. And, somewhere in the space between the different models, there's a variety of hybrids of either of these models. December 2017 tax legislation opened up an opportunity for family offices, like all entities, to reconsider their structure and its relevant tax efficiency. With reduced corporate rates, and new rules pertaining to deductions on "qualified business income" for pass-through entities, now is a good time for family offices to check in with their advisors on the appropriate long-term structure.
Gabby Hirz: Getting more into the details of the Lender Management case, Loretta, could you describe the importance of the decision, particularly under the new tax reform legislation?
Loretta Richard: Historically, the general rule for individuals was that expenses for the production of income, such as investment management expenses and tax-related expenses, such as tax preparation costs, were deductible as miscellaneous itemized deductions under Section 212 of the Internal Revenue Service Code. That means that they were subject to a 2% floor and could only be deducted if they exceeded 2% of adjusted gross income. It also meant they would not be deducted when computing any alternative minimum tax or AMT due. This rule was recently changed under the December 2017 tax legislation. The new legislation bars all miscellaneous itemized deductions from 2018 through 2025. As a result, investment expenses and expenses for the production of income under Section 212 will not be deductible at all during this period.
In contrast, business expenses under Section 162 of the Internal Revenue Service Code have always been fully deductible as we call it, "above the line" without any floor, and prior to computing the alternative minimum tax. As a result, particularly for tax years 2018-2025, it is much more significant to be able to categorize deductions as business deductions and not deductions for the production of income.
Gabby Hirz: How do these differences in tax treatment and the change in the tax law create planning opportunities for family offices?
Christi Lazo: Under longstanding law, an individual's management of their own investments is never considered a trade or business because that individual will not earn anything other than their own investment return. But, by aggregating the management of multiple individuals' investments, a family office creates the ability to transform what may otherwise be entirely non-deductible expenses for each family member into deductible ones by the family office. The rub is that for this structure to work, the family office must receive compensation other than the normal investor's return. This requires that the family office be paid for particular services provided. For example, in the Lender Management case, it was an important factor considered by the court that the success based fee paid to Lender Management did not equal the percentage ownership interests the respective owners of Lender Management had in the underlying investment LLCs. This fact meant that the fee paid to Lender Management represented something other than a normal investor's return on the investment LLCs' performance.
Gabby Hirz: Lender Management describes that during the tax years at issue, Lender Management predominantly managed two investment LLCs and received a profits interest or carried interest based on 2.5% of net asset value plus 25% of the increase in net asset value annually. As a result, Lender Management would receive compensation for its ownership interests annually, but only received compensation for its services if the LLCs generated net profits. How did that factor into the court's decision?
Loretta Richard: Well, Gabby the Court compared these facts to two prior cases that each had different outcomes. In one, called Beals v. Commissioner, the taxpayer did not receive any compensation at all for managing his family's investments and the Tax Court held he was not conducting a trade or business. In another, by contrast Dagres v. Commissioner, the company received management fees and profits interests and the Tax Court found that it was conducting a trade or business. In some sense, you could say that Lender Management fell between these two cases. However, the Tax Court in the Lender's case emphasized that the contingent nature of its profits interest did not alter the fact that the profits interest was compensation for services, particularly since the capital interest held by Lender Management was below 10%, so it ultimately found the facts of Lender Management were closer to the Dagres case.
Gabby Hirz: Loretta and Christi, are there other aspects of the decision you'd like to emphasize here?
Loretta Richard: Yes, Gabby. As we mentioned before, although the Tax Court did find for the family office here, it did apply heightened scrutiny to the facts of the case since nearly the entire structure involved members of the same family. Not only was Lender Management and the investment LLCs owned entirely by the members of the Lender family, but one of Lender Management's key employees was Keith Lender, the grandson of the patriarch of the company Marvin Lender, who was the original founder of Lenders' Bagels. The decision spent a good deal of time discussing both Keith Lender's credentials and his work in running the family office. The Tax Court noted that he had an undergraduate degree in business from Cornell and an MBA from Northwestern, and Keith Lender took continuing education classes in finance and market theory. The Tax Court described that he worked 50 hours a week, reviewed approximately 150 investment proposals per year, talked and emailed daily with the CFO of Lender Management, who was not part of the family, collaborated with an outside investment advisor, held an annual meeting for investors, and had detailed interaction with Lender Management's clients, discussing their investment needs and goals, and traveling to meet with them in person if they could not attend the annual meeting. The decision made it clear that Keith Lender, the CFO and other full and part time staff provided a high level of service and had considerable responsibility.
Christi Lazo: And to further Loretta's discussion on the strict scrutiny standard, another factor discussed under the strict scrutiny standard was the diversity of family members included in the investment LLCs and their ability to withdraw if they were dissatisfied. The Tax Court described that any investor who was unhappy with Lender Management could withdraw their funds from the management. It also stressed that the Lender family members were geographically dispersed, did not have all the same interests, or even get along. Some even refused to attend the same meetings. Now, I wouldn't encourage any family to feel like it needs to meet all of those facts to get a deduction. But the truth is no family is ever going to be perfectly aligned, no matter if they all enjoy each other's company. Each member will have different interests due to their investment horizon, risk tolerance, other personal, professional and financial goals, and unique relationship with the other family members. So, normal deviations between family members like this should be sufficient to qualify—no family feuding should be necessary.
Gabby Hirz: Do you think the result of Lender Management will apply to other family offices?
Christi Lazo: We started our discussion discussing the variety of functions and structures for family offices. So again, family offices come in all shapes and sizes and engage in a wide variety of activities. While Lender Management stands for the proposition that a family office can be successfully structured as a trade or business eligible for normal business deductions under section 162 of the Internal Revenue Code, it is a fact specific inquiry. And it's important to rest upon the fact that Lender Management may have been a particularly good facts case or favorable case, so family offices that don't have all the same facts may have trouble meeting the strict scrutiny standard, Loretta and I discussed. It is important for family offices to consult with an advisor to consider if their current structure should qualify or, if not, if restructuring would be possible to qualify.
Gabby Hirz: And how about the investment LLCs, will those be able to deduct business expenses under the Lender Management decision?
Loretta Richard: Gabby, it's important to stress here that the answer to that question would involve a completely different analysis. The Lender Management decision only involves deductions of expenses at the Lender Management level—including items such as salaries, rent, repairs and maintenance, depreciation, taxes and licenses, and employee benefits. Any investment expenses charged at the investment LLC level were not discussed in this case. For those expenses to be deductible, the individual investment LLCs would have to establish that they were carrying on a trade or business. Here it seems unlikely because the services provided and the amounts paid seemed to all take place at the Lender Management level. Setting up similar investment LLCs to benefit from business deductions would likely be a lot harder than for a family office, but it would depend on the particular facts at hand.
Gabby Hirz: Does Lender Management have any implications outside of income taxes?
Christi Lazo: It does, Gabby. The Lender management structure also offers a window into potential wealth transfer tax planning. An important factor in Lender Management's eligibility for the deduction under Section 162 of the Internal Revenue Service code was its operation for profit. The profit Lender Management earned, accrued to its owners.
Where the family office owner is not an individual, for example, but a trust for the benefit of family members which may be in lower generations, the profit earned by the family office can accrue for the benefit of those lower generations. This kind of wealth transfer of the family office's profits interest to the lower generations can be an added bonus to other wealth transfer planning in which a family may be engaged. Now careful advice should be taken on structuring of the ownership interests and on appropriate compensation of any family members working in the family office who are not also owners of the family office.
Gabby Hirz: Thank you, Loretta and Christi, for joining me in this fascinating discussion. We'll be back in July to discuss the next case of the quarter. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other notable tax developments as they arise. Thank you for listening.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.