In 2017, the Tax Cuts and Jobs Act eliminated the income tax deduction for investment expenses through the year 2025, leading many family offices to look for new ways of reducing costs.1
One option is for the family office to convert from a cost-basis model to a profit-based model, which might allow it to classify its operating expenses as “ordinary and necessary expenses incurred in a trade or business." This would make those expenses tax deductible.2
However, in order to take advantage of this, a family office must be properly restructured as a management company to demonstrate its status as a bona fide business. Two important Tax Court cases — Lender Management LLC v. Commissioner and Hellmann v. Commissioner — provide a clear sense of what a family office needs to do to achieve this and properly convert expenses that are currently non-deductible into fully deductible trade or business expenses.
The Internal Revenue Code does not define the terms “trade or business." Whether a particular activity falls under the umbrella of “trade or business" is thus determined on a case-by-case basis.
There are, however, some precedents to consider. For instance, it has been established that in order to be engaged in a trade or business, a taxpayer must be involved in the activity “with continuity and regularity" and that the primary purpose of the activity “must be for income or profit."3 Furthermore, investors are not considered to be engaged in a trade or business when managing and monitoring their own investments.4
The Lender and Hellmann cases offer further clarity for family offices interested in navigating these distinctions.
In 2005, the Lender family reorganized its family office, creating Lender Management LLC. In a 2017 ruling, the Tax Court held that Lender Management's activities, which involved providing investment management services to others (i.e., family members who did not have an ownership interest in the management company) for profit, were sufficient to constitute a trade or business, allowing it to fully deduct trade or business expenses.
In 2018, the Hellmann family sought similar recognition for its management company, GF Family Management, LLC (GFM). However, the Tax Court refused to issue a summary judgement, instead requesting further factual development, either through a trial or stipulated facts. Believing they would not prevail under these circumstances, the Hellmann family relented, paying the tax they owed and abandoning their effort to be recognized as a trade or business for tax purposes.
From these outcomes, we can glean several important guidelines that family offices should be mindful of when considering restructuring as a management company.
The management company must provide services beyond just investing assets, and have the personnel and expertise to do so. Primary decision-making for investments should rest with the management company.
In Lender, the Tax Court found that Lender Management did substantially more than just keeping records and collecting interest and dividends. In fact, the company provided one-on-one investment and financial planning services to family members. Furthermore, the Chief Investment Officer for Lender Management, Keith F. Lender, satisfied the expertise criteria, having an undergraduate degree in business from Cornell and an MBA from Northwestern. He headed up a team of five employees with an annual payroll of over $300,000 who made investment decisions based on the goals and needs of their family member clients.
Compensation paid to the management company must be greater than a normal investment return, and the taxpayer's ownership of the management company should not be in proportion to their interest in the investment partnership.
This was the major sticking point in Hellmann. Each family member had a 25% interest in the management company. They also each had a 25% interest in the assets being managed by the associated investment partnerships. Because these two streams of income were perfectly proportional, the compensation paid to GFM effectively replaced the investment income each family member would've derived from the investment portfolio.
This was not an issue for Lender Management. Keith Lender owned 99% of the management company, but only a minority interest in the associated investment partnerships. The 25% profits interest and the 2.5% fee on assets under management in the LLCs payable to Lender Management indicated that the management company was receiving a discrete fee for services provided to others and not simply a return on its own investment.
Ideally, no family member would have an ownership interest in the management company; if necessary, it should be limited to just a few family members.
The family should not be especially cohesive or concentrated.
Lender Management provided individualized service to a large, geographically distributed family with diverse needs. Many of the family members did not know one another, and those who did were not always in agreement. Some conflicts were so severe that the members involved refused to attend meetings together. As such, the family in Lender did not act collectively or with a singular goal in mind, and Lender Management did not make decisions for the family as a group. Rather, it treated them individually, addressing their specific needs and risk tolerances.
In Hellmann, the circumstances were almost exactly the opposite. GFM represented only four family members, all of whom lived in the Atlanta area and got along well with one another.
The family members should be free to withdraw their capital interest and hire different investment managers.
Lender Management allowed its clients, the family members, to terminate its relationship with the investment partnerships at any time, subject to liquidity requirements. This means that family members were free to seek investment management services from a different provider if they were unhappy with the management company's investment performance.
From these two cases, we can see that the Tax Court is predominantly concerned with the nature of the services provided by the management company, and the family members' relationships with the management company and among themselves, when determining whether a family office is eligible to deduct operating expenses. A management company that has a qualified staff of employees, accepts fees for individualized services and is largely independent from the familial client base it serves should be able to make the case that it is operating as a trade or business and is thus entitled to deduct its operating expenses.
1 Per Section 67(g) of the Tax Cuts and Jobs Act of 2017
2 Per Section 162 of the Internal Revenue Code
3 Commissioner v. Groetzinger, 480 U.S. 32, 35 (1987)
4 Whipple v. Commissioner, 373 U.S. 193 (1963); Higgins v. Commissioner, 312 U.S. at 218 (1941)
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