The question of whether a family office meets the IRS definition of a trade or business for expense deduction purposes is far from black and white. In fact, it has taken a succession of court cases to provide at least some clarity, the most recent of which was decided in U.S. Tax Court in late 2018, following an out-of-court settlement the previous year. Still, there is no clearly defined test, though these cases are providing some definition. By understanding the decision and order for summary judgment rendered in these cases, you can work with your tax professionals to determine whether your family office is a bona fide trade or business that qualifies for expense deductions.
So, why the increased scrutiny? The Tax Cuts and Jobs Act suspended Section 212 miscellaneous itemized deductions but kept intact Section 162 deductions, which allow taxpayers to deduct ordinary and necessary expenses to carry on a trade or business. In the past, the IRS has typically determined that if a family office is managing its own investments, rather than those of outside clients, it is an investment company with non-deductible investment expenses. But it’s not that straightforward. The following two cases illustrate why.
Related Blog: No “Clawback” From Higher Estate and Gift Tax Exemption
Lender Management, LLC v. Commissioner
Keith Lender, who owned a 99% ownership interest in Lender Management, LLC, managed and directed the assets owned by three investment LLCs—all owned by family members or by trusts for the younger generations of the Lender family. Most of the family members, however, were not owners of Lender Management, which was operated as a for-profit LLC. Family members lived in various geographic locations, and some were not even in communication with one another.
The operating agreement was structured to allow Lender Management, LLC the exclusive right to direct the business operations of the investment LLCs, and to receive a profits interest in exchange for services rendered, including individual investment advisory and financial planning services. Pointing to the family’s size, assorted investment goals and the manager’s compensation structure, along with other factors, the Tax Court overruled the IRS and determined that Lender Management, LLC could be classified as a trade or business for the purpose of deductible expenses.
Hellmann v. Commissioner
Hellmann v. CIR, a case brought to the Tax Court but ultimately settled, concerns GFM LLC, a family office managed by four family members who are the sole owners of the corporation and oversee investment partnerships through various trusts. As in the Lender case, the petitioners in Hellmann wanted to claim ordinary business expense deductions for its operating costs. Although the case settled, it is helpful to understand five factors the Tax Court used in determining whether a family office is a trade or business, including:
- How the family office is compensated for its services
- The nature and extent of the services
- The amounts of expertise and time devoted by family office employees versus those of outside investment managers and consultants
- The individualization of investment strategies for different family members with differing investment preferences and needs
- The proportionality (or lack thereof) between the share of profits inuring to each family member in his or her capacity as an owner of the family office, and the share of profits inuring to that same individual in his or her capacity as an investor in the managed funds
The Tax Court seemed to be focusing on the percentage of the family’s ownership in the investment assets compared with its percentage ownership interest in the profits.
Reconsidering Lender, it is easy to see the differences between the two cases. Keith Lender managed assets for a profit for many family members, and the family members were geographically separated—not your typical single-family office scenario. Conversely, all four members of GFM LLC owned 25% profits interests and the same proportion in underlying investments assets. Given these differences, it’s not unreasonable to surmise that the Tax Court might have ruled in a different direction than it had in Lender. Perhaps the greatest difference is that Keith Lender was operating the business for a profit and to achieve the highest rate of return for assets under management.
As clearly different as these cases might be, they should only be used as guidance for family offices determining deductible expenses and whether there is a case to be made for restructuring their family office. Every situation is different and should be reviewed in detail with a CPA and business advisory firm with a dedicated family office practice.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.