Structuring Your Family Office for Maximum Tax Benefit

Family Offices have long struggled with maximizing the deductibility of their asset management and operating expenses. The Tax Cuts and Jobs Act (TCJA) eliminated the deductibility of investment, accounting, tax and similar advisory fees, which has exacerbated this issue.

A common workaround is to structure the family office as a business entity that can fully deduct these fees as “trade or business” expenses under Internal Revenue Code (“IRC) §162.

Based on recent case law, this is an effective and completely legal way to achieve tax savings, which otherwise have been severely impacted by the TCJA. Nevertheless, the strategy is not as straightforward as it seems. Properly structuring the family office and its operations is crucial to realizing the intended tax benefits.

The best example of structuring a family office to achieve the intended tax savings is outlined in Lender Management LLC, T.C. Memo. 2017-246. Lender Management, LLC was managed and owned by the grandson of the founder of Lender Bagels. The grandson owned a 99% interest in the LLC, with his father owning the remaining 1%. The LLC directed the investment and management of assets owned by three other family members’ investment LLCs. Lender Management received a profits interest in each of the investment LLCs in exchange for the investment management services it rendered.

Most of the family members who invested in the investment LLCs were not owners of Lender Management, LLC. Likewise, the grandson and his father had little economic interest in the investment LLCs that the family office managed. The family office also invested its own funds in the investment LLCs, providing less than a 10% capital interest in each. The family office thereby was entitled to distributions and allocations just like any other member.

The operating agreements of the investment LLCs allowed Lender Management, LLC the exclusive right to direct their investments. The members of the investment LLCs could withdraw their capital at any time, subject to liquidity constraints.

Based on the family office’s structure, business-like activities and profit motive, the court ruled in favor of the taxpayer. It found that the activities of the family office rose to the level of a trade or business and as such the expenses were deductible under IRC §162.

A noteworthy example of an ineffective strategy for deducting investment expenses through a family office structure is outlined in Higgins v. Commissioner, 312 U.S. 212 (1941). The facts of this case demonstrate that the regularity of activities alone – with the absence of a business purpose and profit motive – is insufficient to prove eligibility for IRC §162 deductions.

In Higgins, a resident of Paris, France attempted to deduct expenses incurred by a family office maintained in New York that managed his real estate and investment affairs. The IRS did not contest the deductibility of expenses incurred with respect to the real estate activities. However, it challenged the “trade and business” component of the office’s investment management activities, which included keeping records, receiving securities, interest and dividend checks, making deposits, forwarding weekly and annual reports and following the investment instructions of the owner.

The court sided with the IRS, disallowing the deduction of expenses incurred for management of the taxpayer’s own stocks and bond portfolio. It ruled that no trade or business existed because “mere personal investment activities never constitute carrying on a trade or business, no matter how much of one’s time or of one’s employees’ time they may occupy.”

The court pointed to the fact that the purchases were made by a financial institution, and the taxpayer “did not participate directly or indirectly in the management of the corporations in which he held stocks or bonds.”

Family office owners looking to structure operations to deduct operating expenses as IRC §162 trade or business expenses can draw several conclusions from these cases, including:

  • Deductible trade or business expenses are those incurred by an actual business activity that is conducted regularly, at arms-length and in a business-like manner. (Ideally, as in Lender, a responsible family member or stakeholder remains involved in all activities of the family office.)
  • Activities conducted primarily for the management of one’s own capital do not qualify as a “trade of business,” and its expenses are not deductible under IRC §162. (Note that the owners in Lender were not primarily engaged in personal investment activities.)
  • The intention to earn a profit is supportive of the “trade or business” standard. (A corresponding revenue source for the family office in the form of a “profits interest” was present in Lender.)
  • Operating agreements, even among family members, should clearly explain the relationship between the family office and related entities and lay the groundwork to establish the office’s role as a trade or business. It is imperative that the nature of the family and the family office’s relationship, roles, and scopes of authority be memorialized.
  • The quality and quantity of evidence supporting that the family office is organized and operates as a “trade or business” is important. (While a family office might be hard-pressed to establish as many justifications as in Lender, the supporting facts must be considered and evaluated before determining a family office operates as an IRC §162 “trade or business.”)

As helpful as Lender is as a guide for family offices, it does not encompass all necessary components of a tax-efficient family office structure. There are many other considerations that need to be made to achieve the desired tax treatment.

One of the most important is the choice of tax entity. C-Corporations are particularly attractive, due to the 21% flat income tax rate under the TCJA but have their own set of issues relating to other potential tax traps. Partnerships, S-Corporations, sole proprietorships and disregarded entities each have their own unique pros and cons.

Family offices should also be aware of avoiding burdensome SEC registration and reporting requirements imposed on other investment advisors. This requires qualifying for the family office exemption by limiting family office clients and owners to family, as defined in SEC regulations.

Grassi advisors can help guide you through structuring, setting up, and operating your family office to achieve maximum tax efficiency.

Lisa Rispoli Lisa Rispoli is the Partner-in-Charge of Trust & Estate Services at Grassi and leader of the firm’s Private Client Services group. She has over 30 years of experience in accounting, estate planning & valuation, as well as gift, estate and trust taxation. Lisa is adept at working with clients and their professional advisors to develop estate plans to transfer family, business and personal wealth... Read full bio

Rozleen Giwani Rozleen Giwani, CPA is a Tax Partner at Grassi, where she focuses on tax planning and preparation services for family offices, high-net-worth individuals and closely held businesses. She has spent more than 18 years advising high-profile and ultra-high-net-worth individuals, multi-generational families, CEOs, executives and entrepreneurs on achieving their full tax-savings potential. As a leader in Grassi’s Family Office practice, Rozleen leads ultra-high-net-worth families and... Read full bio