Family offices aren’t new. More than 100 years ago, early multigenerational families created the antecedents of today’s burgeoning family office industry. The family office, an investment company that’s controlled by family members and manages assets owned by related family members, has become commonplace over the past 20 years, with industry growth accelerating.

The family office industry has matured over the past two decades. The family investment company that existed as a hybrid between a traditional wealth manager and a private equity fund developed its own accepted legal and tax framework. Families formed management companies tasked with overseeing administrative, investment and concierge activities. Some families created structures that resembled hedge funds, with complicated carried interests often used to incentivize managers recruited from multinational investment firms. Many of these vintage family offices have since transitioned to the next generation of family members and moved into the next phase of family succession and estate planning.

Almost 10 years ago, estate-planning attorneys began to chatter about family offices again. A case questioning the deductibility of a trade or business was working its way through the bowels of Tax Court with murmurs of an expected ruling, which arrived in early 2017 with Lender Management LLC v. Commissioner.¹ Beginning in 2018, the deduction for investment expenses under Internal Revenue Code Section 212 was temporarily eliminated.² In the years following the Lender decision, the market exploded, with thousands of families joining the small nucleus of family offices worldwide. As the industry matures, we review the tax issues facing family offices now and in the future.

Yesterday

Here are some of the past events that impact family offices today:

Lender Management Decision

The Tax Court opened the floodgates for family offices when it decided that Lender Management LLC (Lender Management) was in the business of managing investments, even when the investments consisted solely of the multigenerational Lender family’s assets. The now-famous ruling began with a challenge by the Internal Revenue Service that the deductions of Lender Management, a partnership that managed various funds owned by individuals and trusts for the benefit of 19 family members across three generations, were deductible as trade or business expenses under IRC Section 162.³

Lender Management was a small family office that managed the assets of the Lender family. The assets were held by three investment partnerships, operating akin to a “fund of funds.” Lender Management was managed by Keith Lender, its 99% owner (and son of one of the two brothers who created the family office). Keith and two other employees worked closely with a third-party investment manager that provided ongoing advisory services, although Keith maintained final approval of investment decisions. The company owned a 2.5% capital interest, received a 25% profits interest in exchange for its investment management services and wasn’t entitled to an asset management fee.⁴ During the years in question, Lender Management deducted compensation costs, rent, retirement plans and employee benefits as trade or business deductions under Section 162.

Lender Management wasn’t a trader, but primarily an investor in third-party funds. Its volume was consistent with its small size, with review of about 150 investments per year and consummation of only a few investments each year, but this was enough for the Tax Court to hold that the activities of Lender Management were similar to those of a hedge fund and its expenses would be deductible as trade or business expenses under Section 162, rather than subject to the rules of Section 212.⁵

Use of C Corporations (C Corps) to Structure Family Offices

Lender Management is more than eight years old and has become, dare we say, established law. Though many family offices used a comparable profits interest structure prior to the decision, the publicity around the case led many families to create or restructure their family offices to allow for the deduction of trade or business expenses. These offices now have years of activity to support trade or business treatment.

Family offices benefit from trade or business deductions through direct deductions of the manager. Expenses ranging from compensation and rent to aircraft expenses are deductible under Section 162 if the expenses are incurred in a trade or business, rather than as an investment activity. When is investing a trade or business?⁶ Aside from Lender Management, the sprawl of trade or business cases addressing investment activity provides little guidance.⁷ The trade or business doctrine adopted by the U.S. Supreme Court in Comm’r v. Groetzinger is too broad to easily determine trade or business treatment for a family office.⁸ When the facts don’t match those in Lender Management, how does a family office protect its preferential tax treatment?

In response to the uncertainty, many family offices have turned to C corps as the preferred family office manager structure. C corps aren’t subject to Section 212, and several rulings conclude that a C corp’s deductions relating to investment-type activities are deductible as business expenses.⁹ A C corp may be allowed a trade or business deduction for the same expenses that would be disallowed under Section 212.

Family office fund owners are typically subject to Section 212 for the payment of management fees to the fund manager. By shifting the manager’s compensation from a fee-based model, in which the fees are paid by the fund and subject to Section 212, to a carried interest model, in which income is allocated to the manager, the nondeductible expense morphs into a shift of income (of an uncertain amount). Thus, Section 212 doesn’t apply, and the fund owners, by receiving less income, have the effect of a deduction.

Trade or business issues and lender-type structuring dominated much of the past decade, but as these issues have become increasingly well-tread, family offices bring new issues for their advisors to ponder.

As part of a tax-efficient strategy, unwinding old funds and replacing them witih new ones remains highly effective and predictable.

Today

Here are some significant steps family offices are taking today:

Use of Private Placement Life Insurance (PPLI)

Family offices strive to invest efficiently, focusing on the holy grail of maximizing after-tax returns in generation-skipping tax-exempt trusts. Investment strategies that produce strong results for both income and estate tax purposes are rare, and when they arise, family offices pounce. PPLI is the next generation of this type of super-investment that can provide good returns and excellent tax outcomes. As PPLI has become more prevalent, family offices are exploring substantial PPLI investments. As advisors, we’re tasked with explaining the benefits and the challenges of PPLI.

The benefits of PPLI make many multigenerational investors salivate. The basic concept is that an investor acquires a life insurance contract designed to change in value based on the performance of its investments. The cost of the life insurance component inhibits the growth of investments, leading to a contract design with a lower insurance benefit. Assets in a PPLI structure grow tax-free as long as the contract remains in effect and will typically pay out tax-free to the beneficiaries at death.¹⁰ The payment of the life insurance proceeds to the beneficiaries will be in cash, which also has the effect of producing the equivalent of a step-up in basis for the recipients. Compared to typical estate-planning vehicles, policy beneficiaries receive cash instead of low basis investment assets that escaped estate tax but weren’t afforded a step-up.

A family office looks great when it can grow wealth tax-free while generating investment-level returns and pay out cash at the insured’s death. So what’s the hitch? PPLI comes with significant tradeoffs for investors. The first hurdle is that the family has no “investor control” in a PPLI structure and can only select among investment strategies available on the carrier’s platform.¹¹ Due to the “investor control” doctrine,¹² the policy owner is precluded from having a voice in the timing or selection of investments or transactions, other than a suggested approach. Family offices have often been unwilling to cede investment control for large PPLI policies. After all, families wouldn’t go through the effort of establishing family offices if they didn’t prioritize control over their investments. Accordingly, even the best PPLI strategy is typically allocated only a small percentage of a family’s overall balance sheet.

PPLI also remains an expensive investment. The minimum investment to make the strategy worthwhile has historically been $5 million or more, due to annual structuring fees, insurance company taxes and costs of insurance, all of which are added to the investment management fees tied to the investments themselves. Upfront structuring fees are estimated at 1% of the premium.¹³ Once the investment has been made, the family office can only access the assets through loans and often not at all during the policy’s early years.

Today, PPLI seems to be the hottest topic for investment-centric family offices. Family offices must weigh the benefits and risks of any PPLI investment, as decreasing costs have pushed aside previously insurmountable hurdles.

Managing Cash in the Family Office

There’s a time when the first generation of a family office decides to create a multigenerational investment company that will carry on the family legacy. There’s a later time when the clients of the family office, now comprised of many individuals, trusts and family partnerships, plus an investment management company with a meaningful carried interest, require cash to fund their needs. How do family offices access cash needed by their clients?

Income taxes are often the largest driver of distributions in the family office. Almost all family office funds are structured as pass-through entities, typically partnerships for tax purposes. Certain family members may need a disproportionate amount of cash to fund their lifestyle, investment or estate-planning needs, and the family office needs cash to fund its expenses.

A typical family office investment fund provides for discretionary tax distributions. Third-party funds treat all their investors the same when making tax distributions. Managers of a family office aren’t so lucky. Instead, some family members may be active in a legacy business or real estate. Some family members hold inherited interests and benefit from IRC Section 743(b) adjustments. A family owner may be subject to Section 704(c) gain when a legacy asset is sold.

It’s not always a good idea to require mandatory tax distributions for a family office. Tax distributions are treated economically as cash distributions and can change the economics of the underlying business. A disproportionate distribution may require complicated allocations due to the Section 704(c) revaluation rules or unintentionally trigger a revaluation and change an owner’s ownership percentage. Instead, family offices should create options that allow easy access to cash with fair economic outcomes for all family members.

Most family offices should establish a line of credit to allow family members and entities to access cash as needed. The line of credit could be with a bank or a family entity that has available liquidity. By allowing family members to borrow money to fund tax distributions and small cash flow shortfalls, family members can avoid being disproportionately affected by fund activities, without changing the economic relationship of the parties. In most cases, the loans would be repaid with future distributions.

One option that’s particularly popular among family office executives is a “cash partnership.” With this approach, the clients of a family office form a limited liability company, much like other family office pooled investment vehicles, except this one is funded with cash. As each owner withdraws cash, their share of the cash partnership decreases, but other members’ funds remain unaffected. This approach avoids the complexities of intrafamily loans and the payment of interest. Operationally, it also eliminates the need to add and remove family office employees as signatories from family member bank accounts and other hassles of family office cash management.

Tomorrow

Here are some issues family offices may face in the future:

Dealing With Deferrals

Family offices now looking at PPLI often hold other tax-advantaged funds. The most common is one that generates capital losses that help offset capital gains elsewhere, while maintaining good overall investment returns, allowing investors to reduce tax and satisfy their investment goals in a single package. While these investment options are advantageous, they aren’t a free ride because deferred taxes ultimately get paid. How should a family office deal with these tax traps on its current balance sheet?

Imagine an investment fund that’s formed by contributing cash in exchange for partnership interests that will be used to purchase marginable investments (for example, an investment in the S&P 500). The fund borrows money equal to about 1x the invested capital to acquire hundreds of long and short positions that effectively hedge market risk. As the market goes up and down, the long and short positions fluctuate, and the losers are sold and replaced with securities with similar characteristics. Even if the core investment, the S&P 500, goes up 20% per year, the losses from the long/short positions will generate significant tax losses each year.

After several years, the investor has no basis remaining.¹⁴ Additional losses provide no benefit, with losses limited under the at-risk rules. This tax deferral strategy leaves the investor paying substantial fees to manage a strategy with no future value. The kick-the-can strategy was successful but has reached the end of the line.

Selling is always an option. With no basis, the full fair market value would be taxable at liquidation. Basically, it creates a one-time reversal of the tax benefits that took years to generate. The family could replace the original loss fund with a new one and continue kicking the can farther down the road. As part of a tax-efficient strategy, unwinding old funds and replacing them with new ones remains highly effective and predictable.

Like other family businesses, the third or fourth generation owners of a family office have to be willing to remain in business with distant relatives.

A natural reaction is that this zero-basis asset would be an ideal candidate for charitable giving, but charitable contributions of this type of fund are particularly inefficient. The leverage used to acquire the long/short positions means that the investment is subject to liabilities. Thus, the contribution of the fund interests is subject to the bargain sale rules under Treasury Regulations Section 1.1011-2, resulting in an inefficient contribution that generates little tax benefit.

A better result may be reached if the fund is retained in a taxable estate. At the cost of estate inclusion, the basis step-up alleviates the deferral. A zero-basis fund interest held in a grantor trust is an ideal asset for the grantor to swap out of the trust. While these tax strategies offer appealing near-term results, family offices will be looked to for recommendations on how to unwind them eventually.

Unwinding and Dividing Family Offices

What we create today, we restructure tomorrow. The family office is typically structured as a perpetual organization, intended to manage the family’s assets for many generations. The founder’s good intentions, however, may lead to conflict in later generations. Sometimes, the family branches want to go in their own direction to pursue different investment philosophies or avoid interpersonal friction. For the more recent vintage of family offices, some may have failed to evolve into the vision of their founder. They may have never found the investment talent or lacked the commitment of family members. Sometimes, the family office is wound down after the family concludes that a single family office is too expensive.

Like other family businesses, the third or fourth generation owners of a family office have to be willing to remain in business with distant relatives. A founder with children and maybe grandchildren morphs over time into a labyrinth of trusts and entities, owned by groups of cousins. Older family offices transition from distant cousin to distant cousin. With such a disparate group of clients, it can become difficult for the family office to be all things to all clients. Should the office focus on direct investments, tax planning or concierge services? At this stage, one or more factions of a larger family may leave the legacy family office to start a new family office. Extricating oneself from a legacy family office is often more complex than anticipated.

The family office that’s too small or has no successor eventually unwinds. Income taxation isn’t typically a significant problem. The distribution of assets by a family fund is typically tax-free under IRC Section 731, except for distributions of money (including marketable securities) to the extent exceeding the distributee’s basis. Disproportionate interests in business assets may contend with IRC Section 751 gain attributable to distributions of “hot assets” (that is, business assets that, if sold, would generate ordinary income rather than capital gains). Typically, family members have sufficient basis to receive a full distribution of their interests without adverse tax consequences.

The liquidation of the family office entity won’t be tax-free if it was structured as a C corp. If the manager ceases to be a trade or business and continues to hold investment assets, it could run into accumulated earnings tax issues.¹⁵ Fortunately, even if the family office is a C corp, it’s often thinly capitalized, so the expense of liquidation is typically manageable.

The best solution for many family offices that can’t manage effectively on their own is to join a multifamily office. Even simpler, a third-party manager can replace the existing manager and retain the existing ownership structure.

Splitting family office assets becomes a complicated economic problem. Should assets like real estate or business interests be divided, or should family members select the assets they want? How should family members deal with the inherent tax attributes of transferred assets? Post-division transition agreements and governing documents remain in place, sometimes long after the family has split apart. And finally, if the goal is full financial separation, that often isn’t possible when multigenerational trusts require centralized management by the trustee.

While family offices were a niche corner of the investment management market just a few decades ago, they’ve grown into an established and significant presence today. As the family office industry continues to grow, their need to address complicated planning continues.

Endnotes

1. Lender Management LLC v. Commissioner, T.C. Memo. 2017-246.
2. All section references used in this article refer to such section of the Internal Revenue Code of 1986, as amended or the Treasury regulations promulgated thereunder.
3. Internal Revenue Code Section 162 provides that a deduction is allowed for ordinary and necessary business expenses incurred in a trade or business.
4. Supra note 1. The company restructured in 2011 because compensation prior to that date was too low to incentivize management. Lender Management LLC (Lender Management) received 2.5% of net asset value (an increase in its capital), together with the 25% profits interest, but it was no longer entitled to a fee. The court noted multiple times that Lender Management didn’t receive fees similar to those in Dagres v. Comm’r, 136 T.C. No. 12 (2011) and that Lender Management received payment only if the investment limited liability companies earned net profits.
5. IRC Section 212 allows deductions for ordinary and necessary expenses incurred for the production of income, or conservation of property, including investment management expenses. Until 2017, deductions under Section 212 were allowed as an itemized deduction to the extent they exceeded 2% of adjusted gross income. With the passage of the 2017 Tax Cut and Jobs Act, the deduction was suspended through 2025.
6. For a detailed discussion of the trade or business of investing, see 880 T.M. “Family Offices, IV.D.2 Operating the Family Office Manager: Treatment as a Trade or Business,” https://go.bloombergtax.com/ product/tax/document/spa/32843371048.
7. See, e.g., Levin v. United States, 597 F.2d 760 (Ct. Cl. 1979) (investing activities of a single individual treated as a trade or business). But see Estate of Yaeger v. Comm’r, T.C. Memo. 1988-264 (under similar facts, investor wasn’t a trade or business); Moller v. U.S., 721 F.2d 810 (Fed. Cir. 1983), rev’g 553 F. Supp. 1071 (1982) (full-time investing activities for own holdings wasn’t a trade or business because their economic return was more like an investor).
8. Comm’r v. Groetzinger, 480 U.S. 23 (1987) (to be engaged in a trade or business one must be involved in an activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit); see also Higgins v. Commr, 312 U.S. 212 (1941) (this case concludes that merely managing one’s investments, without more, doesn’t constitute a trade or business, but didn’t preclude the possibility of managing one’s own investments as a trade or business. Groetzinger affirmed that Higgins remains good law. However, we don’t know how much of its holdings remain valid today).
9. See 880 T.M. “Family Offices,” supra note 6, at II.C (noting that a family office manager formed as a C corporation that engages in substantial activity could rely on Revenue Ruling 78-195 to deduct its expenses as trade or business expenses under Section 162).
10. IRC Section 101; Treasury Regulations Sections 801-818. Private placement life insurance is typically structured using assets that are outside of taxable estates; otherwise, the growth would remain subject to estate tax in the beneficiaries’ estates.
11. See, e.g., Webber v. Comm’r, 144 T.C. 17 (taxpayer had incidents of ownership over insurance policies when he directed the investment manager who only took the insured’s instructions and took no other activity in its investment manager capacity).
12. The basic effect of the “investor control” doctrine is that the investor doesn’t have the power to direct investments, vote shares, exercise options or extract cash.
13. Trevor J. Hamilton, “Private Placement Life Insurance: A Potential Tool for Tax Efficiency and Wealth Transfer,” www. bessemertrust.com/sites/default/files/2019-04/04_30_19_BT_CL_ PrivatePlacementLifeInsurance.pdf.
14. At formation, the investor’s basis is equal to the cash contributed under IRC Section 722. Each year, as the various positions move against the market, those positions are sold and replaced by a “pair” that mimics the economic activity (for example, Coke vs. Pepsi). The hedges are also built with the longs and shorts having similar characteristics to mitigate market risk. These sales create losses, which pass through as short-term capital losses or long-term capital losses to the investor and reduce the investor’s basis to $0. In typical funds, this will take about three or more tax years.
15. This remains true even if the corporation makes an S corporation election if the corporation has earnings and profits.

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