Is Your Company’s Tax Department a De Facto Family Office?

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Many of today’s family offices began as the back office of a privately held company. In such companies, tax department staff members often provide services to the company’s owners and become indispensable. As a result, long after the operating business is gone, the back office lives on in the form of a family office. But when the family’s business is still alive and well, what should the company do to ensure that its internal tax and treasury functions can peacefully coexist with family-related services?

In reviewing some of the risks of providing services to owners through the company’s tax department, this article recommends developing a written policy to govern the provision of services and discusses points to consider when developing such a policy.

Typical Fact Pattern

A privately held business is often owned by multiple generations of a single family and perhaps by trusts for their benefit. The company’s CFO and tax office prepare income and cash flow projections for the company, which are often relevant to the owners’ taxes, especially if the company is taxed as a pass-through entity. In such cases, it is reasonable and practical for the company to become involved in preparing the owners’ tax returns and planning cash flows. Over time, however, additional functions may get layered in, such as advising owners on tax issues unrelated to company income, preparing personal cash flow statements and balance sheets, preparing credit reports for personal mortgage applications, reviewing contracts for home purchases and renovations, preparing payroll for household employees, and eventually providing “concierge” services such as bill payment. This mission creep may occur gradually, making it hard to notice and harder to resist.

Risks to the Company

Providing services to shareholders can create a variety of potential problems and risks for the company. Perhaps the most pervasive problem is that company resources get diverted from important company matters to matters that are important only to individual owners. It is hard for tax staff to refuse a request from an owner, especially if the owner is also an officer of the company. Often, staff will try to satisfy the needs of both the company and the owner, but there are limits to how much they can do, and spreading staff too thin can result in mistakes or missed tax-saving opportunities.

Another potential problem is that providing services to owners can increase company expenses and decrease profitability. Owners will request more services if the company pays for such services at no out-of-pocket cost to the owner. Although an owner will pay indirectly for such services through reduced profits, he or she will bear only the percentage of costs proportionate to his or her ownership interest in the company. Moreover, a perception often exists that the marginal cost of services is zero, because existing staff, who are generally salaried employees, are called upon to provide the services. Nevertheless, increased demands by owners require either that additional staff be hired or additional expenses be incurred, or that existing staff spend less time on company matters and more on owner matters.

There are also potential liability risks in providing services to owners. If company staff miss a tax compliance deadline, provide tax advice that produces a poor outcome, or otherwise act in a way that financially harms an owner, that owner may seek compensation from the company. Although this scenario is unlikely when owners are few and relations between the family and the company are close, the risks can grow over time as the family expands and relationships become more attenuated.

Finally, there are family political issues. Everyone wants to feel that he or she is being treated “fairly,” and perceptions of unfairness can arise when some owners believe (rightly or not) that others receive more services than they do. Sometimes family members or family branches wage disputes by proxy through conflicts over company resources, including services. Such conflicts can divert even more resources from company matters, as the tax office staff spends time navigating the potentially treacherous waters of family politics.

Recommendation: Written Policy for Providing Services

The key to reducing risks and conflicts is for the company to develop a written policy detailing which services it will and will not provide to owners, which services owners will need to pay for personally, and how the company will handle any personal and financial information that owners provide. To be effective, such a written policy must be distributed not only to staff but also to owners.

When deciding what services to provide, it is helpful to begin by determining what services have been provided in the past. Each member of the staff can prepare a list of the services he or she has provided to owners in the previous year. These services can be grouped into categories, such as income tax preparation, personal financial reporting, and concierge services. Staff can then estimate how much time employees spent on these matters during the year.

Who decides what services will be provided? While any corporate officer with the authority to set policy can make this decision, it will carry more weight politically if it is made by a committee drawn from multiple constituencies. For example, the decision could be made by a three-person committee including a nonfamily member who serves as the company’s CFO, CTO, or treasurer or in a similar role; a family member who is a senior officer and an employee of the company; and a family member who is neither a company officer nor an employee. Such a committee will represent the relevant constituencies and will likely produce a better outcome than a policy implemented by a single decision maker.

Some factors to consider in deciding which services to provide to owners include the capacity and skills of existing staff, the liability risks, and the tax-deductibility of the expense. To some degree, these factors are interrelated. The first question to ask is whether the company’s existing staff has sufficient time and expertise to provide the services that owners want. Providing tax advice to individuals, for example, may require different expertise than what staff were hired for originally. Often staff has developed this expertise through continuing professional education and experience, but creating a policy provides an opportunity to reassess. To do otherwise could expose the company to potential liability claims if things later go wrong.

Another factor to consider is whether a company can deduct the costs of providing a service to owners among ordinary and necessary business expenses under Section 162 of the Internal Revenue Code, expenses that would not be deductible if incurred by the owner as an individual taxpayer.

Clearly, if the cost of services is deductible at the company level but cannot be deducted by individual owners, then such services should be provided by the company, all other things being equal. For services that the company cannot deduct, the company should consider either not providing such services at all or charging owners for them. Charging fees can also reduce the volume of services requested by owners, thereby reducing costs and freeing up staff for company-related matters.

Determining which owner-related expenses are deductible and which are not can be murky. If a company is organized as a pass-through for income tax purposes, it should be able to deduct the significant cost of income tax preparation for its owners, because so much of each owner’s individual income tax return relates to tax information flowing from the company. (See Rev. Rul. 92-29, 1992-1 CB 20.) However, the arguments for the deductibility of certain other expenses may be more complex. Moreover, if a company is organized as a C corporation, there is a question not only about whether the company can deduct costs for owner-related services, but also about whether such expenditures constitute a constructive dividend taxable to the owner for whose benefit such services were provided. Ultimately, the tax treatment of expenses comes down to the facts and circumstances of the particular situation. However, when a company determines which services to provide, it may benefit from explaining why such services are provided and how they will benefit the company.

Finally, if owners provide financial and other sensitive information to the company’s tax department, it is important to have procedures in place to protect that information from outside parties and people in the company outside the tax department. In a typical company, the CEO has access to all tax records, but in a family-owned company, the CEO is usually a family member, and other family owners may not want to share all of their own information. If the company’s tax office has been providing services to family members for a year and has established a course of dealing with respect to such information, then it should be sufficient to have a written policy that memorializes those expectations regarding who will have access to the owners’ personal information.

Once a written policy is approved, it should be circulated to all affected staff and owners. If the written policy differs from what the owners have grown to expect, it may be helpful to explain the policy and reasoning behind it at a regularly scheduled meeting of the owners. After all, the company belongs to the owners, so it is important that they understand how such a policy is ultimately for their benefit.

H. Carter Hood is a partner at the law office of Ivins, Phillips & Barker CHTD in Washington, D.C.

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