As a family grows and transitions toward succeeding generations, not all family members may be interested in or have the skills appropriate to managing the family’s assets. At the same time, the family’s assets may be chunky, or it may be difficult or undesirable to divide the assets to give each family member direct possession of his or her allocable share. In such cases, it often falls to one family member to manage the family’s assets on behalf of all family members. In other cases, the family may hire professional help.
In this article, the “family office” under consideration is the entity, comprising family members or professionals or both, that provides such management services to the family members and their trusts or holding companies.
Purposes and Types of Family Offices
Family offices serve various purposes depending on the family—investment management, household and day-to-day concierge services, and coordination of philanthropic efforts. Some purposes relate to the family business, whereas others are personal. Each purpose may require differing levels of involvement from family members. Some family members may even be employed by the family office. Each option involves certain costs, and many families will seek to have as much of those costs as possible deducted against their taxable income.
Depending on the service, incurred costs may be charged to the recipients of the service on a pass-through basis or may be covered through income generated by the family office from various sources. For example, if a family member uses the family jet to take a vacation, the salary of the pilot the family office employs to fly the jet may be reimbursed by the family member out of his or her share of the family’s assets.
On the other hand, if the family holding company hires an investment advisor to trade its assets, the resulting advisory fees may simply be paid by the family holding company. By extension, if the family office itself employs a portfolio manager and a staff of analysts, those persons could be paid by the family office out of advisory fees that the family holding company pays to the family office.
In these examples, the vacationing family member probably cannot deduct the pilot’s salary, because vacation expenses are usually not eligible for a tax deduction. Similarly, the advisory fees paid by the family holding company, whether paid to an outside investment advisor or to the family office, are probably not deductible by the family holding company because they are incurred to manage the family holding company’s own investments, and that likely would be a miscellaneous itemized deduction no longer allowed in light of the Tax Cuts and Jobs Act of 2017. However, in certain circumstances the salaries of the portfolio manager and analysts paid by the family office might be a deductible expense of the family office.
One interesting aspect of the family office is its potential ability to deduct as business expenses certain costs regularly incurred in connection with the management of the family’s investments and other activities that, if paid by the family members themselves, might not otherwise be deductible.
In the profits interest model, a share of each family holding company’s taxable income is allocated
away from the family holding company and to the family office.
“Trade or Business” of Family Office
Section 162 of the U.S. Tax Code generally allows the deduction of all ordinary and necessary expenses that one incurs in conducting a trade or business. Although many individuals and families make investments and incur costs with respect to those investments, overseeing the management of one’s own investments is generally not considered a trade or business. However, managing the investments of others for a profit can be a trade or business, as can other activities typically conducted by a family office.
The U.S. Tax Court recently addressed the trade-or-business question in the context of a family office in the Lender Management LLC case. In its decision, the court outlined roughly six factors that are relevant to considering whether a family office’s activities qualify as a trade or business under Section 162:
- the family office conducts its activities with continuity and regularity (as opposed to as a sporadic activity or hobby) and in good faith for the purpose of making a profit, even if a profit is not achieved every year;
- the ownership and control of the family office is not the same as the ownership of the family holding companies or portfolios that receive services from the family office;
- the family holding companies or family members served by the family office are able to make judgments to fire or replace the family office, or to reduce the level of services provided by or compensation paid to the family office, similar to relationships that might be had with unrelated third parties;
- the family office engages service providers, or various employees or consultants who may or may not be family members, who in each case are qualified to provide the services for which they are engaged and who could provide those services to another nonfamily business;
- the family office is compensated separately from and in addition to what it would achieve as a normal investment return on its assets; and
- the family office has an obligation to provide services, and actually does provide those services, to the family holding companies or family members.
In other words, as the court in Lender Management LLC summarized, for a family office to be considered as conducting a trade or business for purposes of Section 162 of the Tax Code, the family office must carry on “its operations in a continuous and businesslike manner for the purpose of earning a profit, and it [must provide] valuable services to its clients for compensation.”
Family Office Revenue and Tax Reduction
Of particular note in Lender Management LLC is that the revenue of the family office consisted substantially of profits interests in the family holding companies along with some fees paid by the family holding companies. In the profits interest model, a share of each family holding company’s taxable income is allocated away from the family holding company and to the family office. This income is then taxable to the family office rather than to the family holding company. This differs from a fee-based model in which the fees paid to the family office by the family holding company would still be taxable income of the family office but likely would be investment expenses paid for the family holding company’s own account, rather than trade or business expenses, and therefore also taxable to, or at least not deductible by, the family holding company.
Thus, a principal tax advantage of using a family office along the lines described above—one that conducts a trade or business for purposes of Section 162 and that receives revenue in the form of profits interests—is that many expenses ordinarily incurred by the family members or a family holding company but not deductible by those family members or the family holding company may become deductible when paid by the family office, and those expenses can be deducted against taxable income that is allocated away from the family members and not subject to tax in their hands or, because of the family office’s trade or business deduction, in the hands of the family office, either.
Andrew Lom is a partner at Norton Rose Fulbright in New York and is its U.S. co-head of asset and wealth management.