Family offices compete for talent with the top investment advisory firms, investment banks, law firms, accounting firms, other family offices, and other organizations. These talented service providers are typically sophisticated and well aware of tax-efficient and creative ways that individuals are compensated in the general marketplace (including private equity and hedge funds).
This article discusses various considerations relating to compensating employees of family offices in a tax-efficient manner.
Dual Capacity (Employee-Partner) Issue
Last year, the IRS doubled down on its position that an individual cannot be both an employee and a partner in the same tax partnership (including a limited liability company that is taxed as a partnership); this is the so-called “dual capacity” issue. Specifically, on May 3, 2016, the IRS issued temporary regulations that provide, among other things, that an individual cannot be a partner in a partnership and an employee of any partnership subsidiary that is disregarded for federal income tax purposes. See Temporary Treasury Regulation §301.7701-2T(c)(2)(iv)(C)(2) (May 3, 2016).
Prior to these regulations, because disregarded entities are regarded for federal employment tax purposes, some practitioners (the authors excluded) believed that the dual capacity problem could be avoided by having a disregarded entity subsidiary act as the employer.
So, why is the dual capacity issue important for family offices? As discussed below, family office employees may own equity in investment or operating partnerships alongside family members and family trusts. The family may desire to pay a salary with or without a cash bonus to these employees from the same investment partnerships (or from disregarded subsidiaries of these partnerships).
Under the IRS’ view, any salary or bonus from a partnership (or disregarded subsidiary) in which the employee also owns equity is a “guaranteed payment” under Section 707(c) of the Internal Revenue Code (the Code) and, as a result, the employee would be responsible for paying both the employee and the employer portion of self-employment taxes (rather than have W-2 withholding). Among other potentially adverse consequences, the employee might be disqualified from certain benefit plans, including “cafeteria plans” under Code Section 125.
We expect to see the continued use of equity to deliver tax-efficient compensation to family office employees while aligning the economic interests and incentives of the family and the family office’s key employees.
Luckily for family offices, private equity funds and their tax advisors have developed structures to mitigate the impact of the dual capacity issue on their management teams, including using tiered partnerships and S corporations. Family offices should consider consulting their own tax advisors to discuss the potential impact of the dual capacity issue on their key employees and to explore potential structural workarounds.
Deferred Compensation Arrangements
Although nonqualified deferred compensation arrangements require careful planning and structuring for legal compliance, they offer significant flexibility for compensating key employees. Importantly, nonqualified deferred compensation arrangements must benefit only a top paid or key management group in order to be exempt from the strict legal requirements of the Employee Retirement Income Security Act of 1974 (ERISA), as amended. In addition, such arrangements must comply with the detailed regulations under Code Section 409A. In general, Code Section 409A provides that amounts deferred by either the employer or the employee on a tax-deferred basis must be paid out in a certain form of payment (e.g., as a lump sum or in installments) and at a specified time (e.g., upon separation from service or at a specified age).
Code Section 409A severely restricts a family office’s ability to change the form and timing of an already established payment arrangement. Therefore, it is imperative to take great care in structuring such arrangements to avoid a twenty-percent penalty tax on Section 409A violations. One increasingly common arrangement in the family office space is to have a deferred compensation plan balance notionally invested in family office investments. This strategy allows the office to provide a key employee with access to family investments and a quasi-equity ownership interest without issuing actual equity to him or her.
Considerations Regarding Employee Equity
The 2017 Tax Cuts and Jobs Act enacted new Code Section 1061, which did not completely close the so-called “carried interest loophole,” but rather merely requires a three-year holding period for capital gain treatment with respect to certain “applicable partnership interests” (so-called “carred interests”). In our experience, family offices often use carried interests (also referred to as “profits interests”) to incentivize and reward employees in a tax-efficient manner with respect to a particular investment or a portfolio of investments. Although family offices will need to monitor whether a particular carried interest is an “applicable partnership interest” under Code Section 1061, and whether structuring alternatives might exist to mitigate the potential application of Code Section 1061, we would expect that family offices will continue to use carried interests as incentive tools even after the enactment of Code Section 1061.
In addition to traditional carried interests, we are seeing more family offices providing co-investment opportunities or using “hybrid” equity interests for service providers (i.e., interests that require a capital contribution but with profit participation that is disproportionally large compared to the percentage of contributed capital). We expect to see the continued use of equity to deliver tax-efficient compensation to family office employees while aligning the economic interests and incentives of the family and the family office’s key employees.
Patrick J. McCurry and Todd A. Solomon are partners in the law offices of McDermott Will & Emery LLP in Chicago.