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Warner Norcross + Judd LLP is a corporate law firm with over 230 attorneys serving clients in nine offices throughout Michigan. Among the largest law firms in Michigan, Warner works in virtually all areas of business law.

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Two events in December 2017 present new tax challenges for family offices and provide a reason to evaluate the structure of the office and the current classification of family office expenses. One is the US Tax Court’s decision in&nbsp;Lender Management v. Commissioner,&nbsp;TC Memo 2017-246 (“Lender”), and the other is the 2017 Tax Act (“Act”).

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Everyone is focusing on and planning for the provisions of the Act, but the&nbsp;Lender&nbsp;decision is also something you should pay attention to for your family office. The decision is important in that it provides a sort of “road-map” for family offices to follow to retain their ability to deduct appropriate operating expenses.

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Can Single Family Offices Still Deduct Operating Expenses under Section 162?

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Flow-through entity Lender Management LLC, a tax partnership formed to provide management services to LLCs owned by family members, was functioning as a family office for the Lender family. At issue in&nbsp;Lender:

Whether the entity was operating as an active “trade or business,” and thus eligible to deduct operating expenses under Section 162 of the internal revenue code

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Whether the entity was simply providing administrative services, investment oversight and record keeping for the investor LLCs, and thus not eligible to deduct under Section 162 but rather treated as Section 212 expenses that are no longer deductible by individuals and severely limited for trusts

Findings of the Tax Court in&nbsp;Lender Management v. Commissioner

The Tax Court found that Lender Management&nbsp;was, in fact,&nbsp;engaged in a trade or business&nbsp;and&nbsp;could deduct its operating expenses, stating in its decision, “Lender Management was not managing its own money. Most of the assets under management were owned by members of the Lender family that had no ownership interest in Lender Management. Lender Management managed investments and did substantially more than keeping records and collecting interest and dividends.” (Lender&nbsp;at pg. 37). The Court’s explanation of its findings (summarized below) provides the map for family offices to follow in examining their current structure and deduction decisions.

Structure of Family Office for Lender Family

Business Activities of Family Office for Lender Family

Compensation to Family Office for Lender Family

Takeaways for Single Family Offices from&nbsp;Lender Management v. Commissioner&nbsp;Decision

For a partnership family office structure to qualify to deduct the operation expenses under Section 162:

It is important to show that the office is carrying on an active trade or business and not just providing administrative or investment oversight services for the family.

It is important to create documented, legally-distinct family entities within the family office.&nbsp; These entities need to have documented, professional, business relationships with each other, as evidence that family members are not acting “collectively or with a single mindset.”

Family office compensation received was a factor in the Tax Court’s decision because it distinguished the situation where the family office generates income based on a “normal investor’s return” (Lender&nbsp;at 26).&nbsp; However, the structuring of compensation as fees paid versus issuance of a profits interest was not a factor. This is important for family offices to note because:

Investment fees paid by the LLCs under the Act are not tax deductible

Profits interest allocations reduce taxable income allocable to the other members of the LLCs

Even if your family office is structured as a corporation, the above points are important to note as they represent good practices to lessen susceptibility to other tax vulnerabilities, such as personal holding company tax. &nbsp;&nbsp; In summary, this case is important not in that it is groundbreaking or surprising, but rather that it provides guidance for the tax efficient structuring of family offices, especially as offices and families move forward with the changes necessitated by the Tax Act.&nbsp; The case was labeled as a memorandum decision, meaning that settled law was applied to the facts and one Tax Court judge issued the opinion. &nbsp; &nbsp; Furthermore, as an observation, the Lender Family Office and Family Held Investments had evolved beyond the original patriarch in terms of structure and in terms of family cohesiveness.&nbsp; However, this does not mean that the Lender structure can’t be achieved in the early years of a family office. The important item to note is that, regardless of the developmental stage of the office, its structure must evidence that the management is not merely of one’s own wealth.

Still Have Questions about Family Office Structure or Deduction Eligibility?

Of course, the ramifications from the&nbsp;Lender&nbsp;decision must also be combined with the ramifications from the 2017 Tax Act in all evaluations of family office structure and deduction eligibility. Feel free to contact your Warner attorney or Sean Cook, chair of our Tax Practice Group, for assistance in this area.

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Lender Management v. Commissioner Decision Impacts Single Family Offices in 2018

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Lender Management v. Commissioner Decision Impacts Single Family Offices in 2018

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