Family offices help ultra-high-net-worth families tackle the complexities that come with generational wealth. Family offices offer myriad services, including investment management, estate planning, tax services, accounting services, business management, lifestyle management, succession planning, and more.
The tax and regulatory implications for how you structure your family office can vary significantly based on the legal entity chosen, the services provided, and the specific activities of the family office. This article provides a guide on family office types, legal structures, tax considerations, and more.
Understanding Family Office Types & Structures
Structure & Tax Considerations
Once the type of family office is determined, the legal structure of the entity, along with the tax implications, should be considered:
Family Limited Partnership (FLP)
- Legal Structure: Limited partnership
- Tax Implications:
- Pass-Through Taxation: Income is passed through to partners and taxed at their individual rates. General partners are subject to self-employment taxes.
- Estate Planning: FLPs can be used to transfer wealth to younger generations at discounted values, reducing estate and gift tax liabilities.
Limited Liability Company (LLC)
- Legal Structure: LLC
- Tax Implications:
- Pass-Through Taxation: Income is taxed at an individual level, preventing double taxation. LLCs offer flexibility in income allocation and can help in managing tax liabilities.
- Self-Employment Taxes: Individuals may potentially be subject to self-employment taxes on their share of income.
C Corporation
- Legal Structure: Corporation
- Tax Implications:
- Double Taxation: Income is taxed at the corporate level, and dividends are taxed again at the shareholder level.
- Accumulated Earnings Tax: Potential for additional tax if earnings are retained beyond reasonable business needs.
S Corporation
- Legal Structure: The election to be an S corporation
- Tax Implications:
- Pass-Through Taxation: Income is passed through to shareholders and taxed at their individual rates, avoiding double taxation.
- Restrictions: Limited to 100 shareholders, all of whom must be U.S. citizens or residents. Only one class of stock is allowed.
Key Tax Considerations
When structuring a family office, it’s essential to consider the following:
- Trade or Business: Structuring the family office to qualify as a trade or business under Internal Revenue Code (IRC) Section 162 can allow for more favorable tax treatment of expenses.
- Securities Law Compliance: Complying with the Investment Advisers Act of 1940 and the Family Office Rule.
- State Tax Issues: Managing state tax liabilities and compliance, especially for trusts and entities operating in multiple jurisdictions.
Court Cases Highlighting Structure & Operational Impacts on the Tax Treatment of Family Offices
The tax court decision in the case of Lender Management, LLC v. Commissioner determined that Lender Management, LLC, a family office managing investments for the Lender family, was engaged in a trade or business under IRC §162. This ruling allowed the family office to deduct its expenses as ordinary and necessary business expenses, rather than as miscellaneous itemized deductions under §212.
The court highlighted that Lender Management provided active investment management services, including making investment decisions, executing transactions, and offering personalized financial planning to family members, which went beyond the activities of a passive investor. This decision underscores the importance of structuring family offices to qualify as a trade or business for more favorable tax treatment.
Conversely, in the case of Hellmann v. Commissioner, the tax court examined whether GF Family Management, LLC (GFM), a family office owned by the Hellmann family, was engaged in a trade or business under IRC §162. The IRS argued that GFM’s expenses should be limited under §212, but the court compared this case to the Lender case, focusing on ownership interests and compensation structure.
Unlike Lender, GFM’s ownership and compensation were proportional to the family members’ investment assets, and the family members were geographically and personally close. The court did not make a final determination and requested further fact development, ultimately leading to a settlement. This case underscores the importance of structuring family offices to demonstrate a bona fide trade or business, considering factors like ownership proportionality, family member relationships, and compensation structures.
The table below summarizes the key aspects and outcomes of both cases, providing a clear comparison for understanding the criteria and considerations involved in determining whether a family office qualifies as a trade or business under IRC §162.
Key Aspects of Lender Management, LLC & Hellmann Court Cases
| Aspect | Lender Management, LLC | Hellmann |
|---|---|---|
Case Name | Lender Management, LLC v. Commissioner | Hellmann v. Commissioner |
Year | 2017 | 2018 |
Primary Issue | Whether Lender Management, LLC was engaged in a trade or business under IRC §162 | Whether GF Family Management, LLC (GFM) was engaged in a trade or business under IRC §162 |
Family Ownership | Family-owned and operated | Family-owned and operated, less expansive than Lender |
Professional Management | Structured management, professional operations, full-time employees | Structured management, professional operations, much less rigorous than Lender |
Profit Motive | Demonstrated profit motive | Demonstrated profit motive |
Active Involvement | Regular and active involvement in business activities | Regular and active involvement in business activities, less rigorous than Lender |
Business Operations | Business operations had commenced | Business operations had commenced |
Court’s Decision | Recognized as a trade or business under IRC §162 | Further development of facts requested by the court |
Key Factors for Decision | Profit motive, active involvement, structured operations, professional management | Comparison with Lender case, detailed examination of specific facts |
IRS Argument | Not engaged in a trade or business, subject to limited deductibility under IRC §212 | Not engaged in a trade or business, subject to limited deductibility under IRC §212 |
Outcome | Investment management fees deductible under IRC §162 | Settled |
Guidance for Family Offices | Importance of structured management, professional operations, clear roles | Need for detailed examination of specific facts, comparison with Lender case |
How Forvis Mazars Private Client Can Help
It is important to not only initially structure your family office with tax insights but also operate it in line with the tax impact you are hoping to achieve. By carefully considering these tax implications and aligning the family office structure with the family’s goals and needs, families can fine-tune their tax efficiency and help enable long-term success and stability. We work with families through their complex estate, gift, and income tax planning needs and are dedicated to helping families plan for and preserve their legacies. If you have any questions or need assistance, reach out to a professional at Forvis Mazars.