On December 13, 2017, the US Tax Court (Tax Court) held that a family office was appropriately treated as a business, and permitted to deduct its expenses pursuant to Internal Revenue Code (Code) Section 162. In Lender Management LLC v. Commissioner, T.C. Memo. 2017-246, the Internal Revenue Service (IRS) argued that the taxpayer’s expenses should be properly claimed pursuant to Code Section 212 because the family office was not a business for federal income tax purposes, and instead its expenses were merely costs of its investment activities. Whether or not a family office is a business is important because deductions under Code Section 212 are substantially limited.
The taxpayer was the family office to the Lender’s Bagels fortune. It was owned by two Lender family trusts. In 2010 and 2011, the taxpayer reported net losses on its returns and reported net income in 2012 and 2013. The taxpayer provided direct management services to three limited liability companies (LLCs), each of which elected to be treated as a partnership. The owners of the LLCs were the children, grandchildren and great grandchildren of the founder.
The taxpayer engaged a hedge fund specialist to manage the portfolio as a fund of funds. The three LLCs held different classes of investments. The taxpayer also managed downstream entities in which one of the LLCs held an interest. Some of the downstream entities had owners other than members of the Lender family. The taxpayer earned fees for these services. Members could withdraw their investments in the LLC at any time subject to liquidity constraints. The taxpayer received a profits interest in the LLCs in exchange for services. It employed five people, including a Lender family member who was the Chief Investment Officer and received a guaranteed payment for his services. The Chief Financial Officer was unrelated to the Lender family.
On its returns, the taxpayer claimed substantial expenses as ordinary and necessary business expenses under Code Section 162. The IRS, however, determined that the taxpayer was not a business for federal income tax purposes and must deduct its expenses subject to the limitations under Code Section 212.
The Tax Court explained that the Code does not have a definition for a trade or business, and that determination is based on the relevant facts and circumstances. A business, however, must be involved in an activity with continuity and regularity, the primary purpose of which is to generate income or profit. An investor managing his own affairs is not considered to be engaged in a trade or business.
The Tax Court determined that the taxpayer’s activities “went far beyond those of an investor.” The court found meaningful that the taxpayer was entitled to a profits interest as compensation for its services, so its interests were aligned with the LLCs. The court acknowledged that there is heightened scrutiny because a family relationship existed between managing members of the taxpayer and the owners of the LLCs. However, the taxpayer passed this test—the court found that there was no requirement or understanding that the taxpayer would remain the manager of the assets held by the LLCs. Indeed, the services could be terminated at any time. Accordingly, the Tax Court held that the relationship between the taxpayer and the LLCs was a business relationship, and the taxpayer was entitled to deduct its expenses pursuant to Code Section 162.
Practice Point: Lender Management affirms the ability of a family office to be respected as a trade or business for federal income tax purposes. Although the analysis is fact intensive, with careful planning, a family office should be treated as a business and entitled to deduct its expenses pursuant to Code Section 162.
