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Tax Reform Amplifies Court Ruling that Family Offices are Businesses for Expense-Deduction Purposes by Lewis Kevelson, CPA


Posted on April 04, 2018 by Lewis Kevelson

There is no doubt that the Tax Code is made up of a complex set of rules with often-conflicting provisions that are subject to different interpretations. Making this understanding of the law even more difficult is the tax reform legislation that went into effect beginning on Jan. 1, 2018.

Take, for example, the recent tax court case involving Lender Management, a family office with employees and outside consultants providing investment advice and financial planning services to three separate investment LLCs owned by members of the Lender’s frozen-bagel empire. Each LLC has an operating agreement that names Lender Management as its sole manager with the exclusive right to direct its business affairs. In exchange for its services, Lender Management receives a profits interest in each LLC based on a percentage of each’s investment net asset value, a percentage of any increase in net asset value, a percentage of trading profits and other factors.

The issue before the court centered on the more than $1 million in deductions the family office claimed each year from 2010 to 2012 as ordinary and necessary business expenses under Tax Code Section 162.  The IRS disagreed with the taxpayer’s interpretation of the law, stating that Lender Management’s activities do not qualify as a business eligible to deduct expenses for items such as rent, depreciation, salaries and wages under Section 162. Instead, the IRS argued that absent a trade or business, the family office could deduct some of its expenses that qualify as miscellaneous income- or profit-oriented activities Section 212 of the code.

The tax court ruled in favor of Lender Management, affirming that the family office qualifies as an operational business that can use business-related expenses to reduce its gross income. In weighing the facts and circumstances of this particular case, the court explained that the family office’s activities “went far beyond those of an investor.” Not only did the family office consider the business needs of non-family investors, most of the family members did not have an ownership interest in Lender Management. In addition, the court viewed favorably the fact that the management company had a full-time staff of financial professionals performing high-level functions and earned a fee in exchange for the services the family office provided.

The significance of this ruling is more important than ever in light of the Tax Cuts and Jobs Act of 2017. Under the new tax law, deductions for trade or business expenses under Section 162 remain available to qualifying taxpayers whereas miscellaneous itemized deductions for investment expenses are no longer available to help individuals reduce their taxable income in 2018 through 2025. With this in mind, it is critical that family offices review their operations and existing structures to ensure they avoid the restrictions of the new tax law and instead receive the ongoing benefit of deducting business expenses in the future.

The accountants and advisors with Berkowitz Pollack Brant have extensive experience providing family office administrative services and managing the various details of high-net-worth families’ businesses, investments and other financial interests across the globe.

About the Author: Lewis Kevelson, CPA, is a director with Berkowitz Pollack Brant’s International Tax practice, where he assists cross-border families and their advisors with family office services, personal financial planning and wealth management strategies. He can be reached at the CPA firm’s West Palm Beach, Fla., office at (561) 361-2050 or via email at info@bpbcpa.com.

 

Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.