Deducting investment expenses as business expenses is likely an uphill battle for most family offices.
It is generally understood by investors that, in light of the Tax Cuts and Jobs Act of 2017, the ability to deduct management fees relating to private investments has been eliminated through 2025. Increasingly, however, investors are expressing interest in the possibility of establishing a family office as an LLC – in theory, permitting the LLC to deduct investment expenses as business expenses.
This idea has circulated largely as the result of a 2017 Tax Court case, Lender Management, LLC v. Commissioner. Founded as the family office of the heirs to Lender’s Bagels, Lender Management characterized expenses associated with managing investments as deductible trade or business expenses for the years 2010-2012. Recall that under prior law, investment management expense deductions were subject to the 2% of adjusted gross income floor on itemized deductions – but this limitation did not, and still does not, apply to trade or business expenses.
Taking the position that Lender Management primarily managed its own and family members’ accounts, the IRS issued adjustments ruling that the investment expenses were not deductible as business expenses. In the case that followed, the Tax Court ultimately ruled that Lender Management was indeed operating as a trade or business and was therefore entitled to deduct the expenses as trade or business expenses.
Less commonly known than the case itself are the unique factors that led the Tax Court to render its decision. Below, Northern Trust Tax Counsel and Senior Wealth Planner Diana R. Myers explains the nuances of the Lender case – and why its dynamics are unlikely to be replicated in most situations.
If investors are interested in deducting investment expenses, what is the framework?
The rule under the new tax law is that expenses incurred for what are commonly called investment expenses are not deductible through 2025 – but businesses both large and small are still allowed to deduct ordinary and necessary business expenses.
The key to the business expense deduction is convincing the IRS that you are in fact engaged in a trade or business. A retiree who spends several hours a day reading financial news and trading options is not running a finance business. On the other hand, the Lender family office was professionally managed to such a degree that the Tax Court was convinced it was a trade or business. The takeaway is that if you want to deduct investment expenses, be prepared to show that you are running a real business.
If you were to distill the case into three takeaways, what factors led the Tax Court to determine that Lender Management was a real trade or business?
Given these details, what’s the bottom line for most investors who have expressed interest in establishing a family office LLC and deducting investment expenses?
Unless the investor is prepared to hire several full time professionals and open an investment advisory firm, the IRS isn’t likely to accept that a real business exists.