Deducting Investment Fees as a Family Office

5 MINUTE READ

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?

  1. Lender Management was staffed like a professional investment advisory firm.

    The first factor was Keith Lender. The Tax Court opinion rested heavily on Keith Lender’s qualifications. He was one of Lender’s Bagels founder Harry Lender’s grandchildren, and he was also CIO of Lender Management. He had a bachelor’s in business from Cornell University and an MBA from Kellogg School of Management at Northwestern University. What’s integral here is that he worked 50 hours per week for the family office, alongside a non-family member who was CFO. There was also an office manager and several part-time employees. Keith and the CFO selected investments, managed outside vendors and held meetings with members of the Lender family. The family office was run like a real business, so the court treated it like a real business.

  2. Lender Management was structured like a professional investment advisory firm.

    The second factor was the structure of the Lender family office. The main entity, Lender Management, was considered the family office. This entity owned interests in two subsidiary LLCs, one invested in private equity and the other in hedge funds. The key is that the relationship between the family office and the two investment LLCs was one of advisor-advisee, not parent-subsidiary. The family office entity never owned more than 9% of any given investment LLC. Instead, other extended family members – the children, grandchildren and great-grandchildren of Harry Lender – owned over 90% of the investment LLCs. If the family members were ever unhappy about the way the family office was managing the investments, they could pull their money out. It was a real business because it had true clients. It was a private equity LLC and a hedge fund LLC, and the family office served as an arm’s-length investment advisor to each of those LLCs.

  3. Lender Management received most of its revenue from compensation for investment advice.

    The third factor was whether or not the family office was paid for investment advice. Lender Management had two sources of income. It held ownership stakes in the hedge fund LLC and the private equity LLC. That was not compensation for investment advice. But it also held a profits interest in each one of the LLCs and was therefore entitled to a share of the underlying profits if the investments performed well. This profits interest was compensation for investment advice, just like it would be for any private equity manager or hedge fund manager. Additionally, the family office received substantially more compensation for its profits interest than it did from its ownership interest.

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.

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This information is not intended to be and should not be treated as legal advice, investment advice or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.