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Baker TillyEstate and Trust Conference 2018Tax Update – The Lender Bagel CasePresented by:Helene S. JaronVice Chair, Private Client ServicesCozen O’ConnorOverviewThis past December, the United States Tax Court issued an opinion addressing the distinction between investment activities and trade or business activities in the context of a single family office (SFO). The opinion is particularly relevant in light of the new tax act’s suspension of miscellaneous itemized deductions for non-AMT taxpayers through 2025. An SFO is an organizational structure that manages the financial and personal affairs of one wealthy family. While the SFO may provide significant services to the “family” (which may include individual family members, family trusts and family-owned entities), historically, it has not been considered to be engaged in a “trade or business” for income tax purposes. As a result, the expenses incurred by the SFO, to the extent attributable to the management of the SFO, were not taken into account in computing the taxable income of the SFO. Rather, each owner of the SFO was allocated his or her distributive share of such expenses which generally fall into three categories: (1) administrative, including salaries of employees of the SFO, and rent; (2) outside investment advisory fees; and (3) other professional fees, including accounting and legal fees.Prior to the enactment of the Tax Cuts and Jobs Act in December of 2017 (the “Tax Act”), taxpayers had been permitted to deduct expenses that were not incurred in a “trade or business” but were incurred: (i) for the production or collection of income, (ii) for the management of property held for the production of income, or (iii) in connection with the determination or collection of any tax under Code Sec. 212. These amounts were deductible by non-AMT taxpayers as itemized deductions, only to the extent the amount was in excess of 2% of the taxpayer’s adjusted gross income. As of January 1, 2018 (through December 31, 2025), Section 212 expenses are no longer deductible for non-AMT taxpayers. Consider the following example of the effect of the Tax Act:Family L has an investment portfolio with a value of $25 million, which generates approximately $2 million of ordinary income and $1 million of net long-term capital gain annually. Family L pays an investment advisor an annual management fee of $700,000. Prior to the Tax Act, members of Family L would have been entitled to deduct the management fee as an investment expense subject to the 2% floor.Post-Tax Act, Family L is no longer entitled to claim any deduction for the $700,000 annual management fee. Assuming an effective tax rate of 37%, the disallowance of the deduction could increase Family L’s aggregate tax liability by $260,000.Lender Bagel CaseHarry Lender founded the company that ultimately became Lender’s Bagels. Harry’s two sons, Marvin and Murray, continued this business after Harry’s death. Each of Marvin and Murray had three children and many grandchildren.Lender Management LLC (LM LLC) was a separate entity originally formed by Marvin and his wife to provide a broad range of managerial services to Marvin’s family. Over time, however, LM LLC began to offer these managerial services to Murray and his family. Ownership of LM LLC ultimately changed hands, leaving Marvin with a 1% interest and Marvin’s son, Keith, with a 99% interest.During the tax years in question, LM LLC provided direct management services to members of the Lender family and two limited liability companies owned by various family members. Each limited liability company was set up to invest in a specific asset class – one in private equities and one in hedge funds. LM LLC was the sole manager of each investment limited liability company and received a profits interest in each entity in exchange for the services it provided to the investment limited liability companies and their members. These profit interests were designated “Class A” interests under the operating agreements – in both cases, LM LLC was entitled to receive 2.5% of the net asset value annually plus 25% of any increase in net asset value from the prior fiscal year.LM LLC employed 5 employees, including Marvin’s son, Keith. Keith served as chief investment officer.LM LLC elected to be treated as a partnership for federal income tax purposes. On audit, the IRS took the position that LM LLC was not carrying on a trade or business. Rather, the IRS contended that the primary activity was managing the Lender family fortune for members of the Lender family by members of the Lender family. As a result, the IRS disallowed deductions claimed by LM LLC under Section 162 and instead allowed the deductions pursuant to Section 212. The Tax Court disagreed, holding that LM LLC carried on a trade or business. In so holding, the Tax Court relied on the following factors: LM LLC had full-time employees; LM LLC provided investment planning and advisory services to the family members; LM LLC oversaw financial planning activities and negotiated lines of credit for the family entities; The services performed by LM LLC were comparable to the services performed by hedge fund managers; and LM LLC was granted a carried interest as compensation for services to the investment limited liability companies if and when profits were generated. Implementation of a Lender Bagel structureA separate business entity should be formed as the SFO, if not already in existence.The SFO should have employees and separate office space.The SFO should enter into the contracts with third-party service providers and landlords in its own name. The general credit of the investment portfolio should not stand behind those obligations.The SFO should be capitalized by its owners.Some business purpose for the separate existence of the SFO should be evident, e.g., to provide investment management tailored to the interests of family members, to offer specialized employment opportunities, to achieve economies of scale.One or more entities should be formed as the family investment vehicles. Family members would then contribute assets to a family investment vehicle in return for an ownership interest in that entity. For each investment vehicle, the SFO will get a “carried interest”.Additional Issues to be consideredType of entity for the SFOLimited liability companies, limited partnership, S corporation or C corporation. Issue with pass-through entities if owners of SFO are not full-time employees of the SFO. The income being generated by the SFO is derived from the portfolio income of the family investment vehicles. If the owners of the SFO are not actively involved in the business then the expenses of the SFO are passive activity expenses which can’t be offset against portfolio income. It may be possible to use a closely held C corporation.Ownership of SFOShould have diversity of ownership - ownership of the family investment vehicles and the SFO should not be the same – otherwise the family would be considered as managing its own assets. Chapter 14 issues Chapter 14 creates special valuation rules for transfers of equity interests in family controlled entities. A transfer under Chapter 14 also includes capitalization of a new entity and a recapitalization of an existing entity. Chapter 14 applies if a senior family member transfers a junior equity interest in a family controlled entity to the next generation and retains a senior equity interest. In that case, the fair market value of the senior family member’s interest (before the transfer) may be subject to gift tax. For a profits interest to qualify for income tax purposes, it must be subordinate to the capital holders on liquidation, which may make it a junior interest.Securities RegulationsDodd-Frank eliminated the exemption that generally had been relied upon by SFOs to avoid registration under the Investment Advisors Act. The SEC subsequently promulgated a new exemption from registration for an SFO that (a) has no clients other than family clients, (b) is wholly owned by family clients and is exclusively controlled by one or more family members and (c) does not hold itself out to the public as an investment advisor. ................
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