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ACTEC Trust & Estate Talk
Designing the Modern Single-Family Office: Classic Structure vs. Profits Interest
00:11:05
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Bonita Park
Foreign.
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Travis Hayes
The Modern Single Family Office Classic Structure versus Profits interest that is the subject of today's ACTEC Trust and Estate Talk.
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ACTEC Host
Welcome to ACTEC Trust and Estate Talk from the American College of Trust and Estate Council, a professional society of peer elected trust and estate lawyers in the United States, States and around the globe. This series offers professionals best practice advice, insights and commentary on subjects that affect our profession and clients. And now our ACTECH Fellow host with today's topic.
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Travis Hayes
This is ACTEC Fellow Travis Hayes of Naples, Florida. Family offices have long served as the backbone of multi generational wealth management for families of significant wealth, offering centralized control, privacy and tailored services to family members. There are several family office models, but today, building on our previous podcast on the use of Purpose Trust, ACTEC Fellow Bonita park of West Palm Beach, Florida explores two modern structures of a single family office. First, the quote unquote classic single family office structure and second, a single family office with a profits interest structure. She will also discuss what those structures mean from both a legal and tax perspective. Welcome Benita.
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Bonita Park
Thank you so much Travis. As you mentioned, there are several different family office models, but today I will walk through two single family office structures. And when I say family office, I really mean a separate legal entity that has its own staff to serve a single family. I'll also address how evolving tax law and case authority are shaping how we think about these single family office structures. We'll start with the classic single family office, then move into the more complicated profits, interest or investment family office structure, also known as the lender structure. I'll then close with some practical considerations you can take back in working with clients. Let's begin with what many of us would consider the traditional model. The classic single family office is typically structured as a separate legal entity, most often an LLC taxed as a pass through established to provide services to family members. Typically, the single family office is owned by a founder, a family trust, or even a purpose trust, depending on the family's broader planning objectives. From an operational standpoint, the family office enters into service agreements with various family members and their trust and entities and charges fees for those services. These fees fund the family office and can take a number of forms, for example Fixed fees, correct allocations, guaranteed amounts, hourly billing, or a percentage of assets under management, or maybe a combination. The classic family office is usually operated as a cost center. It could be a profit center, but usually the goal is to break even. The founder may fund the family office to cover expenses and or the services should cover expenses to hopefully break even. Now why do Families gravitate toward this model. The benefits it's simple and flexible. It provides privacy and confidentiality. It centralizes governance and control over holdings and providing of services. It allows for in house expertise, reducing administrative burden for family members. It creates economies of scale with greater access to investment opportunities and cost savings by pooling family assets. And from a legal and advisory standpoint, it also supports a controlled environment to coordinate tax wealth planning and investment strategy across the family from generation to generation. But this structure is expensive to operate and staff. You're competing for talent. Technology and cybersecurity must be robust and investors are limited to quote unquote family clients in order to qualify for the family office exemption under the securities laws to avoid having to register with the SEC as an investment advisor. But most of all, the classic single family office structure is not tax efficient as there is limited deductibility of expenses. Historically, many of the single family office expenses fell under code section 212, which are expenses incurred for the production of income which qualified as miscellaneous itemized deductions. The 2017 Tax Cuts and Jobs act suspended those deductions through 2025. Many hoped the deductions would return, but they did not. OB3 effectively eliminated those miscellaneous itemized deductions permanently. So now we have a structure that is operationally simple but often tax inefficient and that brings us to the single family office with profits Interest structure. Because of the limited deductibility of expenses in the classic family office structure, many families like to consider a model that allows for more efficiency than the simpler classic structure and that is the profits interest. The family office is structured so that expenses in managing the family office and investments qualify AS code section 162 trade or business expenses that may be fully deductible for income tax purposes. The expenses that may be deductible are those for investment management fees, personnel or payroll expenses, and office administration expenses. As mentioned earlier, if the family office is not structured or operated as a trade or business and the family office is merely performing a administrative services like our classic deming office structure, the expenses would be treated as ordinary and necessary expenses paid or incurred for the production of income under section 212 and would not be deductible. Typically, a profit center structure is suitable for family offices that are investment family office that is one of the primary functions of the family office is to oversee and engage in investments on behalf of the family. There are more expensive investments like private equity and direct investments in operating businesses. Let's now talk about the structure in the profits Interest Structure Various family members, trusts or entities contribute assets to a variety of limited partnerships or LLCs. Those are really investment entities in exchange for limited partner or membership interest in such investment entities. The investment entities generally are organized based on asset class, for example Fixed income equities, private equity, real estate, et cetera, in which they invest. And then family members can have varying interests in the investment entities and in different investments held by the different investment entities and create their own customized asset allocation. A management company, that is the family office acts as the general partner or manager of the investment entities and in that capacity manages and invests the investment entity's assets. Interests in the management company typically are held by one or more family members, family trust, the Purpa Trust, or other vehicles how does the family office qualify as a section 162 trade or business? Case Law provides helpful guidance. In a 1941 Supreme Court case, Higgins vs Commissioner, the court held that managing one own investments does not constitute a trade or business and you must have an active trade or business to deduct expenses. That principle still anchors the analysis today. More recent cases, particularly Lender and Hellman, give us a roadmap to qualify for the Section 162 deduction, a family office needs to reflect a genuine investment management enterprise rather than a passive administrative vehicle. In lender in 2017, the tax court held that the family office was a trader business and allowed to deduct expenses where it was a multi generational family office. Family members were not a united economic unit. They lived in different states, some were in conflict with one another, they had different investment objectives, risk tolerances and financial goals. Also, the family office functioned more as an investment advisor with multiple clients than a single family administrative function. It operated with business grade infrastructure, having professional employees, and it received its profits interest compensation distinct from a normal investor's return. In Hellman in 2018, the party settled privately, but there was an order entered by the Tax Court requesting additional information and the order provides a lot of great insight into the Court's thinking and analysis. It was a roadmap of several factors that are indicative of a family office trade or business. This is effectively an excellent checklist. The cases highlight that significant entrepreneurial risk is key. The single family office is obligated to pay management costs regardless of performance, which could potentially lead to liquidity issues. So it's on the hook to pay expenses even if it doesn't generate a profit and there should be disparate interest. That is Ownership of the family office should be different from the ownership of the investment entities. So what do we gain by moving to this structure? First and foremost, deductibility if structured and operated properly. Second, it becomes easier to attract and retain talent. A for profit model allows for incentive compensation to attract and retain professionals at the highest level. Third, it formalizes operations, often improving governance and discipline. But there are considerations. The structure is more complex, requires additional accounting, reporting and tax compliance, it's more expensive to operate, and it invites greater IRS scrutiny. Overall, you need to crunch the numbers and determine the appropriate profits, interest. Will there be enough profit and fees charged to cover expenses? So where does this leave us? Some practical takeaways if you're advising families, the decision between these structures is not theoretical, it's highly fact specific. A few practical questions to Is the family office truly engaged in the active investment management or primarily administrative support? Are there multiple family stakeholders with differing objectives? Is there sufficient scale and complexity to justify a business structure and critically, do the numbers work? Because at the end of the day, this is an economic question as much as a legal one, and at its core, it needs to be able to meet the overall goals and objective of the family and the purpose of the family's wealth.
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Travis Hayes
Thank you thank you Bonita, for providing an overview of modern structures for single family offices, including the incorporation of a profits interest structure, sometimes referred to as the lender model, into the family office.
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ACTEC Host
Thank you for listening to this episode of ACTEC Trust and Estate Talk, the podcast series about wealth planning matters from the American College of Trust and Estate Council. To find an ACTEC lawyer near you, visit actec.org Please subscribe to this series and leave us a rating or a review.