Following the Tax Court’s December 2017 decision in Lender Management v. Commissioner, more family offices may seek to qualify for trade or business expense deductions under Section 162 of the Internal Revenue Code through the use of a profits interest structure.This structure is not right for all family offices, however, and requires a careful analysis of both the legal aspects and the unique circumstances of each family office.
Here are five key points to consider in assessing whether profits interest planning is right for your family office:
- Manage family member expectations. Profits interest planning, while efficient from an income tax perspective, can result in a misalignment of family member paradigms and perspectives. Given that profits interests are just that — interests in future profits — there is no guarantee that the annual income associated with a profits interest will match the amount of family office operational expenses. To the extent that a profits interest causes family office income to exceed expenses, the owners of the family office will benefit, with the possible result that some family members may receive, or be viewed as receiving, an economic benefit at the expense of other family members. If a profits interest causes family office income to be less than expenses, the family office will need additional funding to enable it to satisfy its cash flow needs, with the possible result that some or all family members will be asked to fund this deficit. These and other potential consequences of a profits interest structure should be carefully explained to family members so that the risk of disrupting a well-functioning family is minimized.
- Fully inform trustees (if applicable). Many family offices are owned by trusts with non-family member trustees or have such trusts as significant clients. As trustees are bound by fiduciary duties, they should be fully informed about all aspects of the proposed profits interest planning and the consequences. Depending on the identity of the family office trustees and other family dynamics, separate counsel may be advisable.
- Work carefully with tax return preparers. There is no standard form of family office ownership structure or profits interest design. The Lender case involved very helpful pro-taxpayer facts. It is imperative to involve the family office’s tax return preparer from the initiation of (and throughout) any profits interest planning exercise. In the end, tax return preparers will not sign the family office income tax returns unless they fully understand and are comfortable with the relevant circumstances.
- Carefully consider ownership and management of family office and related investment entities. A family office that implements profits interest planning should not be an alter ego of the related family investment partnerships. How the family office is owned and managed, both on paper and in reality, is a critical component of profits interest planning. Again, the Lender case facts were very pro-taxpayer; not all family offices will fit this model.
- Remember the big picture. Family offices are unique, and one size does not fit all. As part of a profits interest planning exercise, consider all family facts and circumstances and how they may be affected by the implementation of a profits interest structure. For example, family investment philosophy, family investment management criteria, family cohesion and other factors should be considered before implementing a profits interest structure. In other words, don’t let “the tail wag the dog.”