On December 13, 2017, in Lender Management, LLC v. Commissioner, the U.S. Tax Court ruled that a family office, Lender Management, LLC (“Lender Management”), was “carrying on a trade or business” as an investment manager rather than serving as a passive investor and therefore was entitled to deduct expenses under Section 162 as opposed to Section 212.
This Tax Court decision is a favorable outcome for similarly-situated family offices because trade or business expenses generally can be deducted under Section 162 without limitation. In contrast, for the years at issue, expenses deductible under Section 212 were treated as miscellaneous itemized deductions subject to a 2 percent adjusted gross income floor under Section 67 and were potentially subject to unfavorable treatment under the alternative minimum tax rules. Under the recently-enacted Tax Cuts and Jobs Act, the ability to deduct miscellaneous itemized deductions, including management fees relating to private investment funds, has been eliminated entirely through 2025.
Brief Summary of the Facts
The case involves relatives of Harry Lender, who founded the company that became Lender’s Bagels.
Lender Management was owned by two revocable Trusts (Marvin Lender Trust and Keith Lender Trust). Marvin Lender was a son of Harry Lender, and Keith Lender was Marvin’s son. Lender Management provided investment management services to three family investment limited liability companies (“Investment LLCs”). Marvin Lender, through Marvin Lender Trust, acted as Lender Management’s managing member until December 23, 2010, and Keith Lender, through Keith Lender Trust, acted as Lender Management’s managing member after December 23, 2010.
A minority portion of the Investment LLCs were owned indirectly in part by Keith Lender and Marvin Lender, with the remaining majority ownership spread among other members of the Lender family. The Investment LLCs were established pursuant to a prior reorganization in order to provide for greater diversification and more flexible asset allocation, with one Investment LLC for private equity investments, another for hedge funds, and the third for public equities.
The operating agreement for each Investment LLC provided that Lender Management was the sole manager for the Investment LLC and had the exclusive right to direct the business and affairs of the Investment LLC. In addition, Lender Management received a profits interest in each Investment LLC that generally provided for allocations based on (i) a percentage of net asset value, plus a percentage of any increase in net asset value, (ii) a percentage gross receipts, plus a percentage of any increase in net asset value and (iii) a percentage of net asset value, plus a percentage of net trading profits (in each case, only to the extent the Investment LLC generated profits).
Keith Lender spent significant time in his role as managing member for Lender Management. His role included researching and pursuing new investment opportunities, such as private equity and hedge fund proposals, and monitoring and managing existing positions. In addition, Keith Lender spent significant time meeting with the other owners of the Investment LLCs to report on the performance of their investments and understand their cash flow needs and risk tolerances for investments. Lender Management also managed revolving lines of credits for the Investment LLCs and had employees and external consultants.
For the years at issue, Lender Management claimed deductions for business expenses under Section 162. The IRS subsequently issued final partnership administrative adjustments (FPAAs) providing that the business expenses were not deductible under Section 162 but, instead, could be deducted under Section 212.
Position of the Parties and Opinion of the Court
Lender Management contended that it was engaged in an active trade or business by providing investment management and financial planning services to the Investment LLCs and these entities engaged with one another at arm’s-length. The IRS contended that Lender Management’s activities did not constitute a trade or business because Lender Management primarily managed funds for its own account and for the account of the family members.
The Tax Court stated that the following three requirements must be present for purposes of determining whether a trade or business exists: (i) the taxpayer must undertake the activity intending to make a profit, (ii) the taxpayer must be regularly engaged and actively involved in the activity and (iii) the taxpayer’s business operations must have actually commenced. Having found that these general threshold requirements were met, the Tax Court considered whether (1) the investment management services provided by Lender Management could be treated as trade or business instead of investment activities and (2) the familial connections between Lender Management and the Investment LLCs could preclude trade or business treatment.
The Tax Court reasoned that services provided by Lender Management were “comparable to the services hedge fund managers provide” and went “far beyond those of an investor.” The Tax Court further noted that Lender Management was entitled to a profits interest as compensation for its services to the Investments LLCs and could receive compensation separate from, and in addition to, the amounts received with respect to its capital interests in the Investment LLCs. In this regard, the Investment LLCs were owned 91.74% and 99.6% by family members that had no interest in Lender Management. As a result, the Tax Court found that Lender Management was providing investment management services to persons other than itself.
The Tax Court acknowledged that a familial relationship existed between the owners of Lender Management and the remaining owners of the Investment LLCs and thus the transactions would be subject to heightened scrutiny. The Tax Court, however, found that Lender Management satisfied such scrutiny. In particular, Lender Management’s investment decisions and related activities were driven by the individual needs of the other owners of the Investment LLCs which often conflicted with the needs of the owners of Lender Management (as opposed to acting “collectively or with a single mindset”) and such owners were able to withdraw their investments if they became dissatisfied with Lender Management’s investment services.
In addition, the Tax Court stressed that most of the family members did not have an ownership interest in Lender Management, and distinguished Lender Management from the Supreme Court case of Higgins v. Commissioner, in which Higgins “merely kept records and collected interest and dividends from his securities, through managerial attention for his investments.”
Finally, based on the factual conclusion that Lender Management “carried on its operations in a continuous and businesslike manner for the purpose of earning a profit, and it provided valuable services to clients for compensation,” the Tax Court held that Lender Management was carrying on a trade or business for purposes of Section 162.