A recent case, Lender Management, LLC v. Commissioner, provides a potential roadmap for family offices on how to structure their operations for U.S. federal income tax purposes. In a taxpayer-friendly decision, the Tax Court in Lender ruled that a family office was "carrying on a trade or business" and was therefore entitled to deduct expenses under Code Section 162 as opposed to Code Section 212. This Tax Court decision is an important blueprint for structuring tax-efficient family investment and management of family capital. However, a number of additional considerations were not discussed in the case that could be highly relevant in determining whether the result in Lender may be applied successfully in other family office contexts.
The Code has historically drawn a significant distinction between expenses incurred in connection with a trade or business, which are generally deductible, and investment expenses. Before 1942, the Code did not allow for any deduction of investment expenses. In that year, Congress amended the Code to provide that investment expenses are deductible as either expenses for the production or collection of income or for the management, conservation or maintenance of property held for the production of income.
Section 212 deductions are subject to a 2 percent adjusted gross income (AGI) floor under Code Section 67, and are potentially subject to unfavorable treatment under the alternative minimum tax rules. In many cases, these limitations result in virtual prohibitions on the ability of taxpayers to claim advantage of such deductions. Many high-income individuals have significant AGI, and, thus, Section 67 severely limits the deduction’s availability to them or renders their investment advisory fees nondeductible. This would not be true if these fees were considered trade or business expenses under Section 162. In addition, net operating loss carryovers can only arise from trade or business activities.
Moreover, 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. Accordingly, for these years, the distinction between business expenses and investment expenses has assumed more significance.
The Lender Case
The principal issue in Lender was whether a family office (Lender Management) carried on a trade or business. Harry Lender was the founder and operator of a food manufacturer and distributor known as Lender’s Bagels. Harry’s two sons, Murray and Marvin, worked in the family business. Marvin had three children and four grandchildren. Murray had three children and six grandchildren.
Lender Management provided direct investment management services to three separate limited liability companies (the Investment LLCs), the beneficial owners of which were entirely Lender family members. Each of the Investment LLCs was treated as a partnership for federal income tax purposes. Lender Management also managed certain "downstream entities" in which one of the investment partnerships had a controlling interest, and investors in some of these downstream entities included persons who were not members of the Lender family. Lender Management’s operating agreement permitted it "to engage in the business of managing the Lender Family Office and to provide management services to Lender family members, related entities and other third-party nonfamily members." (It did not appear, however, that investment advisory services were provided to nonfamily members.)
Lender Management had five employees and paid more than $300,000 in payroll in each of the years under review. Keith Lender, a family member with an MBA and an Ivy League education, served as the chief investment officer of Lender Management. He reviewed more than 150 hedge fund and private equity offerings each year. A substantial portion of the compensation paid in 2011 and 2012 was paid to Keith Lender. Lender Management hired a nonfamily member to serve as its chief financial officer. She managed borrowings and the cash positions of the family. Lender Management also hired other third-party professionals to recommend and evaluate investment opportunities.
The Lender family members were, in some cases, grandchildren and great-grandchildren of Harry Lender. They were very much dispersed, both geographically and in temperament. Although it was an extended family by pedigree, the Tax Court emphasized that the relationships between Lender Management and its "clients" were effectively at arm’s length and that Lender Management could have been terminated as an investment advisor at any time by the Investment LLCs.
The Tax Court considered (1) whether the investment management services provided by Lender Management could be treated as a trade or business instead of investment activities and (2) whether the familial connections between Lender Management and the Investment LLCs could preclude trade or business treatment.
The Tax Court determined that the activities of Lender Management — which involved providing investment management services to others for profit (although the others were all part of the Lender extended family or their related entities) — were sufficient to constitute a trade or business, and thus fully deductible trade or business expenses under Section 162. The court undertook a detailed study of Lender Management’s activities. In support of its conclusion, the court cited the following facts:
- Management had full-time employees.
- It provided investment advisory and financial planning services for the Investment LLCs.
- The CFO oversaw financial accounting, cash management and negotiated lines of credit.
- Lender Management’s services were comparable to the services provided by hedge fund managers.
- Lender Management received a carried interest or fees as compensation for services (the court did not find any negative inference from the fact that Lender Management did not receive fees from two of the three Investment LLCs).
The court held that these facts were sufficient to support the conclusion that Lender Management was engaged in the conduct of a trade or business. The court distinguished these facts from other cases in which the activities were limited to oversight and general accounting functions. The fact that Lender Management was operated in a balanced way for federal income tax purposes appears to have greatly helped the taxpayer’s case. Specifically, Keith Lender, as chief investment officer, was paid a substantial salary for his services, rather than just passing through income from the carried interests as compensation for services.
The court then considered the fact that Lender Management was owned by certain members of the same family who were the clients of Lender Management. The court stated that applicable authority demanded that related party transactions be evaluated with "heightened scrutiny." The operation of Lender Management met this heightened scrutiny standard because of the business-like manner in which it was operated. The fact that family members were not bound to keep their assets in the Investment LLCs meant that, if Lender Management did not perform well, the family members could withdraw their capital and seek alternative investment advisory services. Even with respect to the one Investment LLC that required Lender Management’s consent to withdraw, the court found that there was a "common understanding" that this consent would be granted. The court also emphasized the fact that the family members did not act "collectively or with a single mindset." As a result, the individual family members each represented a different client rather than being members of a single client.
Last, but very important to the decision, was the fact that Lender Management was owned by only a small subset of the family. The court stated that "[m]ost of the assets under management were owned by members of the Lender family that had no ownership interest in Lender Management." Again, the court emphasized that Lender Management provided services similar to those of a hedge fund manager.
Based on these facts, the Tax Court concluded that, in making investment decisions and executing transactions on behalf of the Investment LLCs, Lender Management "operated for the purpose of earning a profit, and its main objective was to earn the highest possible return on assets under management."
Lender gives validation to a structure that some investors and family offices have implemented to ensure that investment advisory fees paid to investment managers are not lost due to limitation. Some investors and family offices have created investor/family-owned management companies that operate as trades or businesses for which expenses incurred in their operations are deductible under Section 162.
When there is a desire to transition ownership of the management company to family members of the next generation or generations, estate and gift tax implications may arise as well. The structures and rationales for wanting to transfer the management company to younger generations can be diverse, but, if such a transfer is desired and it is envisioned that the management company will hold a profits interest in the underlying investment entities, potentially draconian gift tax issues will need to be carefully navigated under Chapter 14 of the Code. There may be ways to structure ownership of the management company by younger-generation family members that will not violate the gift tax rules. These solutions are typically individually tailored and will be largely facts-and-circumstances driven.
Implementing these structures requires significant planning and attention to detail because the IRS has consistently taken the position that the investment of one’s own (or one’s family’s) wealth does not rise to the level of a trade or business that generates deductions under Section 162. The type of entity (e.g., C corporation or pass-through), who owns the entity, who works for the entity, the amount of the entity’s activities, and how the entity and its employees are compensated must all be considered. Consideration of these and similar issues typically requires the assistance of tax advisors experienced with these types of structures, as the success or failure of the tax structure will depend on how the entity is formed and operated. The analysis and holding in Lender, however, suggest a roadmap for structuring and operating a family office in a manner that achieves the intended tax benefits.