Family offices have been rising in popularity in recent years. These specialized companies focus on managing the wealth and the personal affairs of a family. Oftentimes, established, high-profile families need assistance managing their real estate, businesses, trusts, and other assets—this is where the help of a financial advisory team comes in. By working with a large CPA firm or another company offering family office services, families can maintain privacy, develop a unified strategy, establish structured governance, streamline their team of advisors, and overall set up a more cost-efficient way to plan for the future.
However, a family office is an expensive setup—even more so since a tax break that used to be available for family offices disappeared. Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers with a family office could write off certain items like investment expenses and tax return preparation fees under “miscellaneous itemized deductions.” Taxpayers were allowed to deduct any expenses that exceeded 2% of their adjusted gross income. However, under TCJA, this deduction was suspended until 2026. If this TCJA provision is not extended, family offices may once again be able to use miscellaneous itemized deductions in about two years.
Meanwhile, family offices are continuing to look for tax reduction opportunities, and some are turning to another business tax deduction—this time for “ordinary and necessary expenses.” Some taxpayers have looked for a workaround by forming a family management company and deducting the management expenses. This is where things get tricky: before adopting this strategy, we need to ask, “does the family office function in such a way that it actually qualifies as a business?” If its only reason for existing is tax avoidance, the IRS will crack down on you.
What is the difference? If the main purpose of the management company is to leverage the costs of the family office, this will not likely meet the IRS definition of a “business or trade.” Even if the office handles accounting and financial planning for the family, the IRS could consider these services more of a personal expense, and the costs would not qualify for a deduction. However, some family offices have been successful at establishing themselves as a business or trade. To understand how, we can turn to several key court cases, often known simply as Higgins and Lenders.
Court Case #1: Higgins v. Commissioner
This case goes back to 1941, but its implications carried on for many decades. Essentially, the Supreme Court ruled that if all an office does is manage and monitor the investments of its owner, that office does not qualify as a trade or business for tax purposes. This fits the function of many family offices, which were set up so the family did not have to do the work of managing investments and financial planning—instead they have hired a firm to take care of it. Understandably, this type of setup cannot take advantage of business expense deductions.
Court Case #2: Lender Management v. Commissioner
In 2017, a new court case arose that changed how family offices could be perceived from a tax perspective. The Lender Management case involved the family who owned Lender’s Bagels. They set up a family office that the court ultimately decided was a qualified business. What did the Lenders do differently?
First, the company went beyond merely managing its owner’s assets. The office provided personalized investment advisory and financial planning services for assets belonging to different siblings, children, and grandchildren within the Lender family. Though the Lenders had set up one series LLC with multiple families involved, each family continued to own its own assets even though they received protection through the same LLC. In the Lenders’ case, the structure was much more in line with a business where the people who owned the assets and the primary person who owned the family office were not identical.
Second, family members were allowed to withdraw their investments if they were not satisfied with the family office’s financial management. Notably, not everyone in the Lender family used these services for their assets, making the setup more similar to a true business that has to beat out its competition to secure clients. This established an “arm’s length” relationship between the family members and the management company, which is something the IRS looks for in determining whether an entity is legitimately operating as a business.
Lender Management also benefited from qualified leaders and employees. Keith Lender, the company’s principal, held a business degree from Cornell University and an MBA from Northwestern University. The office had other full-time employees and some part-time employees at different times. The company itself was also compensated through a portion of the profit, not a standard investor’s return.
All these factors combined led the court to say that Lender Management qualified as a business and was entitled to the “ordinary and necessary business expenses” deduction.
Summary
Though many family offices may be set up to simply streamline advisors, clarify goals, and reduce costs, some may function as an actual business—under the definition given by the IRS. If this is the case, that company should look into the possibility of claiming business deductions on its future tax returns. For expert advice on whether to set up a family office—and whether your office qualifies for a tax break—reach out to a certified tax planner today.
