Family Office Investment Partnerships
“Family Office Investment Partnerships,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Jonathan Michael, ACTEC Fellow from Chicago. What are the tax and business planning issues when giving a family office an interest in an investment partnership it manages? To teach us more about this topic, we’ll be hearing today from ACTEC Fellow Steve Gorin of St. Louis, MO. Welcome, Steve.
Thank you, Jonathan. Investment management fees are not deductible through the end of 2025 and even after that, they are subject to alternative minimum tax. So, a way that you can use your family office for not only management purposes, but also to save income taxes is to put your family office inside of a C Corporation, which normally I usually hate doing — which is C corporation — but in this time, they can work magic. So instead of paying the management fees from your family investment partnership or directly from your family trust, what you would do is you form an investment partnership; and the investment partnership will distribute profits to the family office, which is in a C corporation. And the C corporation is allowed to deduct investment management fees; and that comes about because there was a revenue ruling back in the 1970s that said that C corporations can deduct investment expenses as if they were from a trade or business. Whereas we know that individuals, including pass-through entities such as S corporations, and trusts and partnerships, cannot deduct investment management fees.
So, what you can do is — your family office will receive a share of the profits from the investments. So you form an investment partnership, whatever family entities you have, which may be trusts or individuals or whatever. You form your investment partnership. You give an interest in the profits of the family office — so instead of paying a fee to the family office, you are diverting your profits to the family office. So, you’re not having a deduction. You are instead diverting your income to the family office. So then when the family office gets this income, the family office can then, as a C corporation, deduct the investment management fees. So that helps you fund your family office, helps the family office achieve its objectives, but also lets you deduct investment management fees; whereas you would not be able to do that directly if you simply paid your investment management fees directly.
So then, the question might be, well, will the IRS respect the profits interest or re-characterize it and say that’s just really disguised fees? You were really just paying fees. You weren’t really giving it a share of the profits. So, we have several things to consider when we structure this profits interest. So first of all, the budgeted annual profits interest should be reasonable, and you don’t want to be paying an unreasonable amount to the C corporation, especially in light of the anti-estate freeze rules of Internal Revenue Code Section 2701, which may attribute more value to the profits interest than there really is.
So, what you want to do is have reasonable annual profits and allow termination or periodic adjustments. So on the one hand, you’re not giving this vested interest that is subject to these awful anti-estate freeze rules; but at the same time, you’re wanting to be able to be flexible and make sure that things are working out for everybody. The family office is doing a good job managing it. If the family office doesn’t do a good job managing, you can just kick it out and replace them with somebody else. And so, they don’t have a right to these continued profits. They just have to earn their profits every year, and if they stop performing, then you can fire the family office and go somewhere else.
Now, at the same time, I wouldn’t want to be adjusting it all the time. Because then, it does kind of look like a fee and like you’re playing games to get a particular result. So I’d want to have the right to do termination or new periodic adjustments, like maybe every year or so. But I wouldn’t necessarily want to do it every year. I probably want to do it every few years, just to make sure that it looks real. Now, there were some proposed regulations in 2015 that IRS said ‘well, if you’re getting an interest in profits, that might be a disguised payment. It’s not really an interest in the profits of the partnership but it’s really like the partnership is paying some money to you, for a fee for services. And if it’s a fee for services, well, then we have a non-deductible investment fee.’ So, if you have a cap on the profits interest, that might make it look like it’s a fee. So a straight pro rata percentage on all partnership items seems to be safer.
Also, the IRS is concerned about the service partner manipulating the annual profits that generate a steady fee. So, if you need to get $500,000 a year to fund your family office, then maybe you just try to make sure you get $500,000 a year in profits that would be allocable to the family office and not do too much, not more or not less. Well, that kind of looks like you’re manipulating it to get a fee. So, you want to really consider it would be the lesser of a portion of the annual income that you actually receive or the cumulative realized and unrealized net income. So for example, if you have a lot of interest and dividends and you have a lot of capital gains, you also need to count your unrealized losses in figuring out what your level of income was so that there’s no manipulation going on.
That’s not a requirement of the regulations but it’s just something that when I analyze them, I thought it would be a good idea to do. And there are some other things you might want to do with it as well. For example, have the distributions of income that are earned in tax in one year. Well, what happens if you have losses in the next year? So, you should have to maybe even pay back some of the money that you received as income. So, you want to have this claw back requirement; but fortunately, the IRS doesn’t make you claw back on tax distributions. So, there are a lot of other things to consider. You would like to give a straight interest, probably to the family office. You also want to make sure the family office is adequately capitalized. You want to make sure that if there are ups and downs and when it gets its interest in the profits, it’s still able to function. If it has income one year and that makes it barely break even, but the next year there are losses and it has to pay that back, well, how’s it going to function? So, you need to have adequate capital in the family office, and that can be through equity infusions, and it can also be through loans from the family at the applicable federal rate. So those are just some of the factors to consider in structuring your family office — getting a profits interest. I hope you find this helpful. Thank you.
Thank you, Steve, for educating us on family office investment partnerships.
This podcast was produced by The American College of Trust and Estate Counsel, ACTEC. Listeners, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The material in this podcast is for information purposes only and is not intended to and should not be treated as legal advice or tax advice. The views expressed are those of speakers as of the date noted and not necessarily those of ACTEC or any speaker’s employer or firm. The information, opinions, and recommendations presented in this Podcast are for general information only and any reliance on the information provided in this Podcast is done at your own risk. The entire contents and design of this Podcast, are the property of ACTEC, or used by ACTEC with permission, and are protected under U.S. and international copyright and trademark laws. Except as otherwise provided herein, users of this Podcast may save and use information contained in the Podcast only for personal or other non-commercial, educational purposes. No other use, including, without limitation, reproduction, retransmission or editing, of this Podcast may be made without the prior written permission of The American College of Trust and Estate Counsel.
If you have ideas for a future ACTEC Trust & Estate Talk topic, please contact us at ACTECpodcast@ACTEC.org.
© 2018 – 2023 The American College of Trust and Estate Counsel. All rights reserved.
Latest ACTEC Trust and Estate Talk Podcasts
Patagonia Purpose Trusts
The founder of Patagonia clothing transferred $3B of stock to a Purpose Trust. What is a Purpose Trust and how does it meet Patagonia’s corporate objectives?
Tips for Joint Representation of Spouses: Part 2 of 2
Podcast two of joint representation offers four more tips for lawyers and the red flags to watch out for as they ensure both spouses are represented equally.
Tips for Joint Representation of Spouses: Engagement Letters (Pt. 1 of 2)
Four tips practitioners need to keep in mind when providing joint representation to spouses and where to find sample attorney engagement letters.