Funding Family Offices through Profits Interests

“Funding Family Offices through Profits Interests,” that is the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow John Challis of St. Louis, Missouri.

Funding a family office through profits interests can offer a flexible and tax-efficient way to align incentives while supporting the long-term management of family wealth. Today, we’ll examine how profits interests can be structured, the tax considerations involved, and the planning opportunities they may present for family offices and their clients.

ACTEC Fellow Dave Berek from Chicago joins us today to share his thoughts. If you’re advising families with significant wealth, this presentation offers practical insights into a sophisticated planning technique. Welcome, Dave.

Dave Berek: Thank you, John. And I really appreciate the opportunity to review my presentation from the June Business Planning Meeting at ACTEC. And I gave that presentation with my colleague, Michael Mazzone, with whom I worked together years ago.

I want to note that this has been kind of an emerging trend in family offices. And a lot of my clients will call me up and say that they would like to adopt a “Lender structure.” And Lender structure was successful in the tax court because they kind of prevailed the tax court by using a profits interest to fund their family office. So that’s what I want to talk about.

One of the reasons this is so topical today is because there were two developments. And those developments were in 2017, but they had kind of gone through the system. And now we have learned over the years, and I say most recently, the past couple years, past maybe three years, we’ve really gleaned from both the Lender (Lender Management LLC vs. Commissioner) case and also the change in the tax law on how to use that to our advantage in a family office structure.

The two changes, the two developments in 2017 were:

1. The first development was the limitation on deductibility of investment advisory fees under Section 212. Those were part of the Tax Cut and Jobs Act bill in 2017. They were made permanent, so the limitation was made permanent, by the One Big Beautiful Bill in 2025. And so, they no longer allow an individual to deduct investment advisory type fees on their Schedule A1040. Therefore, if there were expenses incurred at the family investment pool, they were reported on a K1 and sent down separately to the owners. And so, the income was certainly included on the individual’s 1040 or the trust’s 1040, but the deductions were then categorized, identified, and limited. So that is the big change under 212.
2. The second development is, again in 2017, was the Lender management decision. And the Lender management decision, I want to say, was issued on December 15th of 2017. And then shortly after that, if you recall, the Tax Cuts and Jobs Act came through about a week later, so very close to the end of the year in 2017.

They both came out so close together, I think maybe practitioners missed the Lender decision, and it just became super relevant within about a year. And only now do we kind of really know how to make that work. And so let me talk about the Lender decision, why it’s important to understand how it might apply to your family office client or how it might not.

The Lender Decision and Family Office Tax Deductions

Under Lender, there was a large family group. There was a family office that was serving a large number of individuals, trusts, generations. They had a number of different investment categorizations. So it was what I considered to be a pretty intense and integrated family office structure. Truly the individuals that were investing — the entities, the trust, the people — they were clients of the family office. The family office is offering a service.

I raise that to say that the size of the family matters. If you are investing for a large group of people and entities, a lot of, I would say, a big enterprise, meaning a large investor pool, that really lends itself to calculating a profit’s interest that the family office should receive for providing those services. If you have a smaller family group — like one generation, two generations — and a limited number of what I call clients of the family office, it’s a little more difficult to satisfy all the criteria that were identified under the Lender situation. Not saying it’s impossible, but it’s just it’s much more difficult. Nowadays, when a client comes to me and says, I would like a Lender structure, I step back and say, well, maybe we should have a Lender family first and make sure we qualify there, and then we can see if it works.

Let’s now talk about what did Lender do that was successful that we now know is kind of a critical inherent of the successful profits interest. The Lender family had individual arm’s length asset allocations that they reviewed with their clients. That’s factor number one. Number two, disproportionate and independent investment accounts. It was a very detailed offering. They had number three, tailored and active fee-based services — so not just investment services, but other things that they calculated a fee, a separate fee on a separate basis. So, in addition to the profit center’s allocation, they also were providing different things for different numbers of the family and calculating a fee against that. And the accounts were spread independently across generations.

I raise all these unique attributes of what they offered to fortify the fact that the Lender structure qualified under 162 as a “trade or business expense.” They were doing things that were above and beyond just managing their own money; they were offering a truly investment advisory service that was a trade or business. That is the key to Lender because they surpassed the 212 limitations, not to 212 expenses, these are trade or business 162 fully deductible.

So that’s where you want to end up. You want to end up on 162 land. The reason Lender succeeded was because of those four factors, and they looked at the economic independence of the family office. There were separate client relationships. There was a performance-based compensation element. There was documented business activity. They did all these things, they satisfy the 162.

Structuring Investment Services Under the Lender Model

So what can we do? What should we look at? What might your family office clients be doing? Let’s talk about the structure of the offering. I’m going to go back to those four basic categories:

• individualized,
• disproportionate,
• tailored, and
• independent.

And these all address the separate fund vehicles. The Lender structure — the Lender family — and I imagine a lot of the family offices that you serve also, they offer different classifications of investment type opportunities.

Number one, they separate classification by asset type. So, they had offerings that was income generating; think of bonds, cash, income-oriented strategies. They also had growth and appreciation-oriented sleeves. So, equities, private equity, venture capital, things like that. And then they also had asset class separated by a fund strategy. You might have a public-entities offering. You might have a hedge fund offering. You might have private equity alternatives and direct real estate investments. All very common in the family office structure and something that really classifies the asset type.

They also looked at family line classification. They had family lines by descendants of the founder. They also had trust lines — separate trust were clients and offered different types of investment opportunities for the trust, which you can obviously see. If you had a GST exempt trust, you might want long-term capital appreciation. And if you had a non-exempt trust, you might want low-income tax, municipal bond portfolios, things like that.

And then they had, again, to leverage on that, income tax classifications. certain character of income just to produce the right tax result.

I want what you should be gleaning from this is that the Lender structure is offering a service to clients. They’re not just making it a fee and saying, this is where we’re going to charge you. They’re saying that this is why we’re going to charge you that.

Best Practices for Calculating Profits Interests

Now we need to connect the calculation of the profits interest with the family office activities. And here I’m going to go through a list and say, here are things that best practices that a family office should consider when they’re calculating their profits interest.

• First, you want to draft against a just straight up net profits. It can’t be just like 10% I got a 10% return on anything over 15% return. I get a 10% carry off of any kind of like a flat return. You want to base that on what you’re actually doing. You don’t want it to look like a guaranteed payment.
• You want to match the economics to the services so that if you have passive portfolio that you’re that the family offices is not doing a lot, that’s going to be a lower fee than a highly labor-intensive portfolio oversight.
• You want to use investment mechanics like hurdles, high watermarks, low watermarks.
• You want to manage the profits interest based on what you’re actually doing. That’s a theme I’ll keep saying.
• When you determine what the family office needs to operate, you want to have a detailed budget. You’re going to work on what payroll is expected to be, what kind of advisors you need to employ in order to produce the type of services that you’re offering to your family clients. You want to take into account the cost of the compliance — tax prep, things like that, and the technical things that you might need to do to run it.
• You’re also going to want to keep detailed documentation — minutes, budgets, side letters, engagement letters — all to support the compensation that the family office is charging to the members that support the profit’s interest.
• And then really prefer caps, and we adjust those caps as things change, as people change in and out of the office.

That’s what supports the calculation of the profit centers. And if you follow those rules, then you should be able to get trade or business treatment that’s under 162 and you avoid the 212 but non-deductible expenses from your family office.

Registered Investment Companies as an Alternative

Now I’m going to give a short introduction to a current trend, this won’t be very long, but it’s just going to introduce what is best practices currently or at least a very active trend in the past couple of years. And that is using a registered investment company. I was pressed to find a solution for a family that’s a very small family group. There’s a lot of wealth to be invested, but a small number of clients; one generation. So it didn’t fit the Lender model where they serve multiple generations, multiple offerings, that kind of thing. So, what we looked at was a registered investment company. This was a non-publicly traded RIC that the family office investment pool invested in. Essentially, they created their own registered investment company, contributed the money of the family into this registered investment company. And that was essentially like their sole security, investment security. So that’s what was their investment. And that is the entity that incurred expenses.

That entity then subcontracted out a supervisory fee to the family office. Help us with the investment selection and where we should be employing the investments so that we can provide the best return for the family. That sub-advisory fee to the family office was deductible. The RIC itself incurred the expenses, deducted it directly against the returns that it produced, and then came to essentially net income that it divided it out to the owners, which is the family investment pool, the family investment entities, right? So, all that, there’s no question of 212-162. It was straight 162 because the RIC was an operating entity investing money. It happened to only be investing the money for one particular family, but that’s how it worked.

They use all the same things that the Lender structure use. They have investment baskets, custom baskets for certain types of returns on investments. And you can also within a registered investment company like an ETF. You can redeem out shareholders. You can also change the investment profile tax-free because it’s our investment company, it’s an ETF. It’s very effective and minimizes income tax drag. It doesn’t have difficulty with the Lender family situation. It could be a small group of people.

I will say this, that they are somewhat expensive because you’re running a registered investment company. So, it’s going to be more expensive than a family office. However, the expenses are going to be deductible. So, with a large family with significant wealth that is troubled with the Lender characteristics by not surpassing it, a RIC is an example that should be looked into.

John Challis:  Well, thank you, Dave, for a great presentation on funding family offices through profits interest. I think this will be very helpful to our podcast audience.

 

You may also be interested in

• Designing the Modern Single-Family Office: Classic Structure vs. Profits Interest (June 2026)
• Family-Owned Business and Internal Revenue Code Chapter 14 | Pt 2 of 3 (May 2025)

 

 

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 – 2026 The American College of Trust and Estate Counsel. All rights reserved.