By Phil Jelsma
Under the Tax Cuts and Job Act enacted last month, the ability to make miscellaneous itemized deductions -- including for management fees for private investment funds -- has been eliminated. A recent U.S. Tax Court decision explores whether a family owned investment business was carrying on a trade or business for purposes of Internal Revenue Code Section 162. If so, expenses would be deductible as ordinary business expenses. If not, expenses would be treated as a miscellaneous itemized deduction.
California is a hot bed of family businesses, and in one of the first cases looking at the treatment of a family office, the U.S. Tax Court in Lender Management LLC v. Commissioner found the office was engaged in a trade or business and was allowed to deduct its expenses. T.C. Memo. 2017-246 (Dec. 13, 2017). Conversely, if the family office was not engaged in a trade or business, its expenses would be treated as a miscellaneous itemized deduction subject to a 2 percent adjusted gross income floor.
The case involves Lender Management, founded by Harry Lender of Lender's Bagels. His sons, Marvin and Murray, worked in the family office with Harry until his death. Lender Management had losses in 2010 and 2011, but had income in 2012 and 2013.
Owned by Marvin Lender and his son Keith, Lender Management provided management services to three investment LLCs, which were owned by the children, grandchildren and great-grandchildren of Harry Lender. The investment LLCs invested funds in private equities, hedge funds and public companies. Lender Management made executive decisions and executed transactions on behalf of the investment LLCs.
During the relevant years, Lender Management employed five people who provided investment services. These employees included Keith Lender (Marvin's son) who worked approximately 50 hours a week. Lender Management outsourced its accounting and tax reporting, and served as the manager and held a profits interest in the investment LLCs.
The Internal Revenue Service disallowed the business expenses under Section 162, arguing that Lender Management was not engaged in a trade or business. It did allow expenses under Section 212, which are investment expenses otherwise treated as a miscellaneous itemized deduction and, therefore, must exceed 2 percent of adjusted gross income.
The Tax Court noted that investing and facilitating the investment of others' funds may qualify as a trade or business. Investment advisory services also may be considered a trade or business. The IRS argued that "managing investments for yourself and members of your family is not within the meaning of a trade or business for purposes of Section 162." But the court found otherwise, and noted that if the family members were not satisfied with Lender Management's services, they could terminate those services.
The court also noted the ownership of the investment LLCs did not mirror the ownership of Lender Management, determining that the services Lender Management provided to its clients were comparable to the services hedge fund managers provide. Lender Management had the responsibility to provide its clients with sound investments tailored to their financial needs. Its activities went far below beyond those of a mere investor. As a result, the court concluded the relationship between Lender Management and the investment LLCs was a business relationship.
In light of the repeal of many miscellaneous itemized deductions, the conclusions in this case reached bode well for California's family offices.
Phil Jelsma is a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson LLC (CGS3), a San Diego-based commercial real estate law firm. He is recognized as a leading joint venture and tax attorney, with a 30-year background in real estate exchange transactions, syndications, nonprofit corporations and international tax planning.