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During estate planning, one of the situations you have to plan for is the possible sale of real estate, artwork, and especially operating family businesses. What is sometimes overlooked in planning is what happens after there has been such a sale.
When you do own real estate, artwork or an operating business, the structure is dictated by business needs, control requirements, and income tax efficiency of those assets. Little, if any, attention is paid to the legal, accounting, management and other services that directly or indirectly benefit the owners of the company. IF the real estate, artwork or business are held as investments, that is an asset used for a trade or business, these expenses can deductible by under IRC section 162.
Previously, when the liquid proceeds of a sale were invested into an investment portfolio, these expenses could be deducted as expense to produce income under IRC section 212. Not anymore. The Tax Cuts and Jobs Act (TCJA) of 2017 suspended section 212 until at least 2025, making legal, accounting, tax and similar advisory service expenses no longer deductible except if those expenses are trade or business expense of an operating company and so deductible under section 162.
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The “Holy Grail” of tax practitioners, even before TCJA, has been a family office structure which can deduct the fees and expenses of managing family wealth as an operating company. The Tax Court, in Lender Management (TC Memo 2017-246) decided that the family office that managed the wealth of the children and grandchildren of the founder of Lender’s Bagels was able to deduct these expenses since Lender Management is an operating business.
Having this decision confirms that it is possible to set up a family office that can deduct expenses as an operating company, but it does not ask all of the questions a family need to ask on setting up an operating family office, or some of the pitfalls that, even if the family office is an operating company, can lead to adverse income tax effects.
This is a summary of the questions and some of the pitfalls in setting up a family office when a family has a liquidation event and some suggestions on how such a family office could be enhanced.
Is This the Right Question?
The deductibility of managing family wealth is a laudable goal, but it is often not the right question to lead with. Rather than asking if it is possible, the family needs to ask:
· First, is the Family’s Goal for forming, or maintaining, a Family Office best served by the strategy of making it an operating business? If an operating family office is not necessary to achieve the family’s goals, it will not be worth the time and effort to set one up and to maintain its operations.
· Second, if the strategy of forming and maintaining an operating family office best serves the family, then which tactic is necessary to achieve the family’s objectives? This includes things like choice of entity, being limited to only family as clients, what to outsource, what to bring in house, governance, and oversight.
· Third, is the formation and maintenance of an operating family office going to be sufficient to meet the family’s goals in the long run? The operating family office should be run as a profitable business to be sustainable over time. If it is profitable, will have enough income against which the expenses can be deducted and can return a profit to the owners of the family office. This is critical to avoid the loss of section 162 deductions to prove the family office exists for something more than just the tax savings.
· Finally, what, exactly, are the steps that will needed to set up and maintain an operating family office and are those steps even possible for the family to take?
Even if the Operating Family Office is actually possible, the long held habits and behaviors of members of the family, particularly the founding generation of family wealth, are used to doing things their way with their money, even if they know why there is a tax savings of doing things in a more formal, collaborative, manner. Their behaviors are disciplined in the operating business because they have to meet the approval of creditors, clients, vendors and employees. When it comes to investment of liquid wealth, that discipline is often lacking, and many bad behaviors continue for the older generations and are allowed to grow for the younger.