Client Alert
Some Family Offices May Avoid the Disallowance of Investment Expense Deductions Under Tax Reform
January 17, 2018
By Andrew Short, Ziemowit Smulkowski & Stephen Grace
On December 22, 2017, President Trump signed into law tax reform legislation (the “Act”) formerly known as the Tax Cuts and Jobs Act. Under the Act, miscellaneous itemized deductions that had been available to individual taxpayer’s to reduce taxable income are suspended from 2018 through 2025. Such miscellaneous itemized deductions include items such as unreimbursed employee business expenses, tax return preparation costs, cost incurred in contesting taxes, hobby expenses, investment expenses, and expenses for the production or collection of income among others. As a result, investment expenses and expenses for the production or collection of income under Section 212[1] incurred by individuals (either directly or through pass‑through entities) will not be deductible.
In contrast, deductions under Section 162(a) for trade or business expenses are not miscellaneous itemized deductions and remain available to reduce taxable income. Based on the continuing deductibility of trade or business expenses and the suspension of the deduction for investment expenses, this characterization takes on added importance. Determining whether a taxpayer is engaged in a trade or business or investment activity is a fact-intensive inquiry. Many similarly situated taxpayers may be able to slightly modify their operations so as to be engaged in a trade or business rather than engaged in an investment activity if the result was a change in tax characterization. On December 13, 2017, the Tax Court issued a memorandum decision in the case of Lender Management, LLC, et al. v. Commissioner[2] addressing the distinction between investment activities and trade or business activities in the context of a family office. The Tax Court found that Lender Management, LLC (“Lender LLC,” a family office providing management services to three separate investment entities owned by various members of the Lender family) was not merely an investor, but rather was engaged in a trade or business.
As a result of the Act, the Lender decision may be of increased significance. In deciding that Lender LLC was engaged in a trade or business, the Tax Court noted that Lender LLC received a carried interest as compensation for its services. A common factor in distinguishing between an investment activity and a trade or business is the nature of the return and whether there is a component in excess of an investor’s return. The Tax Court’s Decision also focused on the fact that Lender LLC had multiple employees both full- and part-time, researched investment opportunities, negotiated and executed new investments, monitored existing positions, and worked with individual investment entity members providing one-on-one investment advisory and financial planning services to address such members’ specific needs. The Tax Court found that the breadth of services Lender LLC provided to its clients was analogous to the services hedge fund managers provide to their clients, and went far beyond those of an investor.
As a result of the Act and the Lender decision, family offices offering services to their clients similar to those services provided by Lender LLC may be able to structure operations in a manner to continue to deduct operation expenses and avoid the negative repercussions of the Act’s suspension of miscellaneous itemized deductions.
[1] References to Section are references to Sections of the Internal Revenue Code of 1986, as amended.
[2] TC Memo 2017-246.
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