Critical Tax Considerations When Structuring a Family Office
A wealthy family may create a family office to achieve a wide range of objectives. These objectives may include realizing the benefits of pooled capital in order to maximize the universe of available investment opportunities at optimal cost; maximizing investment returns; ensuring financial security for future generations; and providing coordinated administrative, managerial and wealth advisory services. Regardless of the family's objectives, certain legal and tax considerations often drive the structure and administration of a family office. The purpose of this Advisory is to provide an overview of the typical legal structure of a family office and the circumstances in which expenses incurred by the office may be deductible for federal income tax purposes.
Legal Structure of a Family Office
A key consideration when setting up a family office is to select the structure that best suits the family's objectives. There are several possible structures that may be considered, including forming a single family office, joining a multifamily office, and/or incorporating a private trust company into a family office structure.
A private trust company generally provides fiduciary services to a single family and may be regulated or unregulated depending on the state of formation. If a private trust company is being considered, the family will want to select a favorable jurisdiction in which to form the company. For example, South Dakota, Nevada and Wyoming and several other states provide advantageous legal, financial and administrative rules for private trust companies.
Then there is the highly important and sometimes highly technical question of whether to establish the office as a C corporation, S corporation, limited partnership, limited liability company or some other legal entity. Limited partnerships, limited liability companies and S corporations generally are the entities of choice because they permit the flow-through of income and expenses to owners. In addition, a limited partnership or limited liability company is generally preferred over an S corporation because the limited partnership or limited liability company can have multiple classes of interests, including, for example, an incentive payment or "carried interest" that may be held by junior generation family members, while senior generation members hold preferred interests having a frozen value. Neither preferential distributions nor multiple classes of units are permitted for an S corporation. In comparison, advantages of a C corporation include, for instance, income and expenses do not flow-through to the owners and, therefore, owners can avoid having to pay tax on phantom income, and the 2% adjusted gross income rule discussed below does not apply. However, owners of a C corporation do not directly receive the benefit of preferential capital gains rates on their investments (i.e., all distributable income is taxed as ordinary income).
Finally, depending on the type of investments, it may be advantageous to organize multiple business entities to hold the various assets managed by the family office. In a typical structure, separate entities would be created for various classes of investments made by the office. For example, the office may operate an "Alternative Investments Pool LLC," a "Large Cap Equities Pool LLC," a "Real Estate Investments LLC," etc. A separate Management Company LLC would manage these investments and exist to house the administrative and operational functions of the office.
Deductibility of Administrative Expenses
A key objective that many families hope to achieve in forming a family office is the possibility of deducting certain administrative expenses relating to the business without those expenses being subject to the 2% AGI limitation. For individuals and trusts — as opposed to operating businesses — only expenses that are over 2% of adjusted gross income may be treated as miscellaneous itemized deductions. As a result, individuals and trusts often do not realize a benefit, or realize only a limited benefit, from these deductions. In certain cases, a family office may be integral to the operations of a family business or the office itself may engage is such a high volume of trading activity that the office itself constitutes an active business. This may create the potential for more favorable treatment of certain expenses (e.g., start-up costs, equipment and supplies, overhead and employee salaries). In these cases, such expenses may be above-the-line deductions and would not be subject to the 2% adjusted gross income limitation, resulting in potential tax savings for the family office
Individuals who are considering forming a family office or who have legal questions regarding family offices should consult experienced counsel. The Family Office Group at Wiggin and Dana has experience with a wide variety of legal matters relevant to family offices, including tax and estate planning, tax compliance, governance, securities law, employment, real estate and other matters, and can assist individuals in forming and maintaining a family office that is specifically tailored to their short-term needs and long-term goals. Please do not hesitate to contact us here.