Family offices are as different as the families they serve—one size doesn’t fit all. For families that are seeking to coordinate and consolidate their investment management and planning, a well-structured family office can play a crucial role in the preservation and growth of wealth through the generations.
Just as every family is different, so too is what’s required of every family office. Since business families established the first family offices in the early 20th century, their number has steadily increased, with the first decades of the 21st century seeing the most rapid growth. As they’ve multiplied, family offices have taken different forms, depending on a family’s needs.
As a family’s businesses, wealth and needs evolve over time, the family should revisit the management and structures in place that serve and implement their vision. With strong commitment and governance, a family office, in its many forms and iterations, can provide a family with investment, organizational, legal and tax benefits. Here’s how advisors can help their family office clients achieve these goals.
Overview
A family office safeguards a family’s wealth and values across generations. It implements investment, wealth planning and philanthropic strategies designed to achieve the family’s long-term goals. Depending on the family’s objectives and wealth, the size and structure of each family office will differ.
Most family offices evolve to suit a family’s changing needs, starting within a family business and then becoming a stand-alone organization. The funding, legal entity, ownership, taxes and activities of a family office all have implications that require thoughtful consideration.
What’s a Family Office?
Families create family offices to manage their wealth while nurturing their identity and values. They look after a range of areas from wealth management to wealth transfer, philanthropy and family governance.
The Family Office Exchange (FOX), a membership organization of family offices, defines a “family office” as “a unique family business that is created to provide tailored wealth management solutions in an integrated fashion while promoting and preserving the identity and values of the family.”1 The family office acts as the quarterback for the stewardship of the family wealth, coordinating with the family’s outside professional advisors and creating and implementing strategies connected to the family’s wealth objectives. Typical family office services include providing directly or coordinating with outside professional services such as tax, investment management, wealth transfer (including estate and philanthropic planning), risk management, family governance and financial education and development of the talent of family members. In addition, the best family offices have a higher purpose, which is “to bridge generations to create continuity and cohesion for families around their wealth.”2 In its ideal form, the family office helps steward family wealth by supporting the following four dimensions of the family:
- Business legacy
- Financial legacy
- Family legacy
- Philanthropic legacy3
History of Family Offices
In the United States, the early family offices were established by business-owning families that made their wealth during the Industrial Revolution. One of the first family offices was established in 1882 by John D. Rockefeller Sr. as a mechanism for centralizing the family’s wealth and philanthropy. Numerous other business-owning families of great wealth followed Rockefeller’s lead, such as the Mellon, DuPont and Phipps families.
The growth of family offices connected to family business continues today. A recent study found that more than 70% of family offices surveyed originated from an existing family business, with 60% of those surveyed continuing to own an operating business.4 Because these entities are private and emphasize confidentiality, it’s difficult to get a true number of the family offices currently in existence in the United States. It’s estimated that there are more than 3,000 single family offices (SFOs) and at least twice that number embedded within private operating companies (primarily family businesses).5
Scope of Services
Understanding the services a family office oversees or provides directly gives a strong indication of how it operates in relation to a wealthy family. Family offices typically provide six basic categories of services (see “Scope of Services,” p. 28):
Strategic wealth management. This involves long-term strategic planning for accomplishing family wealth objectives for current and future generations. In addition to determining goals, strategic wealth management includes building the family’s governance structures, including family boards and councils, as well as family mission statements and constitutions.
Investment planning. Whether investments are handled in-house or outsourced, proper investment oversight—including asset allocation, portfolio construction, creation of investment policy statements, manager selection and due diligence—is at the core of family office functions. Also included in this category are investment recordkeeping and reporting (including consolidated reporting).
Trusts and estates. This service involves overseeing the structure and execution of the legal documents necessary for efficient wealth transfer. The family office is also the keeper of these documents, often overseeing their administration and working with those serving in any fiduciary role. Many wealthy families choose to establish a private family trust company (PFTC) under the laws of a trust and tax-friendly state (for example, Nevada, New Hampshire or South Dakota) to act as trustee of the various family trusts. In fact, in some circumstances, the PFTC can act as the family office or the family office can be an affiliate of the PFTC.
Philanthropy. This service includes developing strategies for helping the family be effective in its charitable giving. Creation and oversight of the family’s giving vehicles, such as family foundations and donor-advised funds, are also a component of family office philanthropic services. Involving the rising generations in the family’s philanthropic initiatives can be an effective way of transferring values and engaging younger family members in the overall family governance structure.
Family governance and education. Once family governance structures are in place, the family office coordinates the necessary meetings and communications to make sure such governance structures are working effectively. Family education involves teaching each generation of the family necessary skills to ensure they’ll be effective shareholders, directors and managers of the various family governance structures and businesses.
Tax and financial planning. Tax planning includes the oversight of personal and business tax returns. Financial planning includes cash flow management and budgeting for individual family members, along with bill pay and concierge services such as management of family real estate and art.
Types of Family Offices
Family offices are as unique as the families they serve. They should be structured in a manner that best represents the particular needs of the family. When a wealthy family is considering a family office, there’s a steep learning curve. Numerous for-profit entities provide family office services. These include private banks, private wealth divisions of large brokerage firms, registered investment advisors, accounting firms, private client law firms and consultants. All have their place in the structure and execution of family office services, but the family first needs to consider the type of family office it will create or participate in. These include:
SFO. An entity that manages the financial and personal affairs of one wealthy family. Such an entity typically has several staff members including a chief executive officer (CEO), chief investment officer (CIO), staff accountants, bookkeepers and employees handling family real estate, art and family education and governance. Complicated tax planning, certain investment classes (for example, hedge funds and private equity) and wealth transfer planning are typically outsourced. Some family offices, however, particularly those affiliated with family businesses, have tremendous in-house expertise operating closely held businesses and decide to use that expertise to make direct investments in these types of entities. There can be a dedicated family office location, separate from the family business, with little or no crossover staffing and its own tech infrastructure for privacy and confidentiality purposes.
Virtual/coordinating family office (VFO). A VFO outsources most if not all activities, gaining access to people, products and services when needed. It typically employs one or two individuals to handle day-to-day operations and coordinate outside advisors and outsourced services. It’s usually headed by a senior family member, the family business CFO or a trusted professional, such as a CPA or attorney. Many private banks and private wealth divisions of large brokerage firms have set up specialized departments to provide these entities with full service around investing, along with specialty advice in wealth transfer, succession planning, philanthropy, family education and family governance.
Family-owned multi-family office (MFO). A company that manages the wealth of a group of wealthy families. It’s usually owned by one or more of the founding families. The idea is to reduce the overall cost of services when compared to a full-fledged SFO.
Commercial MFO. Typically, a boutique investment firm owned by a third party that provides investment and certain other ancillary services to wealthy families. These businesses range from pure investment shops to those that provide a full range of family office services.
Some family offices have tremendous in-house expertise, operating closely held businesses, and decide to use that expertise to make direct investments.
Evolution of the SFO
Most family offices begin within the family business before evolving into dedicated entities. Structuring family offices takes careful planning, including legal and tax considerations.
Because the majority of family offices evolve from a family business or the sale of a family business, understanding the evolution of such entities helps put the spectrum of family offices in context. Most family businesses, no matter what the asset level, provide family office-type services to owners and their family members. It isn’t uncommon for a family business to also be called the “family bank.” The formalization of these services into a family office structure depends on several factors, including:
- the size of family wealth;
- the current generation of the family business (for example, a family office serving the founder and their descendants or a family office serving third, fourth and fifth generations);
- the size and complexity of the family;
- the cost; and
- the willingness of family members to work together on their personal financial matters.
The stages of family office evolution when connected to the family business are typically:
Embedded family office. An embedded family office provides services to family members within the family business. There are typically no separate employees. Services are provided by family business employees, specifically long-tenured, trusted employees. Most services are outsourced under the oversight of a family member or trusted employee. This type of structure can work well for smaller families in the founder or sibling generations, or families with total wealth less than $250 million, when hiring dedicated employees may be unwarranted or cost-prohibitive. There are several downsides to this type of structure. First, family business employees may not be particularly skilled in providing oversight of family office services such as investments, wealth transfer and family governance. Second, these employees may favor family members active in the business to the detriment of inactive family members. Third, these entities tend to have less confidentiality and privacy for family members. Fourth, the employees often have other duties, so there’s a competition between business-related duties and family office-related duties. If there’s a major transaction, an employee may be distracted from handling important but perhaps less urgent family matters (for example, estate tax planning). Finally, if the family decides to sell the business or bring in outside investors, it will need to address those “personal” expenses that the business has been covering.
Separate VFO. Sometimes motivated by the scale of family wealth or the increasing number of family members, the family moves family office services out of the family business to a dedicated entity that only handles family office services—a separate VFO. While most services continue to be outsourced, management is professionalized and dedicated specifically to the family office. These types of entities work well with families with total net worth of $250 million to $1 billion.
SFO. Once a business-owning family crosses the billion-dollar mark, things tend to change. More of the administrative services are brought in-house. In addition, SFOs typically have a CIO who may invest in many asset classes in-house. The SFO tends to have the greatest internal costs, but these can be offset by the fact that investment fees to outside providers are reduced by in-house management and economies of scale due to the size of assets under management.
Structuring an SFO
If a family determines that an SFO is the best approach for coordinating and centralizing the management of the family wealth, it’s important to follow a methodical process to help ensure the delivery of the scope of services needed by the family, achieve the desired legal and tax results and establish a governance structure that will serve the family over multiple generations.
Mission and strategy. A family office mission may include:
- preservation and regeneration of family wealth;
- a coordinated approach to decision making;
- development of family talent and entrepreneurship;
- support of family unity; and
- strategic philanthropy.
While the mission of the family office may be initially determined by the senior generation establishing the family office, it will likely evolve over time as rising generations become involved in decision making and governance.
Once the initial mission of the family office is clear, strategies to achieve the goals are easier to evaluate. A crucial element of strategic planning for a family office is to align the goals of the family with the goals of the family business (if there is one), the family office and family philanthropy. Family decision makers and stakeholders should consider holding several meetings at the outset to ensure that opinions, concerns and ideas are raised, debated and resolved. Communication on topics like involvement of spouses, investment philosophy, employment opportunities for family members at the family office and processes for making hiring decisions can be important at the outset to ensure the family is on the same page. The strategy isn’t stagnant: It should be reviewed and revised every few years and when significant changes in family circumstances occur.
Business plan. Once the mission and strategy are in place, the next step is a business plan. Creating an effective business plan for the design of a family office requires putting together a team, including family members, trusted advisors and, under some circumstances, a family office consultant. Mapping out the current situation is a good place to start. Who currently advises and supports the family? What’s working, and where are the gaps? Are the existing tax and legal advisors sufficient, or should new advisor partnerships be established? This will help the team determine the role the family office will play. It will also help determine which services should be handled directly by the family office and which should be outsourced. The business plan should also address governance, legal structures, staffing, tax, accounting and IT. One mantra the team should remember during the business planning process is: “Don’t overbuild.”
It’s important to understand the upfront legal, tax and accounting costs to establish and maintain an SFO. A recent UBS Global Family Office survey estimated that the annual cost of an SFO (including outside investment management fees), expressed as a percentage of assets under management, is typically between 105 to 118 basis points.6
Legal and Tax Considerations
The legal structure of the SFO may generate tax benefits for the family. As a result of recent tax law changes and legal developments, many families are revisiting the structure of their family office to avail themselves of the ability to deduct investment management fees for income tax purposes.
Background. Historically, expenses incurred for the production of income or the management or conservation of property held for the production of income (for example, investment advisory fees) were deductible under Internal Revenue Code Section 212 to the extent those expenses (together with other miscellaneous itemized deductions) exceeded 2% of adjusted gross income for a given tax year. However, the passage of the Tax Cuts and Jobs Act of 2017 (the 2017 Act) changed these rules.
The 2017 Act added IRC Section 67(g), which suspended the deduction of miscellaneous itemized deductions subject to the 2% floor for tax years 2018 through 2025. As a result, unless a deduction for these expenses is available under another section of the IRC, certain individuals and entities, including family offices, engaged in investment management may no longer be able to deduct these expenses.
Under IRC Section 162, expenses incurred in an investment management business are fully deductible. The 2017 Act’s elimination of miscellaneous itemized deductions (including those under IRC Section 212) didn’t impact the ability to deduct expenses under Section 162 for expenses incurred in an investment management “trade or business.” Therefore, an investment management enterprise that’s recognized as a trade or business can still deduct investment management expenses.
Regarding what constitutes an investment management trade or business, courts have historically imposed strict standards for determining whether investment management and related activities constitute a trade or business. Investing one’s own assets doesn’t rise to the level of a trade or business.
Some of the relevant factors that courts have considered are whether the enterprise has a full-time staff, if the nature of the services provided are commensurate with those provided by investment managers in the marketplace, whether the investment manager receives compensation and the type of compensation received and whether the owners of the service provider and the “client” are the same.
Recent case law: Lender and Hellmann.The U.S. Tax Court has addressed the question of whether an investment management activity rises to the level of a trade or business in two recent cases. The first case is Lender Management LLC v. Commissioner.7In Lender, the Lender family (that founded Lender’s Bagels) established an investment management arm of its family office, as shown in “Investment Management Structure,” p. 32.
Lender Management LLC served as the investment management company, and it provided investment management services to the three investment limited liability companies (LLCs). Various Lender family members owned the investment LLCs. The two Lender family members who owned Lender Management LLC also held minority interests in the investment LLCs. To facilitate investment management and diversification for Lender family members, the three investment LLCs were established. Each LLC invested in a different asset class, one invested in private equity, another in hedge funds and the last held publicly traded securities.
In exchange for acting as sole investment manager for each of the three investment LLCs, similar to what would be seen in a private equity or hedge fund, Lender Management received a profits interest as well as a management fee from the Investment LLCs. Lender Management LLC deducted expenses related to salaries and wages for its staff, repairs and maintenance, rent, taxes and licenses, depreciation, employee benefits programs and other expenses involved in running the operations of the entity.
The Tax Court held that Lender Management LLC was engaged in a trade or business and that its expenses were deductible under Section 162. The court identified the following specific factors as being significant in its determination that Lender Management LLC was engaged in a trade or business: (1) its compensation structure was similar to that of a private equity or hedge fund manager as opposed to just representing returns of a passive investor because of the profits interest for its services in addition to its management fee; (2) there was a difference in ownership of Lender Management LLC and the investment LLCs; and (3) Lender Management LLC had full-time employees and substantial operations in managing the investments of the investment LLCs.
The second recent case is Hellmann v. Comm’r.8 The taxpayers and the Internal Revenue Service settled the case prior to a decision from the Tax Court after the initial court proceedings. However, on Oct. 1, 2018, the Tax Court issued an order in the case, denying the taxpayer’s request for a ruling that the facts of the case were so similar to those in Lender that a trial was unnecessary and the taxpayer should prevail as a matter of law. In the order, the Tax Court discussed the Lender case and contrasted the facts of thatcase with those of Hellmann.
The Tax Court noted that the structure in Hellmann lacked the disproportionality of ownership as between the management company and the assets being managed that was present in Lender. In Hellmann, the same four family members who owned the management company also owned the assets being managed in the same proportions. In addition, the Tax Court highlighted that the family members in Lender were more akin to independent clients than in Hellmann because in Lender, some of the family members were geographically dispersed, didn’t know each other and had very different investment goals and objectives.
In the order, the Tax Court in Hellmann reiterated the importance of the following factors in the analysis of whether an investment management enterprise constitutes a trade or business:
- The nature and extent of the services provided by the employees of the family office;
- The expertise of and the time spent by the family office employees as compared with outside investment managers and consultants;
- The differentiation of investment strategies for different family members based on individual investment desires and needs; and
- The proportionality among the share of profits indirectly flowing to each family member through their share of ownership of the family office relative to that same family member’s ownership of the managed funds.
If otherwise in line with the family’s objectives, those family offices and others engaged in investment management activities may be able to deduct expenses (including third-party management and related fees) by following the structure and rationale set forth by the Tax Court in Lender and Hellmann. Specifically, the management company should:
- be owned by different family members or in different percentages relative to the owners of the investment LLCs or “clients;”
- receive a profits interest and a management fee for its compensation;
- provide extensive services rather than only administrative or “back office” services; and
- have full-time employees.
Funding the Family Office
The funding, legal entity, ownership and activities of a family office all have implications that require thoughtful consideration.
Many family offices fund their operations and expenses through a profits interest structure as was present in Lender. The favorable tax treatment and ability to deduct investment advisory fees and other professional fees is possible only if the family office assumes meaningful economic risk. In “Smith Family Office,” p. 34, the Smith family office would receive a management fee and economic return through a profits interest, or carried interest, meaning that the family office only receives cash to cover expenses if the investment LLCs are profitable. If, in any given year, the cash received due to the profits interest is insufficient to cover expenses, the Smith family office, or its owners, would be liable for the balance of the expenses. This structure substantiates the position that the family office is a bona fide trade or business.
Choice of Entity
An additional element of the strategy that might be considered is the use of a C corporation (C corp) rather than an LLC for the legal form of the management company. C corps are entitled to a presumption under the tax law that they’re engaged in a trade or business and, accordingly, that a C corp’s expenses are properly deductible. From a tax standpoint, this may strengthen the argument that the management company is engaged in a trade or business. However, the presumption under the tax law that a C corp is engaged in a trade or business is rebuttable. That is, simply incorporating an enterprise that wouldn’t otherwise pass muster as an investment management trade or business won’t carry the day, but it may be used by a management company as a positive factor tending to show that it’s engaged in a bona fide trade or business activity.
However, when considering C corps, it’s important to pay special attention to other, less desirable tax consequences that might arise. Two such considerations are the personal holding company tax rules and the accumulated earnings tax rules.
The determination as to whether a corporation is a personal holding company and, if so, if it’s subject to the personal holding company tax, is an analysis subject to many nuances and exceptions. In general terms, a personal holding company is a corporation: (1) that receives predominantly income from passive sources (interest, dividends, rents, etc.), and (2) of which five or fewer individuals own, directly or indirectly, more than 50% of the value of the stock. In addition to their regular corporate income tax liability, personal holding companies are subject to an additional corporate level tax on their personal holding company income (a defined term). As such, many family office investment management companies will fall within the definition of a personal holding company and should consult with their tax advisors relative to the application of the personal holding company tax rules.
The accumulated earnings tax is an additional corporate-level tax imposed on corporations that retain earnings in excess of what’s necessary to meet the reasonable needs of the business. Without the accumulated earnings tax, corporations would be able to avoid having their shareholders pay tax on dividends from the corporation by retaining the cash within the corporation. As a result, unless the corporation can show that retained earnings are intended to meet the reasonably anticipated needs of the business, the accumulated earnings tax may apply. Given the reduction in the corporate tax rate that came as a result of the 2017 Act, the IRS is more likely to focus on corporations seeking to avoid issuing dividends that may be subject to higher individual federal income tax rates by retaining the funds inside the corporation. Accordingly, family offices that structure their investment management companies as C corps should consult with their tax advisors regarding the potential application of the accumulated earnings tax.
In addition to the tax issues, there’s an often-overlooked privacy issue. For purposes of diversity jurisdiction in federal court, the court looks through any entity other than a corporation. If a family office is organized as an LLC, this potentially can expose the family’s wealth structure (or at least a part of it) to the public.
If the family office doesn’t hold any underlying investments, then this isn’t an issue. In many cases, a family’s investments are held through trusts, LLCs or other entities, and the family office is only providing management and other services to those entities.
If, however, the family office acts as a holding company, then this is an issue. If, for example, the family office owns an interest in a commercial office building through one or more LLCs and there’s litigation against the owner of the real estate, the court would look through the LLCs and the family office for purposes of determining diversity. If the family owns the family office through one or more trusts, that structure will become a part of the court’s records.
The parties to the litigation can seek a protective order barring the disclosure of that information, and a court often will grant it. However, it’s unlikely that, if a third party—such as a media outlet—challenged the order, the order would survive scrutiny.
The importance of this issue varies from family to family. Some families aren’t concerned about the potential exposure. Other families are more protective of their privacy.
Management Company Ownership
Income tax considerations are critical when considering the ownership of the management company (for example, the Smith family office), and for those reasons, it may not be advisable for the management company to be owned by Generation 1. However, transitioning ownership of the management company to younger generations may result in gift and estate tax consequences. If the management company is funded through a profits interest, a proper valuation of the carried interest should be obtained.
Due to the intra-family nature of the family office structure, if the carried interest is undervalued or overvalued relative to what the value would be in the commercial market, a taxable gift could result. Furthermore, the carried interest should be carefully analyzed regarding whether it would be considered an interest to which IRC Section 2701 applies. If Section 2701 applies to the carried interest, an unintended gift might result.
Securities Law Considerations
Family office management and advisors will need to be familiar with the federal and state securities laws that can affect their operations. Because a family office will generally provide advice relating to the family’s investments in securities, it will be subject to regulation and registration requirements under the Investment Advisers Act of 1940 (the Advisers Act) unless it falls within an exemption. The Dodd-Frank Act created a rule in 2011 that provides an exemption for family offices from regulation and registration as an “investment advisor” if they meet certain requirements.9
The “family office rule” contains complex definitions and requirements that family offices need to examine closely in light of their particular facts and circumstances. Generally, to be considered a family office that qualifies for the exclusion, it must provide investment advice only to “family clients,” be wholly owned and controlled by family clients and can’t hold itself out to the public as an investment advisor.
The definition of “family client” is complex and important to understand. It covers certain family members, certain trusts and entities operated for family clients, key employees of the family office and certain family-funded charitable organizations. Family members include all lineal descendants of a common ancestor (up to 10 generations removed) and spouses or spousal equivalents of those descendants. The family member definition includes individuals adopted, stepchildren, foster children and former family members (for example, divorced family members). Note that the definition doesn’t include in-laws. Accordingly, if a family office provides investment advice to the mother-in-law of a family member, for example, it may lose the ability to claim the exemption from regulation under the Advisers Act. The family office may be able to request a “no-action” letter from the SEC on this issue.
The inclusion of “key employees” under the definition of “family client” creates the ability for a family office to offer investment opportunities to key talent as a means to create an attractive compensation package. The definition of “key employees” includes an employee of the family office (or an affiliated family office, also a defined term) who’s an executive officer, director, trustee, general partner or any other employee, other than a clerical or secretarial employee, who’s participated in the investment activities of the family office for at least 12 months. Former key employees are also recognized as key employees, such that a former CEO, for example, can maintain their investments with the family office but can’t make additional new investments after they no longer work at the family office.
Staffing
Proper staffing is crucial to the success of a family office. Family offices often begin by transitioning a key administrative employee from an operating company to a full-time employee for certain family members and evolve to a larger staff. Key roles include a CEO, CIO and chief operating officer and often require in-house legal counsel, compliance officers, trust officers and foundation personnel. As the size of the staff increases, the family should be thoughtful about providing employment opportunities to family members and how that may impact the dynamic and performance of the family office. They may want to consider creating employment policies that set forth the requirements and credentials necessary to work in the family and create guidelines for resolving conflict in a system in which a family member employee may also be a client.
Compensation
Recruiting and retaining key employees for family office leadership roles often requires creative incentive-based compensation. Many family offices allow certain key employees to co-invest in direct investments (and may make loans to employees to facilitate the investment) and participate in a carried interest in order to share in the profits of investment ventures at a lower capital gains tax rate. It’s also possible for a family office to create a plan that grants performance shares, units or cash that vest over time or after attaining certain goals.
When designing compensation packages, family offices should consider whether the incentive compensation programs are aligned with the family’s goals and balance the potential longer term investment strategy of the family with the shorter term liquidity needs of the employees. As these plans can become very complex, it’s important to consult with qualified counsel to structure and implement an appropriate and tax-efficient compensation structure.
Endnotes
1. Family Office Exchange, FOX Guide to the Professional Family Office (2014), at p. 3.
2. Kirby Rosplock, The Complete Family Office Handbook: A Guide for Affluent Families and the Advisors Who Serve Them (John Wiley and Sons Inc. 2014), at p. 1.
3. Ibid., at p. 9.
4. Ibid., at p. 7.
5. The UBS/Campden Wealth Global Family Office Survey (2019), www.ubs.com/global/en/wealth-management/uhnw/global-family-office-report/global-family-office-report-2019.html.
6. Ibid.
7. Lender Management LLC v. Commissioner, T.C. Memo. 2017-246.
8. Hellmann v. Comm’r, Tax Court, Docket No. 8486-17.
9. Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940.
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