“Family Investing” As a Trade or Business? In the Time of the Lockdown? Seriously? Life Goes On
June 01, 2020
As of last Wednesday night, the SBA’s website reported that almost 4.5 million businesses had borrowed more than $510 billion under the Paycheck Protection Program.[i] Many businesses are wondering whether they will survive through the gradual reopening of the economy.[ii]
Earlier that same day, the U.S. surpassed 100,000 coronavirus deaths.
Last Thursday, the Labor Department reported that more than 40 million people – approximately one in every four American workers – had filed for unemployment since mid-March; one day later, the Commerce Department released data indicating that April had witnessed the largest monthly drop in consumer spending since the government began keeping such records – in case you’re wondering, consumer spending generally accounts for more than two-thirds of the economic activity in the country.
By the end of the day last Friday, the S&P had registered a more than 4 percent gain for the month of May;[iii] when added to April’s 12.7 percent gain, the stock market has done remarkably well – in fact, it has increased by 36 percent since its lows of late March.
If you’re having difficulty reconciling these facts, you’re not alone.[iv]
Then there are those for whom Covid-19, the lockdown, and the poor state of the economy have barely registered.
I was reminded of this last week when one of our attorneys asked me about the U.S. Tax Court’s 2017 Lender Management decision.[v]
“Why the interest?” I asked. Wah, wah, wah.[vi] “A family investment vehicle? Tell me some more. How large . . .” Wah, wah, wah. “What? And who will be managing this fund?” Wah, wah, wah. “Ah, they’re worried about being able to deduct their expenses.” Wah, wah, wah. “Please send me the agreement. I’ll take a look at the compensation provision.”[vii]
Why does it Matter?
The Code allows a taxpayer to claim as a deduction all of the ordinary and necessary expenses paid or incurred by the taxpayer during the taxable year in carrying on a trade or business.[viii] For example, a taxpayer may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered.”[ix] In general, such expenses are deducted in full from the taxpayer’s gross income[x] for purposes of determining their income tax liability for that year.[xi]
Prior to 2018, individuals could also claim itemized deductions for certain so-called “miscellaneous expenses,” including expenses paid or incurred by an individual during the taxable year in connection with an activity engaged in “for the production or collection of income.”[xii] Such expenses have to be “ordinary and necessary, meaning they must be reasonable in amount and must bear a reasonable and proximate relation to the production or collection of taxable income, or to the management, conservation, or maintenance of property held for the production of income.[xiii]
Thus, for example, services of investment counsel, clerical help, office rent, and similar expenses paid or incurred by a taxpayer in connection with investments held by the taxpayer are deductible only if (1) they are paid or incurred by the taxpayer for the production or collection of income or for the management, conservation, or maintenance of investments held by him for the production of income; and (2) they are ordinary and necessary under all the circumstances, having regard to the type of investment and to the relation of the taxpayer to such investment.[xiv]
However, certain limitations apply to the deduction of such non-trade-or-business, investment-related, expenses that do not apply to deductions for trade or business expenses. Specifically, these investment expenses are not deductible unless – together with other miscellaneous itemized deductions – they exceed two percent of the taxpayer’s adjusted gross income, in which case the excess is deductible as an itemized deduction.[xv]
Then, in late 2017, the TCJA suspended all miscellaneous itemized deductions that are subject to this two-percent floor, thereby denying taxpayers the ability to claim investment-related expenses as itemized deductions for taxable years beginning after December 31, 2017 and ending before January 1, 2026.[xvi]
In light of the foregoing, it would behoove the owners of an income-producing activity if their activity were treated as a trade or business for tax purposes, rather than as an investment activity engaged in for the production or collection of income.
The problem, of course, is that the Code does not define the term “trade or business,” and the courts have not always been consistent in their determinations of the trade or business status of an activity.[xvii]
With this background, we can now turn Lender Management.[xviii]
Management LLC operated as a fund manager, and was treated as a partnership for Federal income tax purposes. At all relevant times, Management was owned by two members of the Family, one of whom owned a 99 percent interest and also served as its managing member (“Manager”) and CIO[xix].
Management provided direct management services to three Investment LLCs, each of which was treated as a partnership for Federal income tax purposes. Management directed the investment and management of assets held by the Investment LLCs for the benefit of their owners. The ultimate owners with respect to the Investment LLCs were members of the Family.
The Investment LLCs were created to accommodate greater diversification of the managed investments and more flexible asset allocation at the individual investor level. Each was formed for the purpose of holding investments in a different class of assets: private equities, hedge funds, and public equities; of these, private equities represented the largest investment.
Management’s operating agreement permitted it, without limitation, to engage in the business of managing the “Family Office” and to provide management services to Family members, related entities, and “third-party nonfamily members.” The operating agreements for the Investment LLCs designated Management as the sole manager for each entity. Thus, Management held the exclusive rights to direct the business and affairs of the Investment LLCs.
Management also managed downstream entities in which the Investment LLCs held a controlling interest. Investors in some of these downstream entities included persons who were not members of the Family. Management received not insignificant fees from these entities in exchange for managing them.
Family members understood that they could withdraw their investments in the Investment LLCs, subject to liquidity constraints, if they became dissatisfied with how the investments were being managed.
Management made investment decisions and executed transactions on behalf of the Investment LLCs, and viewed the members of the Investment LLCs as its clients. Its main objective was to earn the highest possible return on assets under management, and it provided individual investors in the Investment LLCs with one-on-one investment advisory and financial planning services.
Manager served as Management’s CIO. Management also employed five employees on a full-time basis during each of the tax years in issue.
As CIO, Manager retained the ultimate authority to make all investment decisions on behalf of Management and the Investment LLCs. Most of CIO’s time was dedicated to researching and pursuing new investment opportunities and monitoring and managing existing positions.
Management arranged annual business meetings, which were for all clients in the Investment LLCs. These group meetings were held so that Management could review face-to-face with all of its clients the performance of their investments at least once per year. Manager would conduct additional face-to-face meetings with clients who were more interested in the status of their financial investments at times and locations that were convenient for them.
Manager interacted directly with Management’s clients, collecting information from and working with these individuals, and developing computer models to understand their cash flow needs and their risk tolerances for investment, and engaging in asset allocation based on these and other factors. Management devised and implemented special ventures known as “eligible investment options,” which allowed clients to participate in investments more directly suited to their age and risk tolerance.
Management also had a CFO who was not related to the Family. CFO worked very closely with CIO-Manager every day, attending meetings for investments, assisting CIO in reviewing and making decisions about new investment opportunities, overseeing daily cash management, monitoring the status of current investments, communicating with individual clients and forecasting their cash needs, securing necessary capital call funds from revolving lines of credit, and providing updated financial information to creditors at least monthly.
Management also retained an unrelated organization to consult with CFO, to provide both accounting and investment advisory services to Management, to prepare annual partnership tax returns and quarterly financial reports for the Investment LLCs, and to collaborate with CIO in selecting new investments for the Investment LLCs.
Management received a profits interest in each of the Investment LLCs in exchange for the services it provided to the Investment LLCs and their members. These profits interests were designated “Class A” interests under the operating agreements for the Investment LLCs. As such, they represented an allocation of future income and appreciation.[xx]
Management received income from the Class A interests only to the extent that the Investment LLCs generated profits. This arrangement was intended to align Management’s goal of maximizing profits with that of its clients and to create an incentive for Management and its employees to perform successfully as managers of the invested portfolios.
Any payments that Management earned from its profits interests were paid separately from the payments that it otherwise received as a minority member of each of the Investment LLCs.
Management paid Manager a guaranteed payment in exchange for their services.[xxi] Manager also indirectly owned – through trusts and other LLCs – minority interests in the Investment LLCs.
Management reported ordinary business losses for the tax years in issue, claiming deductions for business expenses, including salaries and wages, repairs and maintenance, rent, taxes and licenses, depreciation, retirement plans, employee benefit programs, guaranteed payments to partners, and other deductions.
The IRS disallowed the deductions that Management claimed as business expenses, but allowed them as investment-related expenses, subject to the limitations thereon. The IRS argued that Management was not engaged in carrying on a trade or business, and that its primary activity was “managing the Family fortune for members of the Family by members of the Family.”
Management petitioned the Tax Court, contending that its activities constituted the active trade or business of providing investment management and financial planning services to others.[xxii]
According to the Court, deciding whether the activities of a taxpayer constitute a trade or business requires an examination of the facts in each case.
To be engaged in a trade or business, the Court stated, a taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.[xxiii]
Certain activities, however, are not considered trades or businesses. For example, an investor is not, by virtue of their activities undertaken to manage and monitor their own investments, engaged in a trade or business.[xxiv] Expenses incurred by the taxpayer in performing investment-related activities for their own account generally may not be deducted as expenses incurred in carrying on a trade or business. These investment activities may produce income or profit, but such profit, the Court stated, is not evidence that the taxpayer is engaged in a trade or business. Instead, any profit so derived arises from the conduct of the trade or business venture in which the taxpayer has taken a stake (an investment), rather than from the taxpayer’s own business activities.
Compensation is Key
The Court then explained that a common factor distinguishing the conduct of a trade or business from a mere investment is the receipt by the taxpayer of compensation, other than the normal investor’s return; in other words, income received by the taxpayer directly for their services, rather than indirectly through the “corporate” enterprise. If the taxpayer receives not just a return on their own investment, but compensation attributable to the services they have provided to others, then that fact tends to show they are engaged in a trade or business.
Trade-or-business designation, the Court added, may apply even though the taxpayer invests their own funds alongside those that they manage for others, provided the facts otherwise support the conclusion that the taxpayer is actively engaged in providing services to others and is not just a passive investor.
The Court observed that an activity that would otherwise be a business does not necessarily lose that status because it includes an investment function. Work that includes the investment of others’ funds may qualify as a trade or business. Thus, “[s]elling one’s investment expertise to others is as much a business as selling one’s legal expertise or medical expertise.” Investment advisory, financial planning, and other asset management services provided to others may constitute a trade or business.
The Court then described how Management provided investment advisory and financial planning services for the Investment LLCs and their individual owners; it explained that, through their operating agreements, Management had the exclusive right – through its CIO, CFO and employees, all of whom worked full-time – to direct the business and affairs of the Investment LLCs.
These services, according to the Court, were comparable to the services that hedge fund managers provide. Management had a responsibility, the Court continued, to provide its clients with sound investments that were tailored to their financial needs. Thus, Management’s activities went far beyond those of an investor.
The Court then turned to Management’s compensation arrangement. Management was entitled to profits interests as compensation for its services to its clients to the extent that it successfully managed its clients’ investments.
Management and Manager held minority interests in the Investment LLCs. Management was also entitled to a profits interests as compensation for its services as the Investment LLCs’ manager. These profits interests were the primary incentive for Management to work to maximize the Investment LLCs’ success. Management received payment for its services only if the Investment LLCs earned net profits – it received no other fees. The absence of such other fees motivated Management to increase the net values of the Investment LLCs.
To the extent that the Investment LLCs did well, their operating agreements provided that Management could receive compensation separate from, and in addition to, the normal investor’s return that it received for its membership interests, and these profit interests provided substantial incentive to deliver high-quality management services. The contingent nature of the profits interests did not negate their being compensation for services.[xxv]
Based on the foregoing, the Court concluded that Management was in the trade or business of providing investment management services to and for the benefit of its clients. Most of the assets under management were owned by members of the Family who had no ownership interest in Management. Management managed investments, had an obligation to its clients, and tailored its investment strategy, allocated assets, and performed other related financial services specifically to meet the needs of such clients.[xxvi]
What Does It Mean?
Following the Court’s decision in Lender Management, there was a lot of discussion about how it provided a model for very affluent families to establish their own, or “captive,” management firm to oversee the investment and maintenance of their wealth.
Easier said than done, at least if the goal is to treat such an organization and its activities as a trade or business, the expenses of which may be fully deductible for tax purposes.
For one thing, the Lender family appears to be quite large, with several branches and generations; they are geographically widespread and, in many instances, are strangers to one another. In a sense, the “family” looks like a segment of that portion of the public that requires investment management services.
What if the family in issue represents only a relatively small number of individuals? For example, the founder of a successful business that has just been sold, along with their spouse and children? Would the activities of a captive investment management entity for such a small number of family members constitute an investment activity rather than a trade or business, especially where it is likely that most of the family will own an interest in the entity? Unlikely.
Might such a management entity grow into trade or business status over time – assuming the family wealth is preserved and grown – as the family matures, children get married and re-married, their children do the same, etc., and only a small portion of the family is involved in the management function? Perhaps.
Assuming the management entity otherwise qualifies as a trade or business, the Lender Management case seems to have blessed the issuance to the management entity of a profits interest in an investment partnership or limited liability company as compensation for the management services rendered to such investment entity without jeopardizing its trade or business[xxvii] status. Moreover, the issuance of such an interest is generally not taxable to the recipient.
As indicated earlier, however, if this profits interest lacks entrepreneurial risk, or if its status as an equity interest in a partnership is otherwise questionable,[xxviii] there is a possibility that the allocations and distributions to the management entity may, instead, be treated as taxable compensation. If the IRS does not respect the management entity’s activities as a trade or business, the management entity may find itself in a very difficult spot, indeed: taxable compensation and no deduction for its expenses.
Of course, there are varying degrees of difficulty, and given the economic and political directions in which we seem to be travelling, it seems to me, at least, that the same folks who may be concerned about family offices and the like, would be better served if they focused, instead, on reducing their exposure to increased estate and income taxes.
[i] Title I of the CARES Act, P.L. 116-136.
[ii] Even as many health professionals worry that we’re reopening too soon.
[iii] Notwithstanding what, at that point, had been three nights of public outrage following the events in Minnesota on Monday.
[iv] OK. One is strictly historical – it reports what has already happened. The other is forward-looking – it’s betting (that’s the operative word) on what’s going to happen in light of what has already happened; a nod to social science. That’s my simplistic and forced construction.
[v] Lender Management, LLC v. Comm’r, T.C. Memo 2017-246.
[vi] Remember the “voices” of the adults in the old Charlie Brown cartoons?
[vii] The breadth and variety of one’s client base can be in constant flux. In my case, it consists of closely held businesses and their owners. If a successful business is sold – few of them are transitioned to the founders’ children – the next generation’s investment and stewardship of the wealth will determine whether the founder’s family will live comfortably for several generations to come, or be haunted by having lost a good thing.
[viii] IRC Sec. 162.
A taxpayer’s taxable income is computed on the basis of the taxpayer’s taxable year, which is the same as their annual accounting period; this, in turn, is defined as the annual period on the basis of which the taxpayer regularly computes their income in keeping their books. IRC Sec. 441. A taxpayer’s taxable income is computed under the method of accounting on the basis of which the taxpayer regularly computes their income in keeping their books. IRC Sec. 446.
[ix] IRC Sec. 162(a)(1).
[x] After they have run the gamut of the basis, at-risk, passive loss, and excess business loss rules, to the extent applicable. IRC 704(d)/1366(d), Sec. 465, 469, and 461(l), respectively.
[xi] What’s more, net operating losses may carry over from the year in which they were incurred to another year only if the losses were the result of operating a trade or business within the meaning of IRC Sec. 162. See IRC Sec. 172(d). Over the years, Congress has alternately imposed and relaxed certain limits on the use of such losses. The most recent “exchange” was between the Tax Cuts and Jobs Act, P.L. 115-97, and the CARES Act, with the latter temporarily suspending the changes made by the former.
[xii] IRC Sec. 212(1). Reg. Sec. 1.212-1 refers to expenses paid or incurred for the management, conservation, or maintenance of property held for the production of income.
[xiii] Reg. Sec. 1.212-1(d).
[xiv] Reg. Sec. 1.212-1(g).
[xv] IRC Sec. 67(a).
[xvi] Anyone’s guess whether this, and so many other “temporary” provisions, will survive to their scheduled expiration dates. We’re struggling to get out of this economic downturn, and the November elections are around the corner.
[xvii] The TCJA certainly brought a new urgency to defining the term; for example, for purposes of IRC Sec. 199A.
[xviii] For those of you who aren’t familiar with the decision, “Lender” refers to the family that founded Lender’s Bagels (the “Family”). I don’t know about you, but for me, growing up as a first generation American in the Bronx, a Lender Bagel defined what a bagel was – especially toasted, with “Phili” cream cheese and orange marmalade. (Excuse me. I need a moment, please.)
[xix] Chief Investment Officer.
[xx] What happens if the profits interests are not respected as partnership interests? For example, what if there is no entrepreneurial risk associated with the related allocation? See Rev. Proc. 93-27 and Rev. Proc. 2001-43; IRC Sec. 1061, enacted by the TCJA; and the proposed regulations REG-115452-14.
[xxi] Within the meaning of IRC Sec. 707(c).
[xxii] Management also contended that Management and the Investment LLCs should be respected as separate business entities distinct from their owners and that these entities engaged with one another at arm’s length.
[xxiii] A sporadic activity or a hobby does not qualify.
[xxiv] An exception to the general rule applies when the taxpayer is also an active trader of securities.
[xxv] Manager’s position compensated him for the services that he provided to Management; it was his only full-time job and he was highly motivated to see Management receive the benefit of the Class A interests.
[xxvi] The IRS asserted that the family relationship between the Manager of Management and the owners of the Investment LLCs supported its contention that Management’s activities consisted solely of making investments on its own behalf. It contended that managing investments for oneself and for members of one’s family was not within the meaning of a trade or business. The Court accepted that, in general, transactions within a family group are subjected to heightened scrutiny. Where a payment is made in the context of a family relationship, the Court will carefully scrutinize the facts to determine whether there was a bona fide business relationship and whether the payment was not made because of the familial relationship.
The Court found that Management satisfied a review under heightened scrutiny. The end-level investors in the investment LLCs were all members of the Family. However, at all relevant times, only two members of the Family were owners of Management.
What’s more, Management’s clients did not act collectively or with a single mindset. They were geographically dispersed, many did not know each other, and some were in conflict with others. Their needs as investors did not necessarily coincide. Management did not simply make investments on behalf of the Family group. It provided investment advisory services and managed investments for each of its clients individually, regardless of the clients’ relationship to each other or to the Manager.
The profits interests were provided to Management in exchange for services and not because the Manager was part of the Family.
[xxvii] As opposed to investment activity.
[xxviii] For example, under the disguised sale rules of IRC Sec. 707 and the regulations issued thereunder.