January 18, 2018 Family-controlled LLC carried on a trade or business under Section 162, Tax Court holds In a taxpayer-friendly decision (Lender Management, LLC, et al. v. Commissioner), the Tax Court has held that a family-controlled LLC carried on a trade or business within the meaning of Section 162 during the tax years at issue. The court concluded that the LLC's activities — providing investment management services to companies in which various family members held interests — were primarily provided to and for the benefit of clients other than itself. Background Operating continuously for 25 years, Lender Management (LM) is a limited liability company formed in Connecticut that elected to be treated as a partnership for federal tax purposes. Harry Lender, founder of Lender's Bagels, had two sons — Marvin and Murray — who worked in the family business. With his wife Helaine, Harry had three other children who were not involved in the business (Keith, Sondra and Heidi). Initially, LM was owned by two revocable trusts — Marvin Lender Trust (MLT) and Helaine Lender Trust (HLT). Until December 2010, HLT owned a 1% interest and MLT owned a 99% interest, and Marvin, through MLT, acted as managing member. In December 2010, Keith Lender Trust (KLT) acquired by assignment a 99% interest in LM and held his interests through December 2012; during this period, MLT held the remaining 1% interest and Keith, through KLT, served as managing member. During the tax years at issue, LM provided direct management services to three LLCs — Murray & Marvin Lender Investments (M&M), Lenco Investments, and Lotis Equity — each of which had elected to be treated as a partnership. The end-level owners of these LLCs were all children, grandchildren or great-grandchildren of Harry. The services LM provided involved directing the investment and management of assets held by the LLCs for the benefit of their owners. In 2015, LM restructured and divided its managed portfolio into three investment LLCs, each to hold investments in a different class of assets: M&M invested in private equities; Lenco invested in hedge funds; and Lotis invested in public equities. Under an operating agreement, LM provided management services to Lender family members, related entities, and certain third-party nonfamily members. LM was the sole manager for the investment LLCs and received a profits interest in each, in exchange for these services; receipt of these profits interests was dependent on the investment LLCs' earning a profit, which gave LM a greater incentive to maximize profits for the LLCs. LM also provided one-on-one investment advice to the individual investors in the investment LLCs LM employed five employees during the tax years at issue, paying salaries to all, including Keith, who served as chief investment officer and president. Keith had an undergraduate business degree from Cornell and an MBA from Northwestern University, and had taken continuing education classes at the Wharton School of Business. He worked approximately 50 hours per week at LM, where he had ultimate authority to make all investment decisions on behalf of LM and the investment LLCs and spent most of his time researching, pursuing new investment opportunities and managing existing positions. For tax years 2010 and 2011, LM reported net losses totaling approximately $770,265; for tax years 2012 and 2013, the LLC reported net income totaling nearly $1.2 million. On its tax returns for the years at issue, LM claimed Section 162 deductions for a variety of business experiences. In two notices of final partnership administrative adjustments (FPAAs) issued in 2015, the IRS disallowed business expense deductions under Section 162, asserting that LM was not engaged in carrying on a trade or business and that the deductions qualified under Section 212 as investment expenses. The sole issue before the Tax Court was whether LM carried on a trade or business under Section 162 for the tax years at issue (2010-2012). Tax Court case Asserting the LLC carried on an active trade or business and, therefore, was entitled to claim Section 162 expense deductions, LM contended that it provided investment management financial planning services to others during the tax years at issue. In contrast, the IRS asserted that "Lender Management's primary activity is managing the Lender family fortune for members of the Lender family by members of the Lender family." Citing Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Tax Court noted that to "be engaged in a trade or business, 'the 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.'" Indicia that LM's activities were conducted with a profit motive included: — LM provided investment advisory and financial planning services for the investment LLCs and their individual investors — Its employees worked for LM full-time — The services LM provided to clients were comparable to those provided by hedge fund managers — LM was responsible for providing clients "with sound investments with growth potential and investments tailored to their financial needs" — LM received payment for its services only if the investment LLCs earned net profits Citing Dagres v. Commissioner, 136 T.C. 263 (2011), the court concluded "that Lender Management was in the business of providing investment management services to its clients." Based on the facts and circumstances, the court concluded that LM's activities "went far beyond those of an investor," noting that LM's "compensation structure shows that during the tax years in issue its predominant activity was providing investment management services to others, rather than passive investing." The court noted that the familial relationships between the managing members of LM and the owners of the investment LLCs deserve to be "subjected to heightened scrutiny … to determine whether there was a bona fide business relationship and whether the payment was not made because of the familial relationship." LM satisfied this heightened scrutiny, the court concluded, noting that (1) no agreement or understanding existed among members of the family that LM would indefinitely remain as manager of the assets held by the investment LLCs; (2) LM made investment choices based on the needs of its clients and its clients could withdraw their investments if they were dissatisfied with LM's services; (3) LM's clients did not act collectively, and despite being related many of them did not know each other or necessarily like each other. The Tax Court concluded that in making investment decisions and executing transactions on behalf of the investment LLCs, LM "operated for the purpose of earning a profit, and its main objective was to earn the highest possible return on assets under management." Implications Lender gives validation to a structure that some investors and family offices have implemented in order to ensure that investment advisory fees paid to investment managers are not lost due to limitation. Section 212 allows an itemized deduction for expenses incurred in the production of income. However, Section 67 limits the amount of the deduction to an amount that exceeds 2% of an individual's adjusted gross income (AGI). Many high income individuals have significant AGI and, thus, Section 67 severely limits the deduction's availability to them or renders their investment advisory fees non-deductible. This would not be true if these fees were considered trade or business expenses under Section 162. Some investors and family offices have created investor/family-owned management companies that operate as trades or businesses for which expenses incurred in their operations are deductible under Section 162. Although not determinative, a major factor in Lender that led the Tax Court to conclude the management company was conducting a trade or business was the fact that it held a profits interest in the underlying investment entities. The fact that the underlying partnerships had other entities, such as family trusts, as partners was also a favorable factor. When a management company is owned at the first-generation level, structuring a profits interest to be paid to the management company may have income tax implications. But when there is a desire to transition ownership of the management company to family members of the next generation or generations, estate and gift tax implications may arise as well. The structures and rationales for wanting to transfer the management company to younger generations can be diverse, but if such a transfer is desired and it is envisioned that the management company will hold a profits interest in underlying investment entities, potentially draconian gift tax issues will need to be carefully navigated under Chapter 14 of the Code. Specifically, Section 2701 can cause a deemed gift to be triggered by the senior-generation family member in connection with various types of "transfers" in which a younger generation received a subordinate equity interest — such as a profits interest — and a senior-generation family member receives a different equity interest, such as a partnership interest in a family entity. A violation of Section 2701 potentially could result in a deemed gift of some or perhaps all of the senior family member's interest in the family entity — despite that he or she still continues to be the owner of those interests. There may be ways to structure ownership of the management company by younger-generation family members that will not violate the rules of Section 2701. These solutions are typically individually tailored and will be largely facts-and-circumstances driven. Implementing these structures requires significant planning and attention to detail, because the IRS has consistently taken the position that the investment of one's own (or one's family's) wealth does not rise to the level of a trade or business that generates deductions under Section 162. The type of entity (e.g., C corporation or pass-through), who owns the entity, who works for the entity, the amount of entity's activities, and how the entity and its employees are compensated must all be considered. These structures should not be implemented without the assistance of tax advisors experienced with these types of structures, as their success or failure will depend upon how they are structured and operated. However, Lender reflects that if these management companies are structured and operated correctly, the courts (at least the Tax Court) will respect these companies as trades or businesses and the expenses associated with their operation will be deductible under Section 162. Given that the recently enacted Tax Cuts and Jobs Act has suspended all itemized deductions subject to the 2% AGI floor (e.g., investment advisory fees) for tax years 2018 through 2025 (see new Section 67(g)), structuring management companies to provide investment management services will be of great interest to investors and family offices. ———————————————
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