As the economy slowly climbs out of the “Great Recession,” many well-run businesses have undertaken assessments of specific aspects of their operations to ensure that they will be properly positioned to withstand the challenging economic landscape and, at the same time, be able to exploit future opportunities.
While a family office may not initially come to mind as a “business,” as that term is commonly used, many family offices are indeed highly complex businesses, operated with the same disciplines that are hallmarks of the most admired publicly traded companies.
What Is a Family Office?
Broadly defined, a family office is an organization established to oversee (directly or indirectly) the financial matters of a family. This can include investment oversight and financial reporting as well as legal, regulatory, and reporting compliance. A family office may also provide other, more personal, services for family members (coordinating travel plans, overseeing household staffing needs, etc.—so-called concierge services).
Many of the earliest family offices served the wealthiest families in Europe. These offices oversaw multigenerational business holdings and served as the blueprint for many of the early U.S.-based family offices that were established as families in this country amassed great levels of wealth starting in the late 19th and early 20th centuries.
U.S.-based family offices exploded in popularity in the latter part of the 20th century. Indeed, for many of the wealthiest (and some not so-wealthy) families, having a family office became another indicator of economic standing. Even though the economy in general and various markets in particular experienced volatility during this period, the general trajectory of the economy was upward.
The economic tumult of 2008 and 2009 (what many have come to describe as the Great Recession) caused substantial reductions in wealth for many of the wealthiest families in this country. Moreover, many apparently safe investments were subject to restrictions that limited liquidity and further exacerbated financial uncertainty.
This experience has changed the appetite and appreciation for risk of many wealthy families. It has also changed the expectations of many such families regarding future returns. In light of these changes, many wealthy families with family offices are reassessing their role and structure in the current economic climate. Concerns over preserving net worth, maintaining sufficient liquidity, and realigning the family’s business and investment holdings for a more challenging future are testing even the most thoughtfully designed family organizational structures.
More recently, yet another factor that will likely lead to extensive changes in the family office structure is the recent issuance by the SEC of a final rule 1 governing exemption of family offices from regulation under the Investment Advisers Act of 1940 (Advisers Act), following repeal of the private adviser exemption last year by the Dodd-Frank Act. 2 For key provisions of the final rule, click here.
This article explores certain structural attributes of the family office in an attempt to identify some leading practices for families (and their advisers) undergoing this reassessment process. These structural attributes are organized into four categories: (1) ownership and governance, (2) scope of services provided, (3) capital structure and funding, and (4) entity selection and taxation.
Ownership and Governance
Who Should Own and Manage the Family Office?
Family offices are most often established by founders of successful businesses, typically after the sale of that business or similar increase in liquidity. 3 As such, the same generation that had previously owned the business commonly forms and owns the family office. Many family offices, at least initially, are managed as “cost centers” and require a significant capital outlay. Having the senior generation bear the economic burden of the family office seems logical—often they are the only individuals with the financial means to fund its ongoing activities. (This will be discussed in more detail in the section on capital structure and funding.)
Governance can be separate from ownership. Typically, the senior generation (in many cases, the creator of the family wealth) is looked to by the rest of the family for leadership and decision making, and it would seem to be a natural fit for this generation to also manage the family office activities. However, is such an arrangement optimal?
Consider a situation in which a family office is established after the sale of a family business. The qualities of the founder that contributed to the success of the family business do not necessarily translate into success in running a family office. The entrepreneurial risk taker who demonstrated expertise in a particular industry must now switch gears to oversee a more diverse portfolio (e.g., marketable investments, alternative investments, private equity, real estate holdings, and new business ventures) while balancing the potentially competing needs of the family members served by the office.
One of the most challenging hurdles for any family is to realize that there may be a need for expertise outside the family unit to better ensure success during the next phase of the family’s life cycle. This may involve employing an experienced family office manager supported by competent employees and third-party service providers. (This will be examined in more detail in the section on whom the family office serves.) For ultra-wealthy families, it may also involve forming a board of directors comprising both family members and outsiders. These decisions do not obviate the need for senior family leadership—on the contrary, the global direction of the family may still rest in the hands of the senior generation, but the day-to-day management and execution of the global strategy is often better left to experienced family office professionals and the third-party service providers supporting them.
Does it make sense for the junior generation to have an ownership stake in the family office? Like any good business succession plan, the answer is, “It depends.” From an ownership perspective, given the significant capital outlay of the operation, it is generally more advantageous for the senior generation to own the family office for as long as possible. However, if the family office has a long-term objective of serving subsequent generations, a succession plan must be designed to ensure that the office transitions along with the family.
Cultivating the Junior Generation
Another important consideration is whether there are junior family members capable of managing the family office, and, if so, whether they currently are being groomed for this responsibility. If not, what is the time frame for starting this process? If the family office does not currently employ capable junior family members, it may be time to develop a role for them, particularly while there is still an opportunity to learn from and work with the senior generation.
This can be a critical step in the overall succession plan for a family office, because the death of the family patriarch or matriarch will often test the value proposition of the family office. In that event, the next-generation family members will often reevaluate the necessity or benefits of working and investing together through the family office. However, if the next generation has been empowered with a management role, the chances for continued family cohesiveness are significantly increased. A succession plan put into place well before the death of the senior generation family leaders, combined with a good governance structure and a well-run, professionally managed family office, is the better approach to ensuring long-term success. Such an organization can help attract and retain the best personnel to work for the family office, further increasing the long-term viability of the organization.
If there is an intention to ultimately transfer governance to the next generation, it may be appropriate to transfer ownership to it as well. Ownership can be an effective tool to encourage responsibility and can further substantiate the younger generation’s involvement. This, in turn, can establish a level of respect within the family office and the family unit—the younger generation transitions from a family office client to a respected owner of the entity.
Implementing a Family Succession Plan
Assuming there is a transition, it will be incumbent upon the senior generation to determine that the office employees understand and appreciate the family succession plan. This includes encouraging the office employees to train and mentor this next generation of owners. This relationship is clearly symbiotic: The professional growth of the junior family members depends upon the office employees’ accepting the new management and sharing their experience and knowledge. In turn, these efforts will extend the life of the family office and secure the employees’ continued employment.
Once the direction for governance is determined, a transition plan for ownership can be formulated. This transition plan can be accomplished during the lifetime of the senior generation through any number of wealth transfer techniques, or it can be accomplished at death through the dispositive plan of the senior generation. Unless the family office is run as a substantial for-profit activity, the valuation of the office entity will likely be modest, and a transfer of ownership can be easily accomplished.
The transition plan for the family office is often a missed planning opportunity. In many cases, a comprehensive walkthrough of “what happens next” (if current owners die unexpectedly) may uncover some interesting ownership transitions and highlight undesirable dynamics (e.g., between office owners and employees, senior and junior family members, etc.). In addition, particularly in the current economic climate, comprehensively addressing the succession plan for the family office can provide its employees with a greater sense of stability in their employment with the family. Reviewing these issues and addressing them proactively will be time well spent by the family, office employees, and outside advisers.
Whom Does the Family Office Serve?
It is no surprise that the extent of the family office client base and the suite of services that the office intends to provide directly correlate to the capital outlay or “burn rate” of the family office enterprise. Therefore, it is important for the family to consider both aspects during any reassessment process.
Whom should the family office serve? Typically, the family office initially is established to serve the founders and their children. Over time, the children may have their own families. The family office may also serve other family members or, to the extent allowed under the new SEC rules (if applicable), close friends who depended upon the founders before the sale of a business or other increase in liquidity. Defining this client base is important to efficiently allocate the resources of the family office. In addition, establishing client parameters on the front end will allow the office to better handle future requests as the client base changes over time.
In-House or Outsourced Services?
The next step is to define the suite of services that the family office should provide in-house and which to outsource to third-party service providers. In today’s expanding global services economy, wealthy families with family offices have numerous options for buying personal and financial services. However, some family office functions are best kept in-house if capable family office employees can be identified. Exhibit 1 identifies categories of services typically provided by a family office in-house or outsourced.
A few generalizations can be made from Exhibit 1. First, many of the in-house services (e.g., recordkeeping and reporting, bookkeeping, and budgeting and cashflow analysis) address daily activity at a very granular level. Keeping these services in-house not only provides immediate access to and control over this information but is likely to be more cost-efficient and expedient compared with outsourcing these activities to a third-party provider. Many commercial software packages can be used to facilitate these services. 4 Managed by one or more strong professional employees, these activities form the base of family office services.
Services that are sometimes outsourced encompass a wide range of activities. Typically, the larger and more robust an office (which may be directly correlated to the size of its client base), the more these services are provided in-house. Tax and legal services often include some level of service provided by certain employees of the family office, supplemented by outside providers. For example, less complicated tax returns or legal work can be handled by qualified in-house professionals, with more complicated returns or more extensive planning (e.g., estate planning, transactional work) being done by outside providers. This synergy brings the best of both worlds: cost savings on lower-risk or less complicated work combined with cutting-edge planning and a degree of quality assurance for complicated or more extensive work. However, this arrangement requires a high degree of coordination and communication between the family office and outside service providers for it to work effectively. The relationship between the family office personnel and outside professionals must be one of mutual respect, trust, and collaboration; family office personnel cannot feel threatened by the presence of outside providers and must be willing to share time, information, and insights. Correspondingly, the outside professionals should strive to incorporate the family office personnel as part of the team, keeping them engaged and informed.
One of the most significant decisions for a larger family office—particularly one formed after a significant increase in liquidity—is whether to keep investment services in-house or to hire a competent outside investment adviser to oversee the portfolio. This decision may be in large part driven by the initial views of the family. For example, a senior generation family member who recently completed a liquidation of the family business may be less inclined to transition into retirement mode and more inclined to retain control over the direction of the investment portfolio, perhaps by actively pursuing “the next deal” through direct private equity or real estate investments. However, properly managing the family’s investment portfolio requires a significant amount of insight, allocation of resources, capital outlay, and consistent administration (including managing legal and regulatory requirements), particularly when the investments under management represent portfolios of various family members. The family should consider hiring competent professionals to help plan for investing the family’s wealth and the costs and benefits of retaining this function in-house, outsourcing it to competent managers, or taking a hybrid approach. Very few families can build a successful in-house investment platform; many more have appropriately engaged outside professionals in some capacity. 5
Once the client base is determined and the scope of services is defined, the next step is to consider how to appropriately “charge” family members for use of the family office. Although it may be desirable to have the senior generation continue to fund the capital outlay for the office, any below-market services provided to other family members may be construed as gifts by the senior generation to these members. 6 In addition, providing below-market services may encourage more demanding family members to monopolize the office’s resources. As such, the family should consider developing a methodology to determine the appropriate fee to charge their client base. This point is discussed further below.
Given the scope of services provided by employees of the family office, it is important to establish proper internal controls over these activities. Such controls are designed to provide reasonable assurance of the reliability of financial reporting, effectiveness and efficiency of operations, compliance with any applicable laws and regulations, and safeguarding of assets, including asset manager due diligence. This effort may include creating written policies and procedures for office functions and job responsibilities or a test of the controls already in place. Regardless of whether the family office has existed for years or is still on the drawing board, the family is advised to give this matter some attention. 7
Capital Structure and Funding
It was noted earlier that (at least initially) capital contributions by the senior generation owners fund many family offices. This may be easy to manage from an administrative perspective, but it does create a host of other issues, including challenging the ongoing liquidity position for the owners and presenting potential gift tax issues if services are provided to the family office clients at below-market rates. A better answer, which mitigates these concerns, is to design a methodology to charge family clients for the services provided.
How Should the Family Office Charge for Services?
A typical approach is to charge a fee for services rendered that represents a fair allocation of the services provided to that family member. The allocation methodology can be designed any number of ways. One method is to incorporate a traditional “hours and rate” variable charge based on the number of office employee hours spent on the client’s account. This approach, while usually resulting in the fairest and most accurate way to allocate costs, requires accurate time reporting by the family office employees, a task that may not be realistic in all circumstances. Another method, particularly when investments are managed in-house, is to charge a management fee based on a percentage of the assets under management. A third method could be a flat rate based on an agreed-upon scope of services to be provided or, alternatively, a flat rate that represents a “reimbursement” for the client’s share of office expenses incurred for service. There is no best approach; the family should adopt one on a client-by-client basis that is fair and reasonable, that can be accounted for accurately and contemporaneously, and that covers the related costs. A fair and reasonable methodology may also serve as a nonconfrontational buffer against family members who may otherwise monopolize the office resources to the detriment of other members.
Family offices providing more sophisticated investment services may develop fee arrangements that more closely resemble investment manager/hedge fund type structures involving the use of profits interests or carried interests. 8 For example, the family’s investment portfolio may be pooled in several partnerships, possibly organized by asset class category or family line. 9 In situations where a family office (or select individuals within the family office) is providing investment management services, it may be appropriate for the office (or select individuals within it) to receive a management fee and/or an allocation of profits from the investments it oversees (perhaps similar to the “2 and 20” fee arrangement often found in the hedge fund world). This type of arrangement is most common when it is desirable to compensate the family office executives based in part on the performance of the underlying portfolios. Allocating a portion of the profits earned by the family to the family office can fund an incentive compensation plan that aligns the interests of the family office executives with those of the family.
Should the fee arrangement be designed to “break even” or make a profit? A break-even structure might be appealing from a family harmony perspective because the owners of the family office would not be seen as profiting from the involvement of other family members. However, that type of arrangement does not demonstrate an intention to earn a profit, one of the primary factors necessary for trade or business tax treatment of any expenses incurred.
Regardless of the arrangement, the family should understand market corollaries to substantiate the extent of fees in relation to the services performed. This market analysis will not only provide the necessary support to interested family office clients (including those clients that may be fiduciaries) but also demonstrate that the fees are for full and adequate consideration and are not gratuitous. 10
Finally, any methodology should be maintained in writing in the form of an advisory services agreement or similar document (in a more sophisticated arrangement, the terms might be incorporated into a partnership agreement). Any agreement should clearly indicate the scope of services the family office is to provide, how fees are assessed and collected, and the mutual obligations of both the family office and its clients (including under what conditions services are terminated). The agreement and related methodology will also serve as contemporaneous support to mitigate any challenges raised by family member clients or others.
Entity Selection and Taxation
Family offices come in many different shapes and sizes. In some cases, the family office has evolved in an existing legal structure or may have had its genesis within a family business. In other cases, it might be newly formed and serving as a “placeholder” until the family decides its next step, or it may have been carefully designed at inception based upon specific direction from the family. Because there is no typical family office structure, it is extremely difficult to make any generalizations regarding the right structure. This section reviews some of the more common considerations in entity selection and taxation.
Common Entity Classifications and Related Taxation
Exhibit 2 depicts the most common entity classifications and several selected benefits and considerations for each classification.
The most common design for smaller family offices is that of a sole proprietorship or single-member limited liability company (LLC), both of which are disregarded as a separate entity for federal income tax purposes. To the extent that the activity rises to the level of a trade or business, the family office activity typically is reported on Schedule C of the owner’s individual income tax return (Form 1040, U.S. Individual Income Tax Return). The sole proprietorship or single-member LLC is simple in form and easy to administer but is limited to family offices owned by one member. It is also difficult to provide for effective family office succession, because continuity is not necessarily contemplated in these simple arrangements.
Many larger family offices are structured as flowthrough entities, in the form of either a state law partnership, an LLC with multiple members, or an S corporation. These flowthrough entities are treated as separate entities for income tax purposes but then flow income tax attributes through to their respective owners. Without specific provisions to the contrary, the owners of the entity share proportionately in the structure based on their ownership percentages. Flowthrough structures can be more appealing because favorable tax attributes (such as operating losses) can pass through to the owners, and in the case of partnerships, provisions can be made for special allocations. But greater tax flexibility may increase income tax complexity because the subchapter K rules 11 (for partnerships) and/or subchapter S rules 12 (for S corporations) are applicable.
C corporations are an interesting choice for family offices. Unlike flowthrough entities, C corporations make no distinction between ordinary income and capital gain. If the family office is designed as a for-profit trade or business, any excess profits may be subject to double taxation. C corporation family offices also need to address other tax technical rules (including personal holding company rules 13 and personal service corporation rules, 14 both of which may impose additional taxes under certain conditions).
The federal income tax treatment of a family office depends on whether the activities of the family office constitute a trade or business. The term “trade or business” appears in almost 300 sections of the Code but is nowhere defined, so any determination is made on a case-by-case basis based on the relevant facts and circumstances. In many cases, the activities of a family office will not rise to the level of a trade or business.
For example, any activity that is simply a “cost center,” regardless of entity type, and funded by capital contributions of the owner will not be treated as an enterprise engaged in for profit. As such, the expenses incurred in the activity are not deductible as trade or business expenses under Sec. 162. Courts have consistently agreed with the IRS that such a cost center entity used solely to increase the value and profitability of the taxpayer’s investments is not a trade or business. 15
Accordingly, managing one’s investment portfolio through a family office entity owned by the same individual does not result in trade or business treatment for related expenses incurred. Instead, a Sec. 212 “expenses for production of income” deduction should be available. 16 In many cases, however, particularly when the family office in question is structured as a flowthrough entity, the owner’s high adjusted gross income (AGI) or exposure to alternative minimum tax (AMT) allows no significant income tax benefit for these expenses. 17
One very limited exception to the family office described in the paragraph above is for an investment entity or activity that qualifies as a “trader in securities.” 18 Whether such an entity or activity could be deemed a trader is based on a number of factors, including the frequency, extent, and regularity of trades, the average holding periods of trading assets, and the degree of control the entity/owner has over trading decisions. The trader exception is very narrow—the entity or activity must “trade” and not “invest.” 19 The Supreme Court has stated that managerial attention to one’s own investments is not a trade or business, “[n]o matter how large the estate or how continuous or extended the work required may be.” 20
Consider also the taxpayer in Mayer, 21 who formed a corporation and employed several professionals to oversee money managers charged with investing certain of his assets. The Court of Federal Claims determined that “[d]evoting one’s time and energies to the affairs of a corporation is not of itself, and without more, a trade or business of the person so engaged.” 22
However, managing the investments of others does constitute a trade or business. 23 Accordingly, if the family office offers significant investment management and related services to its nonowner clients and appropriately charges these clients for services rendered (as discussed above), such a family office activity may rise to the level of a trade or business, given the right facts and circumstances.
This article only briefly covers the most common structures, and other family office arrangements are certainly possible. For example, multifamily offices or offices formed to serve multiple (and often unrelated) families are not uncommon. A family can also incorporate its family office operations into a private trust company. 24 However, both of these arrangements are outside the scope of this article.
Family offices can be an effective way to organize and centralize a family’s business and investment activities. They can also be a source and catalyst for family dysfunction and increase the family’s exposure to tax, legal, and financial risks if not formed, governed, and operated properly. This article is intended to provide families with some insights on perceived leading practices should they undertake a more critical review of their current organizational structure.
This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication. Copyright © 2011 Deloitte Development LLC. All rights reserved.
Author’s note: The author thanks John Silverman and Steve Thorne for their contributions to this article.
1 17 C.F.R. §275.202(a)(11)(G)-1
2 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, P.L. 111-203.
3 This article does not discuss a de facto family office embedded in an operating entity. Although not uncommon in practice, such an arrangement can present tax risks for the owners and the company, including whether the performance of personal services by company employees on behalf of the owner could be construed to be a deemed dividend. This arrangement is not recommended.
4 Certain professional service firms work with more significant family offices to design an appropriate technology platform, including software selection, testing, and implementation.
5 For example, some families have been successful in outsourcing portions of the portfolio, such as private equity or hedge funds, while managing other portions internally, such as fixed income.
6 See Regs. Sec. 25.2512-8 regarding transfers for insufficient consideration.
7 Typically, an outside provider such as an accounting firm is hired to complete the internal control review, and any findings or recommendations are shared with the family.
8 As defined in Rev. Proc. 93-27, 1993-2 C.B. 343, and further discussed in Rev. Proc. 2001-43, 2001-2 C.B. 191.
9 For a comprehensive article on sophisticated designs of family investment partnerships, see Boyer and Kess, “Family Investment Partnerships: Structuring and Tax Considerations,” 22 Journal of Taxation and Regulation of Financial Institutions 23 (September–October 2008).
10 The market analysis is strongly recommended in situations where the family office has a client that is a charitable entity, such as a private foundation or charitable trust, to substantiate that such services qualify for an exception to the self-dealing rules under Sec. 4941(d)(2)(E) and Regs. Secs. 53.4941(d)-3(c)(1) and (c)(2), Example (2). In many cases, it may be appropriate to request a private letter ruling from the IRS. See also the author’s article “Family Office Management of Private Foundation Funds,” Trusts & Estates (October 2011).
11 Secs. 701–777.
12 Secs. 1361–1379.
13 As set forth in Sec. 542.
14 As set forth in Sec. 269A.
15 See, e.g., Estate of Stangeland, T.C. Memo. 2010-185.
16 More specifically, see Regs. Sec. 1.212-1(g).
17 Sec. 212 expenses are itemized deductions subject to the 2% of AGI limitation under Sec. 67(a), with any expenses above this hurdle included as a preference item for AMT purposes under Sec. 56(b)(1)(A)(i).
18 As broadly defined in Sec. 475(f) and further interpreted through numerous court cases.
19 Whipple, 373 U.S. 193 (1963).
20 Higgins, 312 U.S. 212 (1941).
21 Mayer, 32 Fed. Cl. 149 (1994).
22 Id., quoting Whipple, 373 U.S. at 202.
23 Dagres, 136 T.C. No. 12 (2011).
24 A private trust company is an entity formed by the family that is legally qualified to act as trustee of certain family trusts.
Eric L. Johnson is a partner in the Chicago office of Deloitte Tax LLP and serves as the National Competency Leader for Deloitte’s Estate, Gift, Trust and Charitable Competency Group. He is a member of the AICPA ’s Trust, Estate and Gift Tax Technical Resource Panel and chairs its Family Office Task Force. For more information about this article, contact Mr. Johnson at firstname.lastname@example.org.