This case, which was decided on Dec. 13, 2017, is particularly significant because of provisions in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which was enacted on Dec. 22, 2017. The TCJA disallows all Sec. 67(a) miscellaneous itemized deductions for tax years beginning after Dec. 31, 2017, and ending before Jan. 1, 2026 (see TCJA, §11045). In Lender Management's case, because the Tax Court held it was engaged in a trade or business, its business expenses were deductible in full under Sec. 162 rather than being nondeductible under Sec. 67(g). This case could provide planning opportunities for taxpayers with similar facts and circumstances.
Lender Management's family office structure
During the years covered in the case (2010-2012), Lender Management provided direct management services to three limited liability companies (LLCs) taxed as partnerships for federal income tax purposes. The only members in these three LLCs were the families of Marvin and Murray Lender, two of the sons of Harry Lender, who founded the company that became Lender's Bagels. Each LLC had a distinct investment strategy, with one investing in private equities, one investing in public equities, and the third investing in hedge funds. The end-level owners of the three LLCs were, in all cases, children, grandchildren, or great-grandchildren of Harry.
Initially, Lender Management was owned 99% by Marvin Lender Trust and 1% by Helaine G. Lender Revocable Trust (Helaine was Marvin's wife). Later, Keith Lender Trust acquired by assignment a 99% interest in Lender Management, with Marvin Lender Trust owning the remaining 1%. Keith, Marvin's son, acted as Lender Management's managing member through the Keith Lender Trust.
Lender Management as the sole manager for each LLC had exclusive rights to manage the LLCs' investments, but members of the LLCs could withdraw their investments at any time, subject to liquidity limitations as described in each LLC operating agreement. In addition to managing the "Lender Family Office" and providing management services to Lender family members, related entities, and other "third-party nonfamily members," Lender Management also provided management services to some underlying entities controlled by the private-equity LLC. Lender Management received fees directly from these entities, which also had nonfamily owners.
Lender Management's operations
Lender Management made investment decisions and executed transactions for the underlying investment LLCs and operated for the main objective of earning a high return on assets under management. In addition to making investment decisions for the LLCs, Lender Management also provided individual investors in the LLC with one-on-one investment advisory and financial planning services.
To provide these services, Lender Management employed five employees during the tax years at issue, including Keith, who served as Lender Management's chief investment officer and president. Keith had the ultimate responsibility of making investment decisions on behalf of Lender Management and the investment LLCs and spent most of his time researching and pursuing new investment opportunities and managing existing positions. In addition, Keith worked with the LLCs' investors to understand their cash flow needs and investment risk tolerances, and he devised models to allocate their individual investments in accordance with their needs. Lender Management employed internal accounting and administrative staff not related to the Lender family and hired outsourced accounting and investment firms to address various business needs.
In exchange for its services to the investment LLCs, Lender Management received a profits interest in each LLC. These profits were generally based upon a percentage of net asset value of the investment LLCs plus a percentage of the LLCs' investment returns.
Case and ruling
For the tax years in question, Lender Management reported its incurred business expenses as ordinary and necessary trade or business expenses deductible under Sec. 162. Among these expenses were salaries and wages, repairs and maintenance, rents, and various other expenses of operating the investment management business. For 2011 and 2012, these ordinary deductions also included guaranteed payments to partners. The deductions for each of these years were in excess of $1.1 million.
Lender Management contended that its activities met the test for an active trade or business under the guidelines the U.S. Supreme Court set forth in Groetzinger, 480 U.S. 23 (1987). In Groetzinger, the Court said that to consider an activity as 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." Lender Management further asserted that Lender Management and the investment LLCs should be respected as separate business entities and that these entities engaged with one another at arm's length.
The IRS disagreed with the taxpayer's position and disallowed these deductions under Sec. 162 and allowed them instead under Sec. 212, contending that Lender Management's primary activity was the management of the Lender family fortune for members of the Lender family by members of the Lender family. Thus, the expenses would be allowable only as an expense for the production of income and subject to the 2% floor on miscellaneous deductions.
In reaching its conclusions, the court focused primarily on two items: the activities of Lender Management and the familial aspect of the activities.
The court concluded that the services Lender Management provided to its clients were comparable to the services provided by hedge fund managers. Lender Management had a responsibility to provide its clients with sound investment advice with growth potential and tailored to the individual family members' financial needs. Lender Management also employed full- and part-time employees and engaged outside service providers to supplement its ability to provide services to its clients. Citing Dagres, 136 T.C. No. 263 (2011), the court viewed the activities of Lender Management as going beyond those of a mere investor and constituting a trade or business. The court also ruled that Lender Management's compensation via a profits interest contingent upon the investment success of the investment LLCs did not negate that the compensation was for services it provided and that Lender Management intended to generate a profit from those activities.
Given the familial relationship of the owners of Lender Management and the investors of the investment LLCs, the court reviewed the economic arrangement between the entities with a heightened scrutiny. Specifically, the court examined whether the arrangement was a bona fide business relationship or an arrangement due to the familial relationship. Applying this heightened scrutiny, the court noted: (1) There was no requirement or understanding that Lender Management would remain the manager of the assets held by the LLCs indefinitely; (2) investors could withdraw their individual money at any time (subject to the LLC's liquidity restrictions); (3) Keith, as one of the investors in the LLCs, would still have benefited from the investment returns of ownership of the LLCs if he did not work for Lender Management, and any additional income to him was due to the services he provided to Lender Management; and (4) while each investor was a member of the Lender family, the members did not act collectively and, in some cases, did not know each other or were in conflict with each other. The Tax Court found that even though the investors were all members of the Lender family, Lender Management provided investment advisory services and managed investments for each of its clients individually.
Ultimately, the Tax Court held that the activities of Lender Management rose to the level of a trade or business, and it was entitled to deduct its expenses under Sec. 162.
Use of profits interest for investment partnerships
Given the holding in Lender Management, investment partnerships, including family investment partnerships, may consider arrangements where a provider of investment management services is compensated via a profits interest versus a fee that may be subject to limitations under Sec. 67, and nondeductible under Sec. 67(g), for any tax year beginning after Dec. 31, 2017, and before Jan. 1, 2026 (TCJA, §11045). It is important to note that the profits interest must have real economic substance to be respected.
Specifically, Prop. Regs. Sec. 1.707-2 describes various factors that may be considered in determining if an arrangement constitutes a disguised payment of services versus an allocation of profits. Factors that may cause an allocation of partnership profits to be considered a payment for services include: (1) The arrangement lacks significant entrepreneurial risk, including capped or reasonably certain allocations of income, allocations of gross income, and a nonbinding waiver of future rights to income; (2) the service provider holds a transitory partnership interest or holds the interest for a short period of time; (3) the service provider receives an allocation and distribution in a time frame comparable to that of a nonpartner service provider; (4) the service provider becomes a partner primarily to obtain tax benefits not available if the services were provided by a nonpartner; (5) the value of the service provider's interest is small in relation to the allocation and distribution; and (6) the arrangement provides for different allocations or distributions based upon different services being provided. If the payment is considered a payment for services and not an allocation of profits, depending on the activities of the managed partnership, the allocations to the manager's profits interest by the partnership may be considered to be a Sec. 212 investment advisory expense and therefore subject to the limitations of Sec. 67.
In addition, Sec. 1061, as enacted as part of the TCJA (§13309), may apply to profits allocations from these investment partnerships. Specifically, this section, commonly referred to as the carried interest provision, creates a three-year holding period requirement for long-term capital gain treatment for an allocation of capital gains to a provider of services to an investment partnership. Accordingly, in some circumstances, the profits interest structure of an investment partnership may create additional short-term capital gains allocated to a provider of services such as Lender Management. In advising on these profits interest structures, it will be important to consider the impact of Sec. 1061 and any future regulations issued under that section.
Allocation of profits does not negate 'trade or business'
Lender Management affirms the position that an investment adviser can be in a trade or business even if the primary source of its income is from the allocation of profits from underlying managed partnerships. This provides a great opportunity for many taxpayers with similar activities. In considering these structures, it is critical that taxpayers and their advisers consider the specific facts and circumstances of each particular situation for the structure to be respected.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.