Lender Management, LLC v. Commissioner of Internal Revenue provides family offices with a potential roadmap for obtaining trade or business expense deductions under IRC section 162 in connection with rendering investment management services.

The principal issue in Lender was whether the family office, “Lender Management” carried on a trade or business. Lender Management provided direct investment management services to three separate limited liability companies (“LLCs”), the beneficial owners of which were entirely Lender family members. Each of the LLCs was treated as a partnership for federal income tax purposes, and Lender Management also managed “downstream entities” in which one of the investment partnerships had a controlling interest. Investors in some of these downstream entities included individuals who were not Lender family members. Lender Management’s operating agreement permitted it to “engage in the business of managing the Lender Family Office and to provide management services to Lender family members, related entities and other third-party nonfamily members.”

If the name “Lender” sounds familiar, there is a good reason for it.  The family patriarch, Harry Lender, founded “Lender’s Bagels,” which was the font of the family’s wealth, and some of the Lender family members involved in the case were his grandchildren and great-grandchildren. They were very much dispersed both geographically and in temperament. So although it was an extended family, the Tax Court’s decision made it very clear that—for all intents and purposes—the relationships between Lender Management and its “clients” were effectively at arm’s length and that Lender Management could have been terminated as an investment advisor at any time by the investment partnerships.

Among other key facts in the case were as follows:

• More than 50% of the assets under management were invested in private equity.
• Lender Management also provided individual investors in the investment LLCs with one-on-one investment advisory and financial planning services.
• Compensation was paid to Lender Management for the investment management services that it provided in the form of profits interests (or carried interests) in the various investment partnerships that it advised.
• The taxpayer (Lender Management) therefore received not just a return on its investment but compensation attributable to its services provided to others.
• Lender Management employed five employees during each of the tax years at issue.
• The key person at Lender Management (Keith Lender, who was Harry Lender’s grandson) worked approximately 50 hours per week in Lender Management, had a business degree from Cornell University and an MBA from Northwestern University, and worked for several years in marketing and brand management for major corporations prior to joining Lender Management.

The Tax Court determined that the activities of Lender Management, which involved providing investment management services to others for profit—although the “others” were all part of the Lender extended family or their related entities—were sufficient to constitute a trade or business to give rise to fully deductible trade or business expenses under IRC section 162.

The IRS had contended that these expenses were not trade or business expense deductions under IRC section 162 but were instead deductible under IRC section 212. This meant that—as miscellaneous itemized deductions—the expenses were subject to the 2% of adjusted gross income (“AGI”) floor and the alternative minimum tax. (Importantly, under the new tax law, IRC section 212 expenses are no longer tax deductible.)  The IRS basically asserted that the family was managing its own money—and that family attribution rules should apply where the clients are family members.

The critical distinction that the Tax Court drew in Lender was between trade or business expenses and investment expenses. Commenting on this distinction, the Tax Court observed that “[n]o matter how large the estate or how continuous or extended the work required may be, overseeing the management of one’s own investments is generally regarded as the work of a mere investor” and that “[e]xpenses incurred by the taxpayer in trading securities or performing other investment-related activities strictly for his own account generally may not be deducted under section 162 as expenses incurred in carrying on a trade or business.” The Tax Court further observed that transactions within a family group are generally subject to heightened scrutiny.

Notwithstanding this heightened scrutiny, the Tax Court concluded that the record before it demonstrated that Lender Management provided investment management services to others for profit. According to the Tax Court, “selling 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.” As such, Lender Management’s activities were sufficient to constitute a trade or business to give rise to fully deductible trade or business expenses under IRC section 162.

Thus, the use of a family office management company in Lender effectively converted non-deductible expenses (miscellaneous itemized deductions) into above-the-line fully deductible trade or business expenses. Lender Management’s profits interests in the investment partnerships, in turn, reduced income for those partnerships.

Commentators have observed that, under Revenue Ruling 78-195, the ability of the family office to deduct its general office expenses under IRC section 162 might be further enhanced if the family office entity is instead structured as a C corporation. In that Revenue Ruling, a C corporation that was formed for the express purpose of investing in real property purchased a tract of unimproved, non-income-producing real property, which it held for two years and sold without having made any substantial improvements. The corporation did not make any significant efforts to sell the property and did not engage in any other transactions in real or personal property or in other commercial activities. During the period that it held the property, the corporation incurred expenses for interest, real property taxes, accounting fees, and general office costs. The IRS held that the accounting fees and general office costs were expenses related to investment property of the C corporation and, as such, were deductible by the C corporation under IRC section 162 in the year paid or incurred (except to the extent that such expenses might need to be capitalized).

A caveat should be noted, however: Importantly, the Lender case involved only the question of income tax deductions under IRC section 162.  It does not address any other issues, such as whether the transfer of a carried interest—which was a junior class of equity under these facts, as other classes of equity were preferred to it in receiving distributions from the investment partnerships that Lender Management advised—might constitute a “distribution right in a controlled entity” so as to potentially trigger the application of the deemed gift rules of IRC section 2701. That issue needs to be carefully considered as well.

Being deemed engaged in a trade or business could also potentially trigger certain collateral tax consequences. Depending upon the circumstances, this could potentially include ordinary income treatment on certain trading profits and potential exposure to additional state, local, and unincorporated business taxes. 

Moreover, a family office needs to carefully consider securities law restrictions on managing others’ financial assets. Accordingly, securities law counsel should be consulted as well in connection with the establishment of a family office that seeks to follow the Lender model.  

Kevin Matz, Esq., CPA, LLM (taxation), is a partner at the law firm of Stroock & Stroock & Lavan LLP in New York City and the outgoing chair of the NYSSCPA’s Estate Planning Committee. His practice is devoted principally to domestic and international estate and tax planning, and he is a fellow of the American College of Trust and Estate Counsel (“ACTEC”) and a co-chair of the Taxation Committee of the Trusts and Estates Law Section of the New York State Bar Association. Mr. Matz is also a certified public accountant, in which connection he is currently the president of the Foundation for Accounting Education’s (FAE) Board of Trustees and the chair of the FAE Curriculum Committee. He writes and lectures frequently on estate- and tax-planning topics. He can be reached by email at kmatz@stroock.com or at 212-806-6076.