The Heckerling Institute on Estate Planning January 17, 2019 FUNDAMENTALS OF FAMILY OFFICES FOR THE ESTATE PLANNER

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1 The Heckerling Institute on Estate Planning January 17, 2019 FUNDAMENTALS OF FAMILY OFFICES FOR THE ESTATE PLANNER A PRIMER ON FUNCTIONS, STRUCTURES AND RELATED ISSUES N. TODD ANGKATAVANICH RICHARD DEES WILLIAM J. KAMBAS ROBERT (BOBBY) STOVER, JR

2 I. INTRODUCTION How is a family office developed? A. Putting the family office into context B. Assessing the economic needs for the management of private capital

3 II. STRUCTURING FOR THE MANAGEMENT AND ORGANIZATION OF PRIVATE CAPITAL Which factors lead to success of a family office? A. Identifying different types of family offices and their evolution B. Scope of services C. Considering the right structure 3

4 What is a family office? Single family office (SFO) Dedicated to one family, perhaps with multiple households and generations Multi-family office (MFO) Independent entity that manages the wealth of several families; it may be a small enterprise (at times growing out of a single family office), or it could be a division within a large bank or financial services firm Virtual family office (VFO) Many services are outsourced. The office may have a few administrative or accounting staff, while outsourcing investments, legal, accounting, technology and other services. SFO MFO VFO

5 Sample family office organization Family offices are organized based on actual services offered, skills of the staff hired, and desires of the family. Below are two extremes, from the very simple Founder s Office, to a complex large, multigenerational family office, as well as a medium-sized office example. Founder s Office Multigenerational office Founder Accountant Personal assistant External advisors Medium-sized office Attorney CPA Insurance Investments Family governing board Investment committee Foundation board Business board of directors Closely held businesses Chief financial officer Family council Family office president Tax Accounting: Bill pay Partnership acctg Reporting Technology Fiduciary services Financial planning Chief investment officer Real estate Private equity Marketable holdings Manager oversight Foundations Family foundations External advisors Business board of directors Closely held businesses Attorney CPA Insurance Investments Chief financial officer Tax Accounting: Bill pay Partnership acctg Reporting Fiduciary services Family office president Chief operating officer Client service Concierge services Insurance Personal security Communication Financial planning Technology Chief investment officer Real estate Private equity Marketable holdings Manager oversight External advisors Chief philanthropic officer Family foundations Venture philanthropy Attorney Insurance Consultant Security

6 III. GOVERNANCE A. Legal governance: the basic framework for the family office entity B. Constitutional, committee, and counsel governance: family-oriented approach to decision-making and communication C. Enterprise ownership: A. managing liability B. regulatory considerations D. Memorializing the arrangement: creating agreements tailored to particular needs, including considerations unique to multistate and multinational families 6

7 UNDERSTANDING THE DYNAMICS Legal & Beneficial Ownership Wealth Generators Mom Dad Management & Values $ Family Trust(s) $ Beneficiaries Family Members Trustee Control & Management Family Office Purpose Trust Enforcer/ Appointer Outside Outside Advisors Advisors Letters of Wishes Family Assembly Family Council Committees PTC Protector Assets & Investments Homes Family Assets Toys Family Business Operations Banks Family Investments (FLP) Outside Managers Hedge Family Foundation 501(c)(3)s PE VC RE Economic Benefits Boards Committees Managers 7

8 IV. COMPENSATING MANAGEMENT 1. Attracting talent Key personnel Investors Co-ownership 2. Compensating talent Fringe benefits Equity incentives 3. Retaining talent Retention incentives 8

9 V. GENERATING INCOME AND LOSSES A. Profitable enterprises: tax treatment of profits and cash distributions Capital gains? B. Loss leaders: tax treatment of enterprise losses Deductibility of expenses C. Planning for 2019 and beyond 9

10 Activities treated as a trade or business Trade or business determination is based on facts and circumstances, but must be: Regular Continuous And Have a profit motive Commissioner v. Groetzinger, 480 U.S. 23 (1987) Generally, the management of one s own assets is not a trade or business: Higgins v. Comm r, 312 US 212 (1941) King v. Comm r, 89 T.C. 445 (1987) Beals v. Comm,r, T.C. Memo (1987) Generally, a cost center is not a trade or business: Strangeland v. Comm r, T.C. Memo (2010) 10

11 Sample profits interest structure Services Performed or Contracted G2 Individuals G2 and G3 Individuals G2 and G3 Trusts Outsourced personal services 100% Outsourced investment advisory Outsourced tax and legal services Payroll, rent, etc. Costs NAME PREFERRED HOLDINGS, LLC Revenue: $0.2M Int. $1.0M Div $1.0M Cap Gain $6.0M Costs: ($8.6M) Profit:/(loss) ($.4M) Fee $200,000 Profit Interest 15.74% of profit above hurdle. NAME Capital LLC Funds Funds Funds Legend Partnership Trust LLC treated as a corporation for federal tax purposes Allocation of $8.5M of income earned by NAME Capital. Reduces income by $8.0M, is NOT a fee and retains character Int, Div, Capital Gain, etc. Family Office Structure

12 Lender Management structure G1 = 2 G2 = 3 G3 = 4 KRLT 99% 1% MRLT G1 = 1 G2 = 3 G3 = Largest % = 26% 3 8 Largest % = 32% Lender Management Marvin LLC Marvin 1990 Irrev Tr Murray 1990 Irrev Tr Murray LLC M&M PE Lenco Hedge Public Equity PE Hedge Public Equity Costs: Outsourced Path Stone: % Gross Receipts + 2% of NAV 2.5% of NAV + 25% of NAV 1% NAV + 5% NAV 2.5% of NAV + 25% of NAV Total $1.1 million Payroll $300k to $400k Tax compliance Accounting functions Investing 12

13 Lender Management, LLC v. Comm r T.C. Memo (December 13, 2017) The owners of Management Company substantially differed from the owners of Investment Entities. Investors could withdraw their investments at any time if they were dissatisfied with the management services. Management Company had full-time employees and paid salaries to its full-time employees. In Lender, the Management Company had five employees. Management Company provided investment advisory services and financial planning services, comparable to hedge fund managers, to entities, individuals and certain third-party non-family members. 13

14 Hellmann structure EG SG MG DH 25% each Sole owners and the only employees Ave T SBGTs MEGTs DGHT GF Management LLC 1% in each var% 99% 99% 99% 99% 99% AVE1 SBG1 SBG2 MG1 MG2 DH1 Various underlying investments Illustrative Costs: Outsourced: Total $2.1 million Tax compliance Accounting functions Payroll $600k Investing 14

15 Hellmann v. Comm r Docket Nos , , , Brought before the Tax Court, settled out of court Court asked to determine whether Management Company s (GFM LLC) activity constituted trade or business in the wake of Lender decision Factual differences from Lender: GFM was managed by four family members, who are the sole owners of GFM and of all the underlying investment partnerships, through trusts No outside investors Irrevocable non-grantor trusts, independent trustees 15

16 Lender + Hellmann: Putting it together 1. Separate Entity. Whether partnership or corporation, separate entity analysis. Avoid piercing the corporate veil. Consider cases Goodwin and Moline Properties as well as cases supporting availability of Section Family Attribution. Do Sections 162 and 212 include family attribution rules (consolidate ownership)? If consolidation, then risk managing own assets. Related-party transactions require a heightened standard of review. 3. Asset Ownership. Family office does not actually own the assets as an investor. Can a family office operate as a business entitled to Section 162, as a matter of law? 4. Professionalized Operations. Private equity structure. In addition to Lender, consider Higgins and Groetzinger (among others). Regular and continuous operations with a consistent profit earning motive. Expenses are ordinary and necessary. 16

17 VI. EXPANDING THE ENTERPRISE MERGERS AND MULTIPLE GENERATIONS A. Multilayered structures B. Structural flexibility: mergers, conversions, and liquidations 17

18 VII. GENERATIONAL SUCCESSION OF THE FAMILY OFFICE AND UNIQUE TRANSFER TAX ISSUES When structuring profits interests in a family entity to be owed by (or in trust for) junior family members, there are unique and potentially draconian deemed gift tax issues that need to be carefully navigated to avoid triggering a potentially substantial deemed gift under Section The risk posed if Section 2701 is violated in connection with a restructuring of an investment entity (such as a family limited partnership or LLC) is that the senior family member could potentially be deemed to have made a taxable gift (subject to immediate gift tax) of some or perhaps even all of his/her retained LP interests in the investment entity upon the issuance of the profits interest to the junior family member (directly or by way of a trust and/or entity). There are possible ways to structure the issuance of profits interests to junior family members that are designed to circumvent the potentially harsh results of triggering Section 2701, but they involve some level of uncertainty and customization. 18

Pre-2701 Abusive Discretionary Corporate Recapitalization That 2701 Was Designed to Prevent Parent Retained Preferred (at inflated value) Common Gifted to

19 Pre-2701 Abusive Discretionary Corporate Recapitalization That 2701 Was Designed to Prevent Parent Retained Preferred (at inflated value) Common Gifted to Kids (at depressed value) Preferred (Discretionary Rights Inflated Value) Common (Deflated Value) Valued at $9.9m Valued at $100k Stockholders Agreement Provisions

20 Question whether Section 2701 could apply to issuance of profits interest A transfer includes a traditional transfer, capital contribution, recapitalization and change in capital structure. G-1 G-2 After the transfer, if G-1 holds a distribution right in LP interests LP interests 100% interest the form of the LP interest in Investment Entity ( a right to receive distributions with respect to an equity Mgt Co. interest ) in a family controlled entity. Profits interest Investment Entities 20

21 Thank you N. TODD ANGKATAVANICH RICHARD DEES WILLIAM J. KAMBAS ROBERT (BOBBY) STOVER, JR

22 Disclaimer This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as tax or accounting advice. The views expressed by the presenters are not necessarily those of any organization. SCORE No US

Tax and structuring considerations Family investment partnerships

Tax and structuring considerations Family investment partnerships Content Family Investment Partnerships ( FIP ) can help families address their collective and individual investment goals while offering