Family Office Basics

By David Rosen

It’s much more than a holding company

As more and more families are actively forming (or considering forming) family offices, those on the sidelines wonder whether they should join in. Why would a family choose to form a family office and invest their capital, their labor and possibly the future livelihoods of their family members on this singular venture? Do family offices truly create benefits for the families that make the investment? 

The term “family office” is often used by traditional wealth management and back-office providers to represent performing services for third-party families in exchange for compensation. That is not the type of family office that is the subject of this article. The family office described here represents a management and/or investment company that is owned by the family (or families) receiving investment, administrative and concierge services. Most of these structures are single-family offices or serve just a small number of families. 

What Is a Family Office?

At its core, the family office is an investment company in which the families’ capital constitutes substantially all of the investment assets, and the family invests resources to operate the company as a business. The family office is distinct from a mere holding company, since the family office intentionally deploys sufficient resources to outperform markets and maximize the value of its holdings. Many families hold investment assets through holding companies but do not add value through deployment of resources. Such holding companies are therefore not family offices under this definition.

Another way of thinking about a family office to compare a family’s activities to those in the general market. Professional money managers operate hedge funds, private equity funds and registered investment advisors, engaging in complex trading and investment activities. They are focused on deploying these resources to effectively managing assets in a risk-adjusted manner and outperforming market-level returns. This is diametrically opposed, in some sense, to the activities of a typical family that holds portfolio assets managed by a third-party money manager, with a desire to keep costs low and achieve market-level returns despite not investing specific resources into producing outsized returns.

Every family exists somewhere between these two polarities. Every family office either looks more like the family with assets managed by a third party or begins to look more like the hedge fund and less like that third-party portfolio. It is as this point where the entity usually takes the step to formalize its operations as a family office.

Family Office Framework

Why would a family form a family office? How does a family benefit from holding its assets in a common investment company?

Often the primary reason why a family will form a family office is to benefit family objectives. While a family office is a business and most of its efforts are devoted toward the operation of its investment and management business activities, the reason that family office is formed is often to enhance long-term family objectives. The senior generation aims to perpetuate (and combine) family and charitable aims with economic aims.

Family objectives that are aided by the creation of a well-designed family office include promoting family harmony; providing incentives to family members to behave comparably to the generations that create the wealth; educating family members; and creating transparent, predictable and straightforward family management and governance.

The second element of the family office framework is that the family office enhances financial objectives and helps to achieve above-market performance. Indeed, the family office will often compete with the best talent and recruit the best family members to grow the family’s asset base to the maximum degree.

Specifically, the family office helps to define and focus the family’s objective in key financial areas. Globally, the family can make risk-adjusted financial investment decisions. The family may decide how much capital to deploy toward growth as compared to making distributions to the current generation.  In this manner, financial objectives intersect with family objectives to ensure that good financial decision-making is present at all times.

Ultimately, the family office will guide the family toward determining how much it should try to grow the family wealth as compared to preserving family assets. Similar, the family will determine when (and if) to sell important family assets and when to make distributions to family members. The financial functions are essentially identical to similar roles for a hedge fund, determining how much capital to retain and deploy and how to make the best possible investments in light of the company’s goals.

The third element of the family office framework is the social component, consisting of community and philanthropy. Community reflects the values and intangible objectives of a family: the family’s substantive commitment, the time its spends, the visibility it promotes and legacy that it will ultimately leave. Community is the “what we do” aspect of charitable involvement.

Philanthropy, on the other hand, is giving money to charity. In the family office context, the family office serves as a buffer and a professional tool to assist in charitable decision making. With its support, family members learn when to say “yes” to a charity asking for money, when (and how) to say “no” to a charity asking for money and, importantly, learn to diligence a charitable gift in the same manner as a comparably sized business transaction.

Nearly every family wants to strengthen family bonds while managing family assets over multiple generations. There are, however, few families with the resources to do so effectively. The family office framework guides the mission, but how should the family office be organized to achieve these ends?

Structuring the Family Office

Non-Tax Structuring Considerations

Much of the talk about structure in the family office world revolves around the “Lender” structure. Lender Management v. Commissioner was a 2017 tax court case (featuring the Lender family that had previously sold Lender’s Bagels) in which a third-generation family office was considered to be in the trade or business of managing the family investments.The Lender structure was not unusual — it generally resembles other investment fund structures — which is where we begin when thinking about how to structure a family office.

Investment companies have been around for generations. In modern times, two primary approaches are used by for-profit investment companies. It is not necessary to re-create the wheel. To put in perspective how long these structures have been common, Warren Buffett created his first limited partnership almost 70 years ago and similar vehicles have since proliferated.

Sometimes, using a C corporation could make sense for an investment company. These are often used for public investment vehicles. Traditionally, C corporations have been excellent choices for capital preservation and allocation, and are generally combined with strong centralized management and risk management capabilities. Berkshire Hathaway is perhaps the best example of a successful C corporation investment company model.

In the private marketplace, however, the overwhelming choice is to use a GP/LP/Fund type model that is common to hedge funds and private equity funds throughout the United States. We have a history of nearly 100 years of limited partnership-like structures (dating back to even the early hedge funds that arose during and following the Great Depression) becoming the dominant structure for private investment companies. (See Sebastian Mallaby’s book More Money Than God: Hedge Funds and the Making of a New Elite, which describes the evolution of hedge funds.) Following the model of the most similar businesses — hedge funds, private equity funds and, perhaps more accurately, a fund of funds — is a prudent course for a family office that will operate a like business and compete for talent and opportunities.

The benefit of the fund-type structure is that the manager’s compensation is generally made through a combination of a management fee and/or a carried interest. The use of a carried interest as the primary tool for profits creates a tremendous incentive for the manager to create profits and therefore aligns closely the interests of the manager and the fund investors. The fund structure is also inherently flexible and tax-efficient, compared with corporate structures.

The Lender Management Tax Court Case and Structuring Considerations

In 2017, the tax court took up a bona fide family office case and held in favor of the taxpayer, finding that a family office was considered a “trade or business.” As a trade or business, a family could deduct its investment expenses, including those relating to holding securities, hedge funds and private equity fund investments.It could also deduct salaries paid by the family office, including family members’ salaries. If it were not treated as a trade or business, none of these expenses would be deductible for individual partners of a partnership (such as the Lender family owners).

What the Lender family did was convert their family investment holdings into a fund of funds, in both a practical and legal sense. The family formed a management company (Lender Management LLC), which managed the investments of various fund vehicles that owned third-party fund investments. (Such holdings consisted of public equities, hedge fund investments and private equity investments in three separate family-owned fund entities.) Lender Management performed services for these entities. It managed the investment activities and provided administrative and support services. In exchange for providing these services, Lender Management received, in early years, a fee and a carried interest. In later years, Lender Management performed the services solely in exchange for a generous (25%) carried interest.

The other main consideration derived from the Lender Management case is that at some point a family looks more like a market participant and less like a person managing their own investments. The Supreme Court retains the view that merely managing one’s own money, without more, does not itself rise to a trade or business. The Tax Court’s facts reflect that the Lender family’s activities were not akin to managing one’s own money. The Court noted the amount of time and resources required, the number of people for whom money is managed and the (distant) relationship between some of them. Each family investor was entitled to withdraw their money at any time. The nature of the advisory relationship was hands-on and professional, and the investors received individualized investment choices. These facts supported a trade or business determination.

In light of the outstanding state of the law regarding trade or business deductions, which is primarily driven from Lender Management and prior Supreme Court opinions, a family office should generally create a market-like fund structure similar to that which has been accepted by the tax court.Thus, a family should form a manager entity and one or more fund entities that look like funds in the marketplace. Families frequently use entities to hold the investment in an FO Fund on behalf of investors (such as to segregate assets by family branch or generation). The features of these structures should reflect the following to remain consistent with Lender and meet trade or business criteria:

1.     Ensure that the Manager is properly compensated for its services. Ideally, the fee and carry are developed in light of the assets being managed and types of investment services performed (e.g., active trading vs. monitoring) by a third-party professional.

2.     Maintain adequate variation in ownership between the FO Manager and the FO Fund. We do not know how much is enough, but we strongly recommend maximizing the variance between these two entities. This issue was addressed in both Lender and in the subsequent Hellmann’s case (another family office tax court case, which was settled out of court).

3.     Actively engage in investing activities, generally mimicking the activities of fund managers and investment advisers. A family should hire investment professionals, subscribe to investment services and attend investment conferences. The company should develop business practices and operate like a business.

4.     Treat family investors as investors. Investment companies communicate with their investors and offer a variety of services, such as personalized financial planning, tax and bookkeeping services, and administrative support. A family office that expects to be treated as a trade or business copies these behaviors to ensure trade or business treatment.

5.     Have many owners. A family office is a smaller version of a fund of funds and should look like these businesses. Also, the more owners, the less it will be construed as the manager managing its own money. Accordingly, a family office should seek to have as many different investors (and as many different taxpayers) as possible.

6.     If the fact pattern for the previous factors is not very strong (e.g., the owners of the manager have only modest variation), we recommend that the FO Manager be formed as a C corporation. The underlying trade or business presumption may permit deductibility where deductibility would be barred for an owner of the same entity structured as a partnership.

A family office is a business — and a large one by asset value. To achieve the benefits of a family office, a family should do its best to treat the investment activities as a business. Over the course of a generation or two, family offices will tend to become more formal and institutional, but they will also act as a business in every respect. Assuming the family develops its internal talent properlyband encourages the right values, the shift toward business-like practices ultimately leads to good outcomes for multiple generations of family members.

David S. Rosen, Esq., oversees tax planning for many of the wealthiest families in the United States. He is the primary author of the Family Offices Portfolio on Bloomberg’s Tax Management Portfolios program. Many of the concepts discussed in this article are addressed further in that text.










Audio Sound Duration: 

Other Related Articles