The Advisor: Helping You Manage Your Life and Legacy in Today's Complex World
This quarterly newsletter provides articles of interest, insights, and recent developments involving interdisciplinary legal topics affecting high-net worth individuals as well as family offices, trust companies, financial advisors, and similar private client service providers. We hope you find this publication informative, and we welcome your feedback on topics you'd like to read about in future publications.
Family Offices and the Tax Cuts and Jobs Act: Can Operating as a "Trade or Business" Reduce Taxable Income?
Prior to the 2017 Tax Cuts and Jobs Act (Act), individual taxpayers were able to reduce their taxable income by deducting various investment-related expenses as miscellaneous itemized deductions. The Act suspended miscellaneous itemized deductions beginning in 2018 through January 1, 2026. As a result, investment advisory fees and other expenses incurred for the production or collection of income are no longer deductible by individual taxpayers. The new tax law is a particularly unwelcome development for high-net-worth clients with a family office, as the costs incurred by these operations are often substantial.
However, expenses incurred by a taxpayer engaged in a "trade or business" are not considered miscellaneous itemized deductions and therefore remain available to reduce taxable income. With the continuing deductibility of trade or business expenses and the suspended deduction for investment expenses, characterizing the family office as a "trade or business" has become a valuable distinction. Unfortunately there is no clear definition of what constitutes a trade or business. Rather, whether a taxpayer is engaged in a trade or business or merely an investment activity is based on all of the facts and circumstances, and there had been very little guidance in the family office context until the Tax Court issued its December 3, 2017 decision in Lender Management v. Commissioner (Lender).
Lender addresses the distinction between investment activities and trade or business activities in the context of a family office. The Tax Court found that Lender Management LLC (Lender LLC), a family office providing management services to three separate investment entities owned by various members of the Lender family, was not an investor, but rather was actively engaged in a trade or business. The Tax Court found that Lender LLC provided investment management services for the benefit of its clients, rather than for its own enrichment. This distinction is key in separating personal investment activity from a trade or business.
In deciding that Lender LLC was engaged in a trade or business, the Tax Court noted that Lender LLC received a carried interest as compensation for its services, beyond the return on its own investments. The Tax Court's decision also focused on the fact that Lender LLC had multiple employees, both full- and part-time, that researched investment opportunities, negotiated and executed new investments, monitored existing positions, and worked with individual investment entity members providing one-on-one investment advisory and financial planning services to address such members' specific needs. The Tax Court found that the breadth of services Lender LLC provided to its clients was analogous to the services hedge fund managers provide to their clients, and that such services went far beyond those of a personal investor.
In light of the suspension of miscellaneous itemized deductions, Lender provides a road map for family offices to consider in establishing a new or restructuring an existing operation. Many family offices already engage in some of the activities favorably cited by the Tax Court in Lender, and others may need to reevaluate their particular structure in light of this recent decision.
#MeToo for Nonprofits: What Role Should Philanthropic Funders Play?
As the "#MeToo" movement continues to shed a public light on sexual harassment across a wide variety of industries, it has become clear that the charitable sector is not immune from similar abuses. In recent months, a variety of boldface names in the nonprofit world—international NGOs, think tanks, and more—have found themselves embroiled in sexual harassment and abuse scandals at a variety of levels, from field staff all the way up to senior leadership.
Funders, including individual donors and private foundations, are increasingly being forced to grapple with allegations of sexual harassment at grantee organizations. There is a growing ability (and willingness) by stakeholders, victims' groups, and the general public to track down funders of these organizations to demand action or accountability, and funders who fail to act forcefully can risk their own reputational damage. Moreover, if grantees do not appropriately address sexual harassment issues, funders' philanthropic dollars may not be used effectively for their intended charitable purposes or could even be seen as supporting a toxic workplace environment.
Given these risks, what proactive steps should funders consider?
- Reconsider the diligence process: Many funders are adding diligence on sexual harassment prevention and policies to their normal pre-award processes; where grantee policies or procedures are lacking, funders can either require improvements or refuse funding altogether. What policies and procedures does the grantee have in place to report and address allegations of harassment or misconduct? What training does the grantee require of its management and staff, both to reduce the prevalence of sexual harassment and to make sure that reporting/grievance mechanisms are understood? Some cities and states, such as California and New York, require employers to maintain certain harassment policies and conduct annual training; are grantees in compliance with all local and state laws? Finally, does the grantee have a history of harassment complaints, lawsuits, or settlements?
- Update grant agreements: Funders are increasingly reviewing grant agreements to consider whether they contain appropriate mechanisms to address grantee sexual harassment issues and to protect the funder's reputation and funds. What type of reporting does the funder receive about sexual harassment allegations or settlements, and what additional information can be demanded (particularly in the event of public allegations)? Can funding be withheld, terminated, or refunded if the funder determines that the grant programs or the funder's reputation is at risk? Can grant funds be used for sexual harassment settlements (particularly in the case of "general support" grants)? Can the funder withdraw naming rights or otherwise publicly disassociate itself from the grantee?
- Be prepared for a crisis: While funders should not re-investigate or second-guess all governance or personnel decisions, they can play an active role in encouraging grantees—and grantee boards of directors—to be thorough and proactive in addressing sexual harassment issues. When should grantee boards launch an independent investigation of misconduct? What is the "tone at the top" with respect to allegations? What type of policy or process improvements should organizations initiate in response to allegations or scandals?
Through clear expectations and requirements, funders can help to ensure that grantees have proper policies, procedures, and practices in place to try and prevent sexual harassment in the workplace, and to promptly and thoroughly address problems when they arise.
The Tax Cuts and Jobs Act: Providing for Tax Savings While Investing in "Opportunity Zones"
The Tax Cuts and Jobs Act (Tax Act), passed in December 2017, offers new tax incentives for taxpayers investing through special vehicles known as "qualified opportunity funds" (QOFs) in certain economically distressed areas across the United States that have been designated as "qualified opportunity zones" (QOZs).
Investments in QOFs provide the following three tax incentives:
- Temporary deferral of taxable gain from the disposition of property, to the extent of the amount invested in a QOF during the 180-day period beginning on the date of such disposition. Although a plain reading of the Tax Act seems to extend such deferral to gain from the disposition of any property, the applicable legislative history indicates that it is limited to capital assets. The deferred gain must be recognized on the earlier of (i) the date of disposition of the QOF investment or (ii) December 31, 2026.
- Elimination of 10 percent of the deferred gain if the investment in the QOF is held by the taxpayer for at least five years, and an additional elimination of five percent of the deferred gain if the investment in the QOF is held for at least seven years.
- Permanent elimination of gain on any post-acquisition appreciation with respect to the taxpayer's investment in the QOF, if the investment in the QOF is held by the taxpayer for at least 10 years.
A QOF must be set up as an entity treated as a partnership or corporation for US federal income tax purposes. Furthermore, at least 90 percent of a QOF's assets must consist of "QOZ Property," generally determined on an annual basis, by measuring the percentage of the QOF's QOZ Property at the end of each six-month period of the QOF's taxable year and averaging the amounts.
QOZ Property generally includes tangible property used in a trade or business if: (i) the property was acquired by purchase (and not from certain related persons); (ii) the original use of the property in the QOZ commenced with the QOF or the QOF substantially improved the property; and (iii) during substantially all of the QOF's holding period for the property, substantially all of the use of the property was in a QOZ. QOZ Property also can include equity in certain corporations or partnerships, generally where substantially all of the tangible property owned or leased by the corporation or partnership is QOZ Property.
To date, the only guidance issued with respect to the QOZ program consists of several frequently asked questions. However, such guidance is limited in scope and many unanswered questions remain. It is not clear when Treasury Regulations will be issued.
While the guidance on the QOZ program is limited, we can assist you or your clients with exploring these investment vehicles and advise on how the tax incentives would apply.
© Arnold & Porter Kaye Scholer LLP 2018 All Rights Reserved. This newsletter is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.