Management Services – Trade/Business – IRC Sec. 162
Management Services – Trade/Business deduction under IRC Sec. 162 are supported by the holding in Lender Management LLC, T.C. Memo. 2017-246,
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 the net asset value of the investment LLCs plus a percentage of the LLCs’ investment returns.
Management Services – Trade/Business
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 non-partner service provider; (4) the service provider becomes a partner primarily to obtain tax benefits not available if the services were provided by a non-partner; (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.