Organizing The Family: The Purpose And Operation Of A Family Office
After a matriarch and/or patriarch of a family (often referred to as the first generation or “G1”) accumulates wealth, whether through closely held business arrangements or other investments, the G1 generation begins to consider how and in what form the next generations (children being “G2”, grandchildren being “G3”, and so on) should become involved. Once the G1 generation has made the decision to include subsequent generations in either wealth management or business operations, that G1 generation has inevitably created some form of a “family office,” whether intentionally or unintentionally. The manner in which a family office can be structured varies greatly, but the common theme is that it is a way of putting certain formalities around the manner in which a family manages wealth and perpetuates the family’s shared purpose and values.
Single Family Office or Multi-Family Office
As its name implies, a family office that is generally considered a “single” family office is one that is commonly organized through a separate legal entity, usually a limited liability company, and may involve many affiliated entities, all of which are ultimately owned and/or controlled by the family (via individuals, trusts, or both). The centralized structure of the single-family office may serve multiple households within a single family but focuses on one family. The family office will typically focus on estate planning, investment management, tax planning, bill pay, cash flow, and household staff for the single family. Thus, while there are many outside advisors and employees connected to the family office, there is one centralized “organization” focusing on a single family.
Alternatively, a multi-family office is an entity that is not owned by the family but an independent institution. Many banks, trust companies, and wealth managers offer “family office” services to multiple families. As with the single-family office, these services include estate planning, investment management, tax planning, bill pay, and cash flow. Like the single-family office, a multitude of “outside” advisors (attorneys, accountants, etc.) will be involved with the family office.
A family office structure not only helps strengthen familial relationships, but it can allow for pooled purchasing power, more impactful philanthropic giving, coordination of advisors (lawyers, CPAs, financial advisors), better tracking of wealth and management costs, better risk management, assisting with privacy, tax efficiency, employee type benefits, and maintaining better control over family businesses and investments.
Accomplishing Purpose – Regular Meetings
Although many family offices are formally organized as a separate legal entity, in many cases, the core purposes of the family office structure are not dependent upon the existence of a formal legal entity. These purposes are commonly (a) training; (b) perpetuating core family values; (c) imparting historical knowledge; (d) obtaining multi-generational input; (e) strengthening familial bonds; (f) accountability; (g) accomplishing common goals; and (h) charitable giving. Although a formal legal structure is not necessarily required for a functioning family office, the holding of regular family meetings is the central means through which the objectives of the family office are accomplished. Simply put, the family must communicate on a regular basis.
Frequency of the meetings, topics covered, and allowed participants vary greatly by family. For example, some family meetings include children while others may be limited to adults or even those above age 25. Some family meetings include spouses at all meetings, at certain meetings, or not at all. Many family office meetings will include outside advisors at some or all of the meetings (attorney, accountant, investment advisor, others).
As with any meeting in the business context, family meetings need to be organized with an agenda that is reviewed by all participants in advance of the meeting. Each meeting may be led by a different person, or different portions of the meeting may be led by different participants, depending on the topic. Sometimes families will need to feel their way through the first several meetings in order to figure out what works best for them, but the point is that the meetings are regular and organized.
The Family Mission Statement
A family mission statement provides the “constitution” for the family office and a guidepost for each family meeting. It expresses the values, vision, philosophy, and mission of the family. The statement helps to define the purpose of family wealth, the intention for the generational reach of the wealth and family office, goals and objectives, and related items. It can also include statements about minimizing family discord, encouraging respect and open dialogue, as well as expectations for familial contributions. Importantly, there is no one size fits all approach, but having a mission statement helps to center the family as it proceeds through the years. Again, it should be noted that adopting a family mission statement can be helpful for families of any wealth-level and even those that operate without a formal legal structure for a family office.
In addition to, or as part of, the family mission statement, it is very important for the family office to develop expectations. This may include expectations of certain family members in relation to active business operations or other roles. In addition, expectations about privacy, confidentiality, humility, and other traits can be envisioned through the family office structure.
As noted above, many family offices are conducted through limited liability companies. The flexibility of a limited liability company (LLC) can provide a broad range of owner and governance options. For example, the LLC could be structured with voting and non-voting ownership interests with non-voting interests held by one or more irrevocable trusts that benefit multiple generations of family members. The non-voting ownership could comprise the vast majority of the economic value of the LLC (i.e, 99%) but with no voting control. In this way, the vast majority of the economic appreciation from the family office’s investments and activities will inure to the benefit of the trusts that can provide controlled cash flow to the family members. Moreover, the trust structure provides asset protection and other benefits to the family members.
With respect to voting control, this can be maintained by the G1 generation until such time as control is transferred to the family more broadly. For example, the G1 generation could hold the voting interests and through the voting interests, establish a family committee (or family board of directors) with various governing rules. The family committee/board could also select officers to carry out specific functions of the family office. At some point, however, the voting ownership interests would be converted in a manner that results in the family committee having governing control over the family LLC (potentially through the use of a special purpose trust or other vehicle).
The family office would be permitted to invest in a variety of investments. Where a family has an operating business, ownership and operation of the family business will need to be carefully coordinated with the family office. In some instances, the family office limited liability company may own the voting control of the operating business. Thus, the family committee/board would be responsible for selecting the board of the operating business. In many instances, non-family board members would be required at one or more levels of the family office.
Although tax planning is not the ultimate purpose of the family office, for families with significant wealth, particularly illiquid wealth (such as a family business), tax considerations are very important to help perpetuate the family legacy. As noted above, irrevocable trusts and other estate planning strategies (GRATs, discount planning, life insurance trusts, etc.) should coordinate with the family office structure and help to facilitate efficient perpetuation of family wealth via estate tax minimization. Necessarily, this includes multi-generational planning through generation skipping transfer (GST) arrangements.
In addition to estate taxes, the issue of income tax deductibility of management and operating expenses will invariably arise. Under the Tax Cuts and Jobs Act, the deductibility of personal investment, accounting, tax, and similar advisory fees has been eliminated. Thus, for now, a family office will generally be unable to deduct many expenses associated with these services unless the family office can deduct expenses as a “trade or business” under Internal Revenue Code Section 162. A relatively recent Tax Court case, Lender Management LLC, T.C. Memo. 2017-246, illustrated how a family office might be able to deduct expenses. In this case, the grandson of the founder of Lender Bagels owned 99% of, and operated, Lender Management, LLC. The purpose of the LLC was to manage and direct the investing of investments owned by other family members (through their own LLCs). Lender Management received a profits interest in each of the investment LLCs in exchange for the investment management services it rendered. The Tax Court concluded that because Lender Management, LLC operated in a business-like manner and with a profit motive, expenses were deductible under Internal Revenue Code Section 162. An interesting aspect of Lender was that because Lender Management received profits interests for services, the various family LLCs that in effect “paid” Lender Management, LLC for services did not have to worry about the deductibility of such fees. Instead, Lender Management, LLC was allocated economic performance which effectively assigned the income (without the need for a deduction) from the family LLCs to Lender Management. Then, because of Lender Management’s own activities, it could take deductions against its own income as a trade of business expense.
It should be noted that any profits interest received in this context must not be deemed disguised compensation. This is a facts and circumstances analysis but generally focuses on whether the profits interest obtains an allocation of income that is a predominately fixed amount or reasonably certain, and whether the allocations are capped or otherwise do not have the common markers of a typical partnership interest. Moreover, if the profits interest is of short duration or evidences a timeframe that would be analogous to a non-partner service provider, among other factors, the profits interest may be challenged as a disguised service arrangement.
Finally, as noted above, the choice of entity will be impactful for the family office. Where the family office is primarily conducted via a flow through entity such as a limited liability company taxed as a partnership, the family will have to consider the impact of tax rates on flow-through income as well as the necessity of tax distributions. On the other hand, if a C corporation structure is desired, the family will need to consider the impact of the current 21% corporate income tax rate along with a second level of tax on any distributions (which may be as high as 23.8%). Moreover, with a C corporation structure, the family office will need to consider personal holding company tax rules and accumulated earnings tax rules.
Every family is different, and therefore every family office will need to be tailored to the specific family situation. Moreover, as the family, wealth, and business activities change over time, so too must the family office structure. However, where a family desires to attempt unity, common purpose, and perpetuation of values, the formalization of a “family office”, along with regular organized family meetings, is one of the great ways to accomplish these goals.