Family office structuring: Considerations in Lender model planning

Why Lender model planning?

Lender model planning, grounded in the 2017 Tax Court case Lender Management v. Commissioner, provides a roadmap for when a family office crosses from managing its own wealth into operating as an investment management business. The economic objective is straightforward: Since the Tax Cuts and Jobs Act (TCJA) eliminated the deduction of most investment expenses incurred by individuals and trusts, structuring a family office as a bona fide trade or business has become an important tax-efficiency strategy.

Introducing a management entity

A revised structure typically introduces a centralised management entity (frequently organised as a corporation) that replicates, as closely as possible, the economic and operational profile of an institutional-grade investment manager. Rather than relying primarily on fixed service fees, the management entity participates in the economics of the platform through “profits interests” and targeted allocations, and bears the cost of operating expenses. 

Management entity choice

Entity choice also plays a meaningful role in the analysis. While both flow-through and corporate structures are used, there is a growing preference for corporate management entities in this context. A corporation can deduct investment-related expenses at the entity level without being subject to the individual limitations that constrain partnerships and their owners. It also avoids certain re-characterisation risks associated with carried interest holding periods enacted under the TCJA. That said, these benefits come with trade-offs, including potential exposure to double taxation, and the need to manage regimes such as the personal holding company and accumulated earnings tax rules.

Allocation mechanics

From a partnership taxation perspective, the allocation methodologies are often where these structures succeed or fail. The ability to push expenses up to the management entity and allocate them in a manner that reflects the intended economics depends on satisfying the substantial economic effect requirements under the Treasury Regulation. 

To navigate unpredictable cash flow, well-designed structures build reserves within the management entity, layering in limited fixed-fee arrangements where appropriate, and coordinating distributions and loan repayment strategies across the broader family office platform.

Managing audit risk

Finally, these structures are inherently factually specific and therefore audit sensitive. The Internal Revenue Service (IRS) will focus on whether: i) the activity truly rises to the level of a business; ii) the ownership and compensation arrangements are consistent with that conclusion; and iii) the allocations and deductions are supported by the governing agreements and underlying economics. 

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Robert H. Garner is a partner in LP’s Corporate and Tax Planning Practice Groups. He works closely with private equity firms, real estate investors, and entrepreneurs on tax structuring related to acquisitions, dispositions, reorganisations, restructurings, recapitalisations, and other tax matters. 

Adam S. Garber is a partner in Levenfeld Pearlstein’s Trusts & Estates Group, where he counsels families on the transfer of assets from one generation to the next. Adam focuses his practice on helping family business owners handle their daily challenges as well as plan for the succession of their businesses.