What is a Family Office?
Family offices have become an integral part of the wealth management toolkit for ultra-high-net-worth families. Experts estimate there are now between 3,000 and 5,000 single-family offices in the United States, growth that has occurred in just the last two decades. While other wealth management vehicles are advantageous for certain ultra-high-net-worth families, family offices provide a convenient, comprehensive solution for the right situation. Single-family offices can be created to handle the full breadth of duties related to legacy planning, investment, financial and estate planning, and lifestyle management functions. In addition, some families still prefer to involve third-party wealth managers to oversee investment and financial planning and execution, while using a family office for administrative and concierge functions. A hybrid model with a family office environment for control and specific debt, and other large loans at historically low interest rates , can provide reasonable solutions in the current economic environment. A family office typically employs a chief executive officer or president, along with vice presidents of investments, legal, investments, accounting, financial planning, tax and human resources. All coordinated through a senior management group, a family office can be run as a centralized personal services operation providing lifestyle and concierge services that address everything from the basic to the most elaborate functions. This typically includes but is not limited to the management of charitable trusts and the facilitation of communication, and information sharing among family members. These are all typically on a fee-for-service basis. The administration of a family office is intended to benefit family units but is often delegated to a corporate entity to insulate the family from liability. While family offices will occasionally provide support and services to trusted friends, ancillary and ancillary fiduciary services are often provided on a fee-for-service basis.
Tax Considerations for a Family Office
While establishing a family office is an exciting milestone and can be a rewarding experience, it does come with significant tax implications.
Income Tax
An obvious tax issue for family offices to consider is whether the family office will be subject to U.S. income tax on its income. This issue is often driven by whether the family office will operate a trade or business in the United States. If the family office is not a grantor trust, C corporation or S corporation that is eligible for S election, it must pay U.S. income tax on its income that is effectively connected with a U.S. trade or business and that is not excluded from U.S. taxation by an applicable tax treaty or exemption. Of course, even if the business activities are foreign, the family office may still have U.S. source FDAP income or U.S. real property interests that would give rise to U.S. income tax liability.
While it might be unclear on inception whether the family office will be subject to U.S. income tax, the family office should plan for and analyze these issues carefully. A family office should engage in strategic planning to achieve optimal levels of income tax efficiency and to ensure unexpected tax liabilities are avoided. In addition, planning will impact on how the entities of the family’s structure will be owned.
In addition, it may be important for the family office to consider obtaining private letter rulings from the IRS on certain tax issues in order to mitigate the risk of an unexpected tax liability.
Although the amount of capital gains tax liability may not necessarily be significant, the family office should also consider how capital gains will be taxed. In some instances, if assets are transferred to the family office or sold to the family office, the structure of the transfer or sale may impact the capital gains tax liability.
Estate Tax
As mentioned earlier in this article, U.S. estate tax is another important consideration for a family office to keep in mind. If the primary beneficiaries of the family office are considered U.S. persons for gift and estate tax purposes, a U.S. taxable estate may be created that potentially could create exposure to significant estate tax liability for the family.
If the family office will be a foreign corporation, such entity and its subsidiaries and branches may be treated as owned by the individual shareholder. As a result, if the individual U.S. person is the grantor or a deemed owner of a foreign trust, the entire value of such trust may be deemed to form part of such shareholder’s taxable estate for U.S. gift and estate tax purposes, while distributions from such trust may also be subject to U.S. gift tax in certain circumstances.
A U.S. estate tax exposure may also arise if the family office owns U.S. real property or if the family office owns shares of a foreign corporation (as shares of foreign corporations may be deemed to be U.S. real property interests).
Common Family Office Tax Structures
In addition to the tax-wise structuring of an investment to minimize tax, a further layer of tax structuring must be considered when structuring a family office. This fourth layer of structuring is the family office itself. Various different structures can be used for family offices including Single Family Offices ("SFOs"), Multi – Family Offices ("MFOs"), Private Trust Companies ("PTC") and Private Trust Companies ("PTC"). The choice of which structure to use will depend on the specific requirements of the relevant family.
Single Family Offices
An SFO’s sole purpose is administering the needs of its member families (i.e. the SFO acts for only one family). An SFO can provide the same services a MFO provides, with one exception — due to the SFO being owned by one family, an SFO can offer its services, such as investment management, direct real estate and private equity fund investing, to this family without incurring any financial/fiduciary risks that arise from dealing with several different families. Also, an SFO is free from regulatory requirements applicable to MFO’s.
Multi – Family Offices
An MFO’s primary goal is to engage in family office activities for multiple families, so as to lower both operational costs and fees by pooling purchasing power and services. This structure allows each family to retain a comfortable level of privacy and control over their assets and affairs.
Private Trust Companies
A PTC is an entity that is regulated in circumstances where individual trustees are not used. Essentially, a PTC would be set up in a jurisdiction that does not make it compulsory that trust companies be license and regulated. A PTC is established by a promoter, which sells shares to the family or families that wish to avail themselves of this particular structure. The number of families investing in the promoter’s PTC will usually range from between 2 and up to 50.
The promoters of the PTC should not take any part in the administration of any of the trusts held by the PTC. In addition, the PTC may not administer any trusts other than those administered by it in the capacity as trustee. The promoter may only be used for the purpose of establishing the PTC.
Trusts in a Family Office’s Tax Strategy
Trusts have long been the preferred mechanisms for achieving not only estate tax minimization, but also income tax minimization and asset protection. This is true across the board and not simply in the context of family offices.
But, as with other advanced estate planning management tools, the family office environment provides a more structured and heightened opportunity to wield the advantages of trust structures in order to achieve these goals. Trust structures can also provide additional benefits not typically available otherwise.
Irrevocable Trusts
As family offices continue to amass greater wealth, accumulating and protecting that wealth without triggering an estate tax liability becomes more and more crucial. Setting up an irrevocable trust to receive gifts can help accomplish both of those goals while also providing flexibility and control – tools that are normally missing from family gifting decisions.
Putting family assets into an irrevocable trust can also remove future appreciation in those assets from an estate, which may also minimize future estate taxes. This typically is the goal in creating a generation-skipping trust where children are beneficiaries and grandparents are trustees. Careful planning can minimize taxes at each generation, but IRAs are often ignored, and there can be adverse tax consequences when they are not put into a generation-skipping trust.
Irrevocable trusts can also help protect assets from creditors and ensure that those assets are passed to grandchildren or other beneficiaries according to the donor’s wishes. Many such trusts are set up so that the beneficiaries have access to the assets only during a certain period of time and under certain circumstances – typically controlled by a trustee. This trust structure can be a boon to those looking for asset protection and creditor controls, as well as those who want to create generations of inherited property.
It has become common to fund irrevocable trusts with insurance in order to avoid estate tax liabilities, providing yet another layer of asset protection and tax efficiency. Additional ancillary requirements can include a change in trustee on the death of the settlor or a restriction on the trustee to heirloom or other assets that are important to the surviving spouse and kids, eliminating paranoia about liquidation and disposal of those types of property.
Revocable Trusts
Revocable trusts can offer many of these benefits as well. While often overlooked as the simple estate planning tool for those worried about probate and incapacity, the benefits of a revocable trust in a family office structure can accrue just as much as with irrevocable trusts. In addition to those benefits often overlooked, revocable trusts can also be attractive precisely because they allow the settlor to retain complete control over the assets to the extent desired.
On the flip side, this can be a detraction from some wealth preservation strategies, as any control can leave those assets vulnerable to creditors and other potential adverse issues.
Irrevocable "Profit Sharing Plans"
A relatively newer form of irrevocable trust in the family office realm includes the inclusion of "profit sharing plans" that cannot be accessed by creditors. When drafted correctly, the tax structure will allow the trust to be taxed at lower capital gains rates rather than ordinary income rates.
The important caution here, however, is that those tax advantages are only enjoyed if the irrevocable trust is set up correctly. If it is not, including an irrevocable "profit sharing plan" could actually end up costing thousands of dollars in additional taxes to top tier clients (think multi-generational clients). This, of course, would be the opposite goal of why someone would want to set up such an estate-planning structure.
International Tax Planning for a Family Office
The complex global financial landscape requires family offices with non-US assets to carefully plan to avoid unwelcome international tax surprises. With the increasing amount of information now available on offshore entities and accounts, it is much more difficult for taxpayers to hide their money in low or no-tax jurisdictions. As a result, those who do not correctly identify the appropriate tax treatment of their foreign holdings often find themselves exposed to significant tax exposure both domestically and abroad.
But, planning is more than just laying low in a low- or no-tax jurisdiction. The foreign assets of a US taxpayer will often be taxed by the US and the foreign jurisdiction in which the asset is located, and so must be carefully analyzed to ensure that its taxation has the most favorable outcome for the taxpayer. For example, in general, a sale by a US taxpayer of stock of a foreign corporation creates no capital gain under US rules, but it typically will create capital gain abroad. Thus, irrespective of the US tax treatment, the shareholder will want to be sensitive to the potential foreign gain that is being recognized. In contrast, a typical sale of US stock by a US taxpayer would trigger US tax, but, depending on the jurisdiction, may not trigger foreign tax and may even generate a foreign tax credit in the US . Therefore, the US taxpayer will want to be sensitive to the potential US tax impacts of a sale of US stock (or other US-based assets) as well as the potential for credits against the US tax (by maximizing foreign taxes paid so as to get lower US tax) when appropriate.
Best, however, is to combine these two strategies when selling the stock of a foreign corporation that has significant US assets. The stock of a company that has its "tax place of organization" in a foreign country must be sold in an arm’s length transaction between unrelated parties for cash (not stock) in order for the gain on the stock (if any) to be treated as foreign-source gain (not US-source capital gains). This means, then, that the "highly valuable" US assets that are typically used both as the basis of a company’s operations and as security for its debt obligations may be sold as part of the overall sale of the company. As a result of this structure (and presuming the minimum holding period is met), the gain realized on the sale of the stock of the foreign company will generally be subject to tax solely in the foreign country, and no foreign tax credit can be utilized towards any US tax on the foreign-sourced gain realized upon sale of the foreign company stock.
Thus, careful planning by a central treasury function of a family office can have dramatic effect. For to maximize the results of such planning, the family office must engage with a trusted adviser who understands both the US and international tax traps in which a foreign investor may experience.
How Tax Law Changes Impact Family Offices
Tax laws are always evolving, and such changes may significantly impact the complex operations of a family office. It is critical to consider how new rules and regulations may affect upcoming tax planning strategies. Staying up to date on current law changes may help to further maximize and protect the wealth of the family office. Limiting any adverse impact will require constantly reassessing the estate planning structure in which the family office is operating. Any impact will often be best minimized by making planning decisions that take into account the evolving end goal and not merely reacting to new laws. The fact remains that family offices require a tax approach that not only minimizes current obligations but also allows for future flexibility. The ability to adapt to any changes in laws may ultimately result in a significant increase of wealth retained.
Choosing Your Family Office Tax Advisors
For the most part, you need advisors who have been there before, otherwise you need to pay for the valuable lessons they learned. Choosing a tax advisor is similar to how you choose an attorney: convenience, are they located near your city? Do they know your language? Do you have a connection with them? Throw out all of those things. Only experience matters when it comes to choosing a tax advisor. You want to know that this person has worked with family offices before. They know the language, they know the questions to raise, and they know the roadbumps you will face.
Tax advisors need to take in the big picture. They need the wealth advisor’s blueprint, so to speak. This is the document that includes every detail concerning income sources, shareholders of the entity, owners and directors and any other piece of information that will accurately reflect the intentions of the family office. Only then can the tax advisor put together a plan that compliments the family office.
They check in regularly to ensure that the structure is working properly. As the advisor gets to know the family and the business environment that it operates in, they can provide advice on what is the best plan going forward .
We recently came across a family office whose foundations had been set up in such a way that it was losing money because of how it was structured. There was no real reason behind it, but the family office hadn’t looked at the plan in a decade. You don’t want to be in that situation.
We hope this article gives you a good idea of how to structure your family office’s taxes properly. Tax planning is one of the keys to success.
The important part is to start now. There is no such thing as too soon or late when it comes to tax planning. You probably saved a lot of money establishing the family office. You can save even more by correctly structuring its taxes. This does not end with the last quarter of 2018. Family offices are designed to last, but they never really get old. You should aim to create a family office that will stand the test of time.
We have seen a lot of family offices try to implement tax strategies based on where their primary residence is located. Get that out of your mind. Choose a tax strategy based on where the business will be located. This will be the entity that provides the most efficiency.