After covering business entities and formations such as LLCs and C corporations, let’s look into the growing industry of family offices, how they are formed, and why.
A family office is any collection of dedicated professionals, whether separate from a family business or not, which provide personal and professional services to a family. This usually includes a broad diversification of services where one individual could manage the operational aspects of the family; for example, travel arrangements and asset collections. Other services, such as professional staff managing accounting, estate planning, tax, legal, philanthropic, investment, and administrative matters, are also rendered.
The size of a family office can consist of as little as only two people or as many as 300 or more.
Families have the ability to create a family office that can support their overall financial needs after a significant liquidity event, such as the sale of a family business. Every family office must reflect the unique component as s the family it serves.
It can provide a wide range of services, including:
Before 2018, most family offices could not implement their structures particularly tax-efficiently. Family offices used to be structured as limited partnerships or limited liability companies (“LLCs “) and can provide financial services such as tax, investment management, accounting, and concierge services for family members and various family members entities.
Often, the family members and entities would pay the family office (collectively, the “Family Clients “) through management fees.
These management fees were, however, deductible by a Family Client only to the point where the fees exceeded 2% of the Client’s adjusted gross income (“AGI “) for the tax year. Deductions for operating expenses, including salaries, office rentals, and payments to any third-party vendors, were likewise limited for many family offices.
If structured properly, some family offices often avoided most limitations on deductions by claiming status as an active trade or business, thereby taking their deductions in full. However, taking such a position was seen by the IRS as aggressive tax planning to avoid tax, and the IRS had often challenged attempts by single family offices trying to claim that they were a trade or business.
Historically, expenses incurred by family offices have been deducted under one of the two provisions of the Internal Revenue Code (IRC) listed as:
Resulting from two key developments occurring by the end of 2017, traditional family office structures had become less viable. Still, at the same time, new structures provide opportunities for much greater tax efficiency.
The first significant development was due to case law. It involved the case of Lender Management v. Commissioner, where the Tax Court had ruled that a family office had the option to be treated as a business as long as it met specific criteria. The second included the passage from the 2017 Jobs and Tax Cut Act, which disallowed deductions that fall under Code Section 212 and reduced the national corporate tax rate by 14% (35% to 21%).
In the case of Lender’s Bagels, the taxpayer’s role belonged to a family office that gave management services to a collection of investment LLCs owned by the family business’s children, grandchildren, and great-grandchildren (Lender’s Bagels).
When determining whether the family office had engaged in a business or trade (therefore fully deducting its expenses), the court noted large amounts of scrutiny if a family relationship had existed between the family office owners and the LLC owners. Despite this, the court had found that the family office could be considered a trade or business. The decision was backed up by several factors that had differentiated the Lender Management operation from other activities conducted by an investor to manage and monitor their own investments:
When reviewing all of the gathered facts that the court discussed (and had led the court ruling in favor of Lender Management), some recommended practices to best treat a Family Office as a business or trade are set out below:
Since 2017, The Jobs and Tax Cut Act (also known as the “Tax Act “) has significantly reorganized the federal income tax system for corporations and individuals. For corporations, the income tax rate decreased from 35% to 21%, and for individuals, an enormous number of changes were imposed. Still, the most significant deduction for this discussion and mentioned above was eliminating deduction for expenses that fall under Code Section 212.
As a result, clients’ payment of management fees towards a family office is no longer considered deductible. Family offices unable to meet Code Section 212’s sufficient criteria will be categorized as a business or trade. They will be given the unappealing inability to receive any deductions for their expenses, even if said expenses are over the 2% of the AGI floor.
The corporate tax rate’s recent change has made using a C corporation serving as a family office much more appealing to families. Unlike other optional entities, C corporations are considered to conduct a business or trade as a primary function of its structure. C corporations are able to deduct their expenses if they are under Code Section 162, so long as they are considered necessary expenses from running the corporation as predicted, with no notable additions. As a result, many families consider converting their family office to a C corporation.
As noted earlier, there are two ways in which deductions are no longer permitted concerning family offices:
Now that we’ve looked at what a family office is and its past structure, let’s examine standard methods for building your own family office today.
There are two main kinds of family offices that entrepreneurs choose from for various reasons that best suit their financial goals as a company. They are:
Single Family office – Wealth owners who possess investable assets exceeding $100 million can choose to form their own wealth management business, known as a single-family office, which oversees all aspects of their financial and human wealth.
Multi-Family Office – A multi-family office (also known as an MFO) is a wealth management firm that provides integrated and highly customized services towards a limited quantity of clients. Participating families with an MFO will have access to a wide array of integrated services.
The first and most vital step when creating a family office structure is to state the goals of an individual or multiple family members. A family office formation is similar to forming a regular business entity, where developing an organizational structure is the first move.
The next step would be to determine whether you want to establish the family office in-house or have a third party form the structure, hire personnel, and provide/maintain all essential services the family office offers.
Once that evaluation and decision are made, the third step is to choose which assets shall be managed by the family office or be managed by one or more family members.
Like any other new entity, the family office operation and associated costs will need to be assessed before confirming your next step to opening one. Sizes of family offices range from small to very large, depending on the amount of wealth required for management (such as asset management, risk management, wealth management, investment management, etc.) and the types and diversity of assets the money is invested in.
A small family office usually requires six employees and costs anywhere from $1 to $2 million to operate on an annual basis.
A medium-sized family office often requires 15 people to best operate, with an annual operating budget of $3 to $4 million minimum.
On the other hand, a large family office would require about 25 employees with an annual budget of $8 to $10 million. When considering a large family office, however, you’d be talking about 40 to 50 employees, along with an operating budget ideally of $14 to $20 million.
Depending on jurisdiction and purpose, a family office’s legal structure can take various forms. The most popular legal structure for a family office in the US is an LLC, then an S Corp, and 3rd a C Corp. A Private Trust company is the least popular structure used.
Families who want to start a family office will need at least $100M in investable assets and have the goal to:
Advisors are key components to any family office as they provide the expertise that is not available internally in a family office.
Services most utilized by family clients are:
Interestingly, these three most utilized services are provided jointly by the family office and any external providers.
Selecting the ideal advisor team who will understand your unique needs and be able to support your family always needs careful due diligence on the part of the family.
A governing board is ideal when driving a company’s success. A family governing board is necessary and mandatory for operating a family office and essential for the family enterprise’s preservation.
Wealthy families sometimes need to comprehend the role and need for a financial services board when managing their wealth, assets, net worth, etc. However, there has been an increased awareness of the importance of such a board in the past few years.
Working in wealth management often involves more than just hiring money managers to invest the proceeds of the sale. Preserving wealth requires owners to consider the wealth management process a shared family business.
Managing a family’s wealth successfully is a complex and unique undertaking, so understanding which financial services to look for or provide for that unique case is necessary before moving forward.
The job of a family wealth manager is to establish a professional structure for private work to best grow and protect a family’s assets for later generations. Examples of success include asset protection and growth and the peaceful transition of control over assets and wealth from one generation to the next. This can be done by a cohesive group of cousins who are collaboratively managing the original family member’s charitable wishes.
Whatever the measures are for the family wealth manager to execute, the work that comes from managing the family wealth can never be underestimated without negative cost to the family and their family office. That is the reason why many families decide to form a dedicated family office, as it means having a professional way to address the challenges that financial families often encounter.
Individual family requirements will dictate the scale and scope of all operations. Principals are also encouraged to use the following functions to inventory what is carried out today on their behalf, as well as what new or expanded procedures might be carried out in the future. This list of typical basic and advanced functions serves only as a guideline.
A family office’s most basic yet necessary duty is handling wealth, net worth, and investment management for wealthy families or individuals. Such is a common and most often successful way to grow the wealth already created, as well as transferring the wealth across multiple generations through succession planning.
Aside from the necessary technical credentials of a family office (investment, legal, accounting, etc.) and experience that will be required in the family office role, it is essential to have the following professional characteristics when starting and throughout the family office’s time:
Most governing boards for a family office require an average of four members of the family and one member who is not. Families often include independent, non-family members on their board to either provide the professional experience they need or act as an objective party who supports the execution of the family’s vision and strategy.
Below are seven vital components that your future partner must have or aspires to achieve before you enter a legal agreement with them:
After answering the questions above and better comprehending what your family office will look like, it’s time to examine current and future contributions to ensure everything can happen in the formation process.
Families should quantify and evaluate their current costs, including staff, retained legal/accounting services, direct and indirect investment expenses, technology, infrastructure, and others. They should further review their current effective tax rate and then look at how the effective rate could change under a Lender-like structure. State taxes are essential to examine as well.
This first step should help a number of families quickly decide. Every family is different, but when aggregate expenses are less than $1 million, often it may not make financial sense to form or restructure a family office—and for such families, the outsourcing option may now be more attractive than it was a few years ago. Additionally, families that already have operating businesses may find that the incremental deductions are insufficient to justify a change.
If the tax savings under a Lender-like structure would be compelling, the next step is determining if such a structure is practical or feasible. There are several hurdles to clear.
First, does the family’s situation require the family office structure to have a logical basis? A model similar to Lender will make sense for a family with multiple branches, each containing various generations. It is essential to have independent advice for different family members and outside investors within the family office.
There are additional hurdles to qualification as a “trade or business.” For example, it is only sometimes feasible to compensate staff based on a profits interest in the family office. Further, the ideal structure may come at a cost. Finally, the structure may require new or different management skills, and it is crucial for families to know whether that talent is available at a reasonable cost.
Finally, a structure similar to Lender appears both financially and practically attractive and achievable to a family. In that case, the members must still take an honest look at how the office and its structure will likely impact their day-to-day lives and determine whether they are comfortable with adhering to new rules over time. Any new family office structure, as mentioned, will likely require new costs, as well as require new staff and leadership to operate it properly. The extra time to review, hire, and go over financial goals with the office can lead to family members needing to be more entirely unified in taking on these additional requirements. In addition to the new burdens, managing and calculating all the family office’s profits interest is also complicated and may create tension amongst the family. Any changes in how the family members will meet and interact with the family office/each other going forward may also require adjustments.
No two families are financially identical, as every family will react differently to a present or upcoming change in how their investment assets are managed and to any downstream adjustments that will be required to adjust to a new management structure. In every case, a complete understanding of the anticipated changes is necessary for the office’s long-term success.
Asena Advisors focuses on strategic advice that sets us apart from most wealth management businesses. We protect wealth.
Now that you’ve built an overall sense of how to build a family office and ideas of what yours would look like, we must go over the five key rules that come to family office formation listed below. Checking off each throughout your company’s process and final stages will help ensure that the structure is stable and can handle a growing number of unique cases.
Below are common company decisions that are avoidable with ways to secure your new system:
A successful family office must be formed through close consultation with experienced legal accountants, advisors, and other counsel. Based on various investments, including private equity, debt finance, venture capital, and real estate, a family office will need to address all legal needs and tax strategies. The office should also work closely with tax experts and transactional attorneys so that structure will handle most investments, analyze and negotiate all terms and conditions surrounding an opportunity, as well as minimizing any adverse tax consequences.
Every factor, such as the company’s mission, goals, role, scope, and lines of accountability of the family office, must always be defined at the moment of formation, followed by being incorporated into the structure of the family office, even if it will be changed later on to meet evolving purposes.
A successful family office is required to manage significant traditional assets and, in many cases with Family Clients, oversee unique assets (ex: residential and vacation real estate, hedge funds, fine art, luxury items (e.g., investment vehicles such as cars, boats, planes, and helicopters), and collectibles). The assets must also be insulated from potential liabilities.
Every successful family office must be responsible for cultivating sustainable wealth for the family’s future generations. Their unique structure needs to accommodate the utilization of significant financial possibilities such as direct private equity-style investments, generation-skipping trusts for real estate purchases, and other alternative investments that would deploy long-term capital.
A management company must employ staff to best provide an array of services for their Client (i.e., the family office and their Family Clients). To perform this expectation, said management company will need to administer the operations, execute and/or oversee all of the professional and consulting services, and handle many other matters that the family office will require.
Most importantly, a family office is required always be vigilant about compliance. That way, it can insulate each entity from other holdings incurring any liabilities. Compliance also includes required filing and maintaining all books and records for every family member and any related entities.
With a team of experienced advisors, a successful family office will be able to create and maintain a financial structure that can maximize any short and long-term investment possibilities with little to no exposure to extraordinary liabilities, so family wealth is safeguarded.
Typical roles within single family offices include:
Usually, the core team of a single family office consists of a few partners in key positions. A Chief Executive Officer (CEO) leads the whole investment firm, a Chief Investment Officer (CIO) is responsible for investment decisions, a Chief Financial Officer (CFO) is responsible for tax and financial topics, and a Chief Operating Officer (COO) who is responsible for daily operations. The partners are directly in touch with family members or a representative family board. Smaller single family offices even only consist of the executive team, while larger SFOs with billions of assets under management have several sub-divisions.
Usually, the specialized investment teams are led by directors who have already served in leading positions at investment firms for many years. They are, in turn, working together with a few talented investment associates and analysts. The Chief Investment Officer (or CEO, depending on the size and structure of the SFO) supervises the investment teams and is in steady exchange with them. Investment decisions are either made or brought to the family investment committee/investment board when the deal size is more extensive.
Which investment teams exist and how they are structured heavily depends on the investment focus of the family office. Very often, the following teams exist:
The back office supports the family’s daily work and necessary operational functions. Possible teams are:
Let’s reiterate a couple of important family office structure need-to-knows:
The cost of each family office will be dependent on many vital variables, such as the size of the family, the quantity of staff, and the nature of the family’s overall investments.
The complexity of said office is the key predictor of cost for a family office. Receiving an “all in” cost of wealth management must have detailed consideration surrounding the family office’s costs, the fees paid towards ideal advisory firms (e.g., accountants, attorneys, etc.), and towards investment costs (e.g., outsourced CIO, custody, investment management fees, investment consultant, etc.).
The recommended starting amount for families who want is at least $100M via investable assets.
Families can create an office to support all of their overall financial needs after a significant liquidity event, with every family office being unique as the family it serves.
Opening and operating a family office, or expanding upon the financial services of an existing family office, requires careful consideration and planning to properly manage and protect a family’s wealth so it can flourish over time. As with any organization, a family office’s relative success or failure relies on effective governance.
