Tax Court Holds That Family Owned Investment Fund Manager Carried on a Trade or Business

(Parker Tax Publishing January 2018)

The Tax Court held that a fund manager, which provided management services to three investment LLCs, carried on a trade or business where the fund manager and the investment LLCs were owned by members of the same extended family. The Tax Court found that, while investors managing their own assets are generally not in a trade or business, the fund manager's investment advisory and financial planning services went beyond the activities of an investor, and the relationship between it and the investment LLCs was a business relationship notwithstanding the family connection. Lender Management, LLC v. Comm'r, T.C. Memo. 2017-246.

Background

Harry Lender founded Lender's Bagels. His sons, Marvin and Murray, managed the company after their father's death. The Lender family, which includes many grandchildren and great grandchildren of Harry Lender, is spread across the U.S. and overseas.

Lender Management, LLC, (LM) is a fund manager that has been in continuous operation for 25 years. For 2010 through 2012, the years at issue, LM was owned by Marvin Lender and then by his son, Keith. LM provided management services to three investment LLCs: Murray and Marvin Lender Investments, LLC (M&M); Lenco Investments (Lenco), and Lotis Equity, LLC (Lotis). Each was formed to hold a different class of assets; M&M invested in private equities, Lenco invested in hedge funds, and Lotis invested in public equities. The end level owners of the LLCs were all children, grandchildren, or great grandchildren of Harry Lender. LM was a member of each of the investment LLCs, and Marvin and Keith Lender indirectly owned interests in the LLCs by serving as managing members of LM. LM provided management services to Lender family members, related entities, and other third party nonfamily members. It also managed downstream entities controlled by M&M which included nonfamily investors.

Keith Lender was LM's chief investment officer for the years at issue and he became president in 2012. He worked 50 hours per week, which included evenings and weekends. He referred to members of the investment LLCs as clients of LM. Lona Flament, who is unrelated to the Lenders, was the chief financial officer. LM had five employees and had a total payroll of between $330,000 and $390,000 for the years at issue.

In 2010, LM's compensation was a fixed percentage of the value of the investment LLCs. Beginning in 2011, LM began receiving contingent profits interests, meaning it was paid only to the extent that the LLCs generated net profits. The change was intended to align LM's goal of maximizing profits with that of its clients and to create a greater incentive for LM to successfully manage the portfolios.

LM's services included making investment decisions and executing transactions on behalf of the investment LLCs. Its purpose was to earn a profit and it sought to earn the highest possible return on assets under management. LM also provided individual investors with one on one investment advisory and financial planning services.

Taxpayer and IRS Positions

LM claimed deductions for trade or business expenses of approximately $1.1 million for each of the years at issue - 2010, 2011, and 2012. The IRS disallowed the deductions under Code Sec. 162, but allowed them under Code Sec. 212, which applies to activities engaged in the for the production of income. Certain limitations apply to deductions under Code Sec. 212 that do not apply to Code Sec. 162 deductions. Expenses are deducted from adjusted gross income to arrive at taxable income and are subject to floor limitations. Code Sec. 212 deductions may be limited by the alternative minimum tax. Additionally, net operating losses carry over only if they were the result of operating a trade or business under Code Sec. 162.

Trade or business is not a defined term in the Code, but is determined on the facts in each case. An investor who merely manages and monitors his own investments is generally not engaged in a trade or business. However, under Whipple v. Comm'r, 373 U.S. 193 (1963), an investor may be in a trade or business if compensation is received for services provided to others. The Tax Court in Dagres v. Comm'r, 136 T.C. 263 (2011), held that investment advisory, financial planning, and certain asset management services provided to others may constitute a trade or business. However, transactions within a family group are subject to heightened scrutiny to determine whether there is a bona fide business relationship.

LM argued that its investment management and financial planning services to others constituted an active trade or business. It also argued that it and the investment LLCs should be respected as distinct business entities that transacted at arm's length. The IRS argued that LM's primary activity was managing the Lender family fortune, which was done by and for the Lender family. According to the IRS, the family connection between the managing members of LM and the owners of the investment LLCs meant that LM was making investments solely on its own behalf.

Analysis

The Tax Court held that LM was carrying on a trade or business under Code Sec. 162 for the years at issue. It found that LM's activities were providing investment management services, which it primarily provided to and for the benefit of clients other than itself. According to the Tax Court, the services LM provided to its clients were comparable to the services provided by hedge fund managers. Because LM had a responsibility to provide clients with sound investments that had growth potential and were tailored to clients' financial needs, the Tax Court concluded that LM's activities went beyond those of an investor.

The Tax Court further found that LM was a duly constituted business entity and was entitled to profits interests for its services. The Tax Court noted that LM's compensation was separate from its normal investor's return, and the profits interests provided substantial incentive to deliver high quality management services. The fact that LM received contingent profit interests in 2011 and 2012 did not negate their being compensation for services, according to the Tax Court. Rather, the Tax Court found that the contingent profits interests showed that its predominant activity was providing investment management services to others, rather than passive investing. The Tax Court found that LM's membership interests in the investment LLCs for the years at issue were far less than what LM could have earned for its services via contingent profits interests payments, and found that most of the portfolios it managed were made up of investments beneficially owned and controlled by others.

LM's activities also withstood the heightened scrutiny that applies to a family relationship. While the end level investors in the investment LLCs were Lender family members, the Tax Court pointed out that only two, Keith and Marvin, were owners of LM, and they owned only small minority interests in the investment LLCs. The Tax Court found that although investors were all Lender family members, they did not act collectively or with a single mindset. Clients were geographically dispersed, many did not know each other, and some were in such conflict with others that they refused to attend the same meetings. The Tax Court further noted that LM did not provide services for the family as a group, but rather advised each client individually, regardless of the clients' relationship to each other or to the managing member of LM. LM was expected, in the Tax Court's view, to provide services similar to those of a hedge fund manager, and the relationship between it and the investment LLCs was a business relationship.

For a discussion of the definition of a trade or business, see Parker Tax ¶90,105.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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