June 2018

How To Avoid IRS Challenge On Your Family Office

June 28, 2018 | By: Robert A. Green, CPA | Read it on

Investors may no longer deduct investment expenses, including those passed through from an investment partnership. Restructuring these expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses. Before you go in that direction, it’s wise to learn the lessons of the Lender Management court case from December 2017, which is one of the first on family offices.

Size matters
A single-family office serves one ultra-wealthy extended family, whereas, a multi-family office handles more than one family. Well-established single- and multi-family offices offer a wide variety of financial services, including wealth management, financial planning, accounting, tax, and personal finance. They have substantial staff and salaries, offices, equipment, and operations — the markings of an independent financial services company.

Family office requirements
A family office management company with underlying investment partnerships can use business expense treatment when it has the following characteristics, borne out of the Lender Management tax court case and earlier case law:

- It’s a functional financial services company with significant staff and salaries, an office, equipment and bona fide operations.
- It operates in a continuous and business-like manner.
- Its staff has expertise that is valuable to its clients.
- A profit-allocation of capital gains is considered advisory fee compensation for services rendered. It gets paid more than just its share of profits based on capital.
- It should be profitable.
- It caters to many extended family members with diverging financial needs. It does not operate with a single mindset but provides customized services to each family member.
- Family members and their investment partnerships are not obligated to use the family office.
- There should not be a majority of common ownership between the management company and investment partnerships (this factor is critical).
- It’s safer to have third-party clients who are not family members (a suggestion, not a requirement).

Small family offices have trouble
If two spouses own an investment partnership and management company, then the family office has 100% common ownership, which fails the requirements. The micro family office renders services exclusively to the spousal-owned investment partnership. The management company does not function as an independent financial services company, with outside staff or an outside office. It does not stand alone as a financial service provider. In the eyes of the IRS, it oversees its own investments. This management company should not use business expense treatment. (Some trader accounting and law firms sold this scheme to traders who do not qualify for trader tax status. I’ve always said it did not work and the Lender court confirms it doesn’t work.)

Management fees and carried interest
Consider this typical example: An investment partnership pays a 0.5% management fee on funds under management of $1M ($5,000 per year). The investment partnership also pays a 20% profit allocation (carried interest) based on performance (say, $50,000 for the year). The investment partnership passes through an investment expense of $5,000 for the management fee, which the investor cannot deduct on their tax return. The profit allocation avoids the investment expense deduction problem because it carves out a share of capital gains on each investor’s Schedule K-1.

The management company reports $5,000 of revenue for the management fee, which gives the impression of being a trade or business. However, that’s not enough revenue to cover expenses, so it lacks presumption of business purpose. The management company also reports capital gains income of $50,000 from the profit allocation of investment income. Total income is $55,000 minus business expenses of $52,000 equals a net income of $3,000. The capital gains help satisfy the presumption of business purpose test. The owner sacrificed the $5,000 deduction in the investment partnership to arrange $52,000 of deductions in the management company. However, the IRS might disallow the entire $52,000 deduction, asserting the management company is also an investment company with non-deductible investment expenses because it did not satisfy the requirements for a family office under the Lender court.

Hedge funds
Assume a hedge fund manager owns the management company, which deducts business expenses. The hedge fund partnership does not qualify for trader tax status, so it’s an investment partnership. Most hedge funds meet this scenario. The management company is genuine, and there is little common ownership because the hedge fund is predominately owned by outside investors. That satisfies the Lender court requirements for a management company.

It might be different for a startup hedge fund before outside investors become limited partners in the limited partnership. Until and unless that happens, the manager is managing his own investments, and it fails Lender. The limited partnership is probably not paying the management company advisory fees including profit allocation in connection with the managers capital.

Lender Management tax court case
In Lender Management v. Comm. (Dec. 16, 2017), the tax court overruled the IRS by awarding business expense treatment to Lender Management. It was a well-established single-family office servicing many family-owned investment partnerships. Lender provided customized investment and management services throughout the year to many different family members, with varying needs, across an extensive family tree. Lender Management and the investment partnerships did not have too much common ownership according to IRS and tax court calculations. Only a few of Lender’s dozens of family members owned the management company.

The IRS was unable to cite attribution rules that should apply to Lender. The Lender case also dealt with how to handle revocable vs. irrevocable trusts in the overlap test for common ownership. The Lender court did not define how much overlap ownership is permitted.

Other tax court cases
In Higgins v. Comm. (1941), the tax court said, “No matter how large the estate or how continuous or extended the work may be, overseeing the management of one’s own investments is generally regarded the work of an investor.”

In Dagres v. Comm. (2011), “Selling one’s investment expertise to others is as much an expertise as selling legal expertise, or medical expertise.”

Trade or business partnerships
In Higgins, replace the words “business” for “investment” and the outcome is favorable: “Overseeing the management of one’s own businesses is generally regarded as the work of a business.” If there is a trading partnership with trader tax status, or a rental real estate partnership with ordinary income, then the management company can look through to the business treatment.

A C-Corp management company
Some families and tax advisors are considering a C-Corp management company to take advantage of the new tax law’s 21% flat rate.

Be sure the management company meets the Lender court requirements for a family office. Otherwise, the IRS does not permit a C-Corp investment company to deduct investment expenses. Section 212 (investment expenses) applies to non-corporate taxpayers, not corporations. A C-Corp with a trade or business is entitled to deduct business expenses in connection with making ancillary investments, like investing treasury capital.

When taking into account the Tax Cuts and Jobs Act, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, corporate taxes in 44 states, and IRS 20% accumulated earnings tax assessed on excess retained earnings, which is any amount above zero for an investment company. (See How To Decide If A C-Corp Is Right For Your Trading Business.)

Apportionment between investment and business partnerships
Family offices might want to consider having more of their underlying investment partnerships achieve business treatment, like trader tax status or rental real estate income. If a family office does not satisfy the requirements, and it services investment partnerships and business partnerships, it might consider using hybrid reporting to apportion business expenses vs. investment expenses.

Wealthy families diversify their interests and invest in family-owned investment partnerships in securities and commodities, outside hedge funds, private equity funds, venture capital funds, and real estate partnerships and REITs. Consult a tax advisor to learn more about which underlying investment partnerships have investment expense treatment vs. trade or business activities.

Darren Neuschwander, CPA, and Roger Lorence, Esq., contributed to this post.


Hope For Active Crypto Traders With Massive Losses

June 16, 2018 | By: Robert A. Green, CPA | Read it on

The AICPA recently asked the IRS to permit cryptocurrency traders, eligible for trader tax status (TTS), to use a Section 475 MTM election on securities and commodities providing for ordinary gain or loss treatment.

In my March 2018 blog post Cryptocurrencies: Trader Tax Status Benefits And Section 475 Issues, I suggested crypto TTS traders consider filing a protective 2018 Section 475 election on securities and commodities, due by April 17, 2018, in case the IRS allowed it. Many crypto traders had significant losses in early 2018 with the market correction, and with a 475 election, they might avoid the $3,000 capital loss limitation using ordinary loss treatment. I said it hinged on whether the IRS changed its designation of crypto from intangible property to a security or a commodity.

The AICPA letter* implied that the IRS could keep its current classification of crypto as intangible property, yet still permit the use of Section 475.  However, it does raise other questions: The AICPA letter did not distinguish between securities and commodities, whereas, Section 475 does. TTS traders may elect Section 475 on securities only, commodities only, or both, and that has other tax implications.

If the IRS considers crypto a security, then Section 1091 wash-sale loss rules for securities would apply. Wash-sale loss adjustments are a headache and can be costly. (If you buy back a losing trade 30 days before or after, you must defer the wash-sale loss to the replacement position’s cost basis.) As intangible property, crypto is not currently subject to wash-sale losses. A Section 475 election on securities exempts TTS traders from making wash-sale loss adjustments.

If the IRS considers crypto a commodity, then a TTS trader should be able to elect Section 475 on commodities. However, that election has other tax consequences: If you trade Section 1256 contracts, including futures, you will surrender the lower 60/40 capital gains rates on 1256 contracts. For that reason, most traders elect Section 475 on securities only.

AICPA letter excerpt
8. Traders and Dealers of Virtual Currency

“Overview: Taxpayers considered dealers and traders who engage in buying and selling securities in the ordinary course of business to customers may make a ‘mark-to-market’ election under section 475. This election recognizes ordinary gains or losses on the deemed sales involved in the mark-to-market process. The securities holdings on the last day of the year are deemed as sold for their fair market value resulting in both ordinary income and ordinary expenses the same as for any other trade or business. Taxpayers who trade virtual currencies perform this activity on virtual currency exchanges that contain all the robust trading features available on trading platforms for securities and commodities, including the same level of liquidity. In this context, virtual currencies are akin to securities and commodities. This particular issue is also under consideration by the Commodity Futures Trading Commission.

Suggested FAQ
Q-22: May taxpayers who trade virtual currency elect the mark-to-market rules under section 475 if they otherwise qualify as a dealer or trader?

A-22: Yes. The nature of virtual currency trading is akin to dealers and traders of securities and commodities and a taxpayer may elect mark-to-market treatment. The taxpayer must otherwise qualify as a dealer or trader in order to make the election.

* The IRS has made no indication that they intend to adopt all, or any, of the many excellent recommendations from the AICPA.

SEC update
On June 14, CNBC reported, “The SEC’s point man on cryptocurrencies and initial coin offerings (ICOs) says that bitcoin and ether are not securities but that many, but not all, ICOs are securities and will come under the regulatory control of the SEC and relevant securities laws.”

The official explained what constitutes a security in the eyes of the SEC. An initial coin offering is likely a security because a third-party company, which is not decentralized ownership, sells an investment product to the public. The sponsor uses the money raised for its internal use. The buyer/investor expects a profit — a return on the investment. Conversely, bitcoin and ether are likely not securities because there was no ICO, ownership is decentralized, and they were not sold as investments.


Spending Crypto For Personal Use Can Be A Tax Mistake

June 4, 2018 | By: Robert A. Green, CPA | Read it on

If a taxpayer purchases virtual currency (cryptocurrency) and spends it on personal use, the IRS requires him to calculate a capital gain or loss on each transaction. Capital gains on personal-use property are reportable and subject to tax, whereas, the IRS disallows capital losses.

The AICPA recently asked the IRS for some equitable relief by adopting a “de minimus election,” which provides a $200 threshold for excluding capital gains income on personal transactions. (See the AICPA letter and an excerpt of the de minimus rule proposal below.)

If a taxpayer acquires virtual currency as an investment, though, then all capital gains and capital losses are reportable, and the de minims rule should not apply.

The AICPA suggests the IRS apply a similar de minimus rule used for foreign currency transactions in Section 988(e)(2) (see below). The code section refers to personal purchases, not Section 162 business or Section 212 investment property. For example, if a taxpayer acquired Euros for a European vacation, the de minimus rule applies, and the taxpayer can exclude capital gains on the Euros spent if the capital gain is under $200 per transaction.

The IRS does not permit taxpayers to deduct capital losses on personal-use property, including foreign currency or virtual currency held for personal use. Taxpayers may not deduct capital losses on the sale of a private auto or a primary residence.

Examples of using crypto for personal use vs. investment property

1.    Joe purchased one Bitcoin in early 2017 for personal-use spending, and his Bitcoin rose in price substantially during the year. Joe planned on many vendors adopting Bitcoin as a means of payment. Joe’s original intention was for personal use, so a de minimus exemption should apply to him if the IRS approves that AICPA recommendation*. If Joe bought Bitcoin in 2018, he might have a capital loss, which would be non-deductible on personal-use property.

2.    Nancy invested in 10 Bitcoins in early 2017, and her intention was capital appreciation and diversification into a new asset class. She spent Bitcoin frequently during the year on personal transactions, buying goods and services wherever Bitcoin was accepted. She hoped it would be tax-free, but it’s not.

The intention of the taxpayer is critical in determining tax treatment. If the aim is for personal use, then the de minimus rule should apply to capital gains under $200, and capital losses are not deductible. If the intention is for investment, then it’s capital gains and losses. If the purpose is for business, ordinary gain or loss treatment applies.

With tax treatment hinging on category (personal use, investment, and business), it’s wise to segregate cryptocurrency into these buckets carefully. If the IRS agrees with the AICPA proposal on the de minimus exemption, declare a crypto wallet for personal use, and the rest as an investment to protect capital loss treatment on the bulk of your crypto that you don’t plan to spend.

Excerpt from the AICPA letter
4. Need for a De Minimis Election

“Overview: Some taxpayers may only have a minimal amount of virtual currency that is designated for making small purchases (such as buying coffee). Tracking the basis and FMV of the virtual currency for each of these small purchases is time consuming, burdensome, and will yield a de minimis amount of gain or loss. A binding election applicable for a specified amount of virtual currency is beneficial to taxpayers.

Currently, section 988(e)(2) allows for an exclusion of up to $200 per transaction for foreign currency exchange rate gain, if derived from personal purchase. The same exclusion should apply to virtual currencies even though they are considered property rather than foreign currency.

Suggested FAQ

Q-9: May individuals use a de minimis rule for virtual currency similar to the section 988(e)(2) exclusion of up to $200 per transaction for foreign currency exchange rate gain?

A-9: Yes. Individuals may use a de minimis rule, similar to section the 988(e)(2) exclusion, for virtual currency transactions to alleviate the burden or recordkeeping for individuals who use virtual currency as a medium of exchange. This de minimis rule allows taxpayers to exclude transactions resulting in $200 or less of gain.”

Section 988(e)(2) Exclusion for certain personal transactions
“If—

(A) nonfunctional currency is disposed of by an individual in any transaction, and

(B) such transaction is a personal transaction,

no gain shall be recognized for purposes of this subtitle by reason of changes in exchange rates after such currency was acquired by such individual and before such disposition. The preceding sentence shall not apply if the gain which would otherwise be recognized on the transaction exceeds $200.

(3) Personal transactions. For purposes of this subsection, the term “personal transaction” means any transaction entered into by an individual, except that such term shall not include any transaction to the extent that expenses properly allocable to such transaction meet the requirements of—

(A) section 162 (other than traveling expenses described in subsection (a)(2) thereof), or

(B) section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).”

(Note: Section 162 is for business, and Section 212 is for investments.)

* The IRS has made no indication that they intend to adopt all, or any, of the many excellent recommendations from the AICPA. 


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