• Managing company carried on a trade or business and thus is entitled to business expense deductions—In Lender Management LLC v. Commissioner, T.C. Memo. 2017-246 (Dec. 13, 2017), the Tax Court addressed the issue of whether a management company carried on a trade or business for the purpose of deductions under Internal Revenue Code Section 162. For years 2010-2012, the Internal Revenue Service issued notices of adjustment, denying certain business expense deductions under IRC Section 162. While the IRS allowed the expense deductions under IRC Section 212, that section is more restrictive: Certain deductions are subject to floors (such as the floor under IRC Section 67 limiting miscellaneous itemized deductions only to those that exceed 2 percent of adjusted gross income), may be limited by the alternative minimum tax and affect net operating loss carryovers.
Harry Lender founded the company that ultimately became Lender’s Bagels. Harry had five children, two of whom worked with him during his life and managed the business after his death. As the Lender family expanded, children and grandchildren lived all across the country, and internationally.
Lender Management LLC (Lender) was owned by various trusts, principally (although indirectly through a trust) by Harry’s son Marvin for most of 2010 and then principally (and indirectly through a trust) by Harry’s son Keith through 2012. Lender provided investment management services to three other limited liability companies (LLCs) (investment LLCs), each of which was a partnership for tax purposes. Each of these LLCs was owned by (or trusts for the benefit of) Harry’s children, grandchildren and great-grandchildren. The LLCs were structured to allow for a tailored and diverse investment strategy, as each investment LLC was formed to hold different classes of assets.
During 2010, Marvin (through his trust) served as the managing member of Lender. During that time, he owned small membership interests in the investment LLCs. When Keith (through his trust) took over as managing member of Lender, he too owned small membership interests in the investment LLCs.
Lender received a profits interest in each of the investment LLCs, designated as Class A interests. The profits interest was different for each investment LLC, but each was structured as a percentage of net asset value or realized profits/receipts, plus a percentage of the increase in net asset value from the prior fiscal period.
The opinion goes into detail summarizing Keith’s business experience and role in managing Lender. It noted that he spent a great deal of time researching and reviewing investment performance and meeting with hedge fund managers and individual clients (Lender family members and a few non-family members who were members of the LLCs) to understand their cash flow needs, risk tolerances and asset allocation goals. Keith was a full-time employee of Lender and worked closely with Lender’s CFO, who wasn’t a Lender family member, to manage the investment LLCs’ cash holdings, lines of credit and investments and to coordinate with accountants and outside advisors. While he retained outside advisors who counseled him on prospective deals and presented him with investment opportunities, he ultimately exercised full discretion over the investments of the investment LLCs.
Under Section 162, the taxpayer must be continually and regularly involved in an activity for the primary purpose of producing income or profit to be considered as engaged in a trade or business. However, an investor managing his own investments isn’t engaged in a trade or business. One factor distinguishing mere investment from a business activity is whether the taxpayer receives compensation for his services rather than just an investor’s return.
The court analyzed the activities of Lender and concluded that its activities weren’t merely those of an investor acting on its own behalf. Instead, it was providing the members of the investment LLCs with significant investment and financial services. It received profits interests as compensation for its services, separate from and in addition to, its normal investor’s return. The court specifically noted that the contingent nature of the profits payments (being dependent on there being a profit or an increase in net asset value from year to year) didn’t negate such payments from being compensation for services.
The IRS further argued, however, that the family relationships of the members of the investment LLC negated it being a bona fide business. The court disagreed. It acknowledged that the investors in the investment LLCs were predominantly family members but noted that the members were a large and diverse group that didn’t act collectively. Importantly, the investors were entitled to withdraw their capital interests. This indicated that Lender wasn’t making investment decisions on behalf of one uniform family group, but instead was providing tailored investment strategies for many different individual members with different needs. Furthermore, most of the individual investors in the investment LLCs didn’t own interests in Lender, and Lender’s interests in the investment LLCs were relatively very small. So, Lender wasn’t merely managing its own assets.
Because Lender was carrying on a trade or business, its deductions under Section 162 were upheld by the Tax Court.