Tax and Benefits Considerations for Service Providers for Family Offices.

• Author: McCurry, Patrick J.
• Position: FROM THE FAMILY OFFICE

Family offices compete for talent with the top investment advisory firms, investment banks, law firms, accounting firms, other family offices, and other organizations. These talented service providers are typically sophisticated and well aware of tax-efficient and creative ways that individuals are compensated in the general marketplace (including private equity and hedge funds).

This article discusses various considerations relating to compensating employees of family offices in a tax-efficient manner.

Dual Capacity (Employee-Partner) Issue

Last year, the IRS doubled down on its position that an individual cannot be both an employee and a partner in the same tax partnership (including a limited liability company that is taxed as a partnership); this is the so-called "dual capacity" issue. Specifically, on May 3, 2016, the IRS issued temporary regulations that provide, among other things, that an individual cannot be a partner in a partnership and an employee of any partnership subsidiary that is disregarded for federal income tax purposes. See Temporary Treasury Regulation [section]301.7701-2T(c)(2)(iv)(C)(2) (May 3, 2016).

Prior to these regulations, because disregarded entities are regarded for federal employment tax purposes, some practitioners (the authors excluded) believed that the dual capacity problem could be avoided by having a disregarded entity subsidiary act as the employer.

So, why is the dual capacity issue important for family offices? As discussed below, family office employees may own equity in investment or operating partnerships alongside family members and family trusts. The family may desire to pay a salary with or without a cash bonus to these employees from the same investment partnerships (or from disregarded subsidiaries of these partnerships).

Under the IRS' view, any salary or bonus from a partnership (or disregarded subsidiary) in which the employee also owns equity is a "guaranteed payment" under Section 707(c) of the Internal Revenue Code (the Code) and, as a result, the employee would be responsible for paying both the employee and the employer portion of self-employment taxes (rather than have W-2 withholding). Among other potentially adverse consequences, the employee might be disqualified from certain benefit plans, including "cafeteria plans" under Code Section 125.

Luckily for family offices, private equity funds and their tax advisors have developed structures to mitigate the impact of the dual...