Cutting Through the COVID-19 Chaos Strategies for Family Office Compensation Structures & Investment Partnerships

Date: April 22, 2020
Thank you for joining today’s webinar as we cut through the COVID 19 chaos to discuss strategies for family office compensation, compensation structures and investment partnerships. Over the next hour we’ll work to better understand the options available to you and answer the questions you have submitted. Questions can be submitted through the Q&A function. You can also submit topics you’d like addressed or items you like further clarified. Today’s PowerPoint presentation slides will be distributed after the webinar concludes. If you were requesting CLE credit in New York, please listen at the end of our presentation for the validation code needed to obtain CLE credit. Joining me today are my partners Patrick McCurry and Tom Ward. Patrick concentrates his practice on the corporate and tax aspects of complex business and investment transactions, with a particular focus on transactions involving private equity funds and other financial sponsors, family offices, emerging businesses, partnerships and strategic joint ventures, limited liability companies, and closely held corporations. Tom focuses his practice on the structuring and implementation of transactions involving partnerships and limited liability companies, including private equity fund formation, portfolio company investments, and representation of pension fund investors in private equity funds. He also advises clients with respect to the use of profits interest as compensation and legislative efforts to change the tax treatment of carried interests. Tom, would you kick us off with a brief overview of today’s presentation?

Great. Thanks, Toni Ann. So appreciate everybody joining us today. Hoping you and all your families, and, and all the families that we all collectively work for are doing well in this, this unprecedented time and challenge. Patrick and I thought that it made sense to, you know, maybe put some thoughts out there for the family offices and sort of things that we’re seeing in this unprecedented time. You know, understanding, of course, there’s no easy fixes or solutions for any of us right now in terms of how we approach this, but thought we would throw some ideas out there, and see, you know, hopefully get a good dialogue going and would definitely encourage questions and comments from, from all the participants. But this seems this, this pandemic seems to provide an opportunity to do a thoughtful reexamination of the family office structure. Think about CARES Act and what it might mean for family offices in how family offices interact with, with the investment partnerships and other recipients of services, you know. But we’re going to talk about, you know, developments as they are today. I think we all know this is a changing landscape. So there’s going to be more legislative, more IRS guidance coming down the path. So obviously, you know, this will be, evolving discussion, and we’re still waiting to see how the states react to some of the CARES Act changes. But we’re going to, we’re going to break the discussion today up between CARES Act considerations. And then in the second half of the presentation, think about what this new environment could mean for the existing profits interest and compensation structures that family offices may be using. So we’ll turn to the next slide.

So I think there are really three—and again, there are not anything unique to family offices here by any short, by any means, but I think there are three main changes, income tax changes, that are coming out of the CARES Act that, you know, we wanted to highlight and make sure at least was on your collective checklist of things to be thinking about as you assess the tax environment for your family. The first one is, of course, the loosening up of the NOL rules. So on slide four, we summarize what the rules pre-CARES Act looked like. There was no NOL carrybacks allowed. It was indefinite carryforward, but there was an 80% limitation based on taxable income. So, as we probably all know, one of the important things the CARES Act did was allow for NOLs incurred in the tax years 2018, 19, and 2020 to be carried back five years preceding the tax year of loss. With the default rule being, you’d carry it back to the earliest year and then carryforward. Taxpayers have the ability to waive the carry back and just move with carryforward if they choose. And equally important is the removal of the 80% limitation requirement. So, I think this is a very positive benefit. For family offices structured as C corporations that may be expecting to see a loss in 2020, this is certainly a, a favorable development. For family offices that are structured as flow throughs, one note here, because I’ve had a couple of questions come up on this, recall that NOL, individuals do have the ability to carryback NOLs. But there’s other limitations that individuals may have on their ability to use a loss, including enough basis and partnership interest or S Corp interest, the at-risk rules under 465, and the passive loss rules under 469. So, we would encourage all family offices to give thought to have these NOL rules can be used and be helpful in terms of maximizing tax efficiencies. But in those flow through structures, do be mindful of some of those other, other limitations that can exist.

Hey, Tom. Just one other thing here on NOLs. First of all, hello to everyone. I hope you’re staying healthy and sane. You know, not directly related to family offices as, as a business, but I’m sure some of your families or, you know, clients have portfolio companies essentially that were bought or sold in post-tax reform years, so 2018, 19, 20. You know, in the M&A world when folks were negotiating purchase agreements, in those years, they were all assuming that there were no carrybacks because that’s what 2017 act said. So it was a question, or maybe an opportunity, under applicable purchase agreements if you have, you know, direct investments or clients with direct investments, whether there might be an opportunity to extract additional purchase price in connection with an NOL carryback that’s triggered in a year of an M&A transaction because of a, you know, it’s, you know, transaction expenses or exercise of compensatory stock options etcetera. So just to put that on everyone’s radar as well.

Thanks, Patrick. Slide five is just, you know, an attempt to summarize some of the more pertinent guidance that’s come out on NOLs. We won’t spend a ton of time here. Obviously, these are intended to make the process as user friendly as possible. But, as we all can appreciate, best efforts notwithstanding, there there’s a lot of devil in the details. But here’s a little summary of some of the more recent pronouncements. The, the 20, Rev. Proc 2020-23 is sort of an interesting one because it acknowledges that necessarily having to follow the new partnership audit rules and seeking administrative adjustment request can be, I think the technical term is pain in the butt. So the idea of allowing for amended returns, I think, is a favorable development. Turning to sort of the second main, on slide six, the second main change, the excess business loss rules. So, one of the changes in the 2017 act was to create a new loss limitation rule in code section 461(l), as in Larry, to limit the ability of taxpayers to utilize the new defined term excess business losses. And this was for non-corporate taxpayers. And so, the second bullet point there summarizes what that rule was. Basically you can offset your deductions attributable the trader businesses against your gain or income from such trader businesses, plus 250,000 for individuals and 500,000 for married filing jointly. And any amounts that were subject to limitation could be carried forward as an NOL. And so one of the things that CARES Act did is it suspended the application of these rules for 18, 19, and 2020. And so I think that’s a welcome relief for taxpayers who otherwise were subject to these limitations. The changes to the CARES Act also make clear that capital losses are not taken into account in determining the application of this, and that capital gains could be taken into account for aggregate business income to the extent of the lesser of the amounts attributable to your trade or business or to your net capital gain income. And then it also provides that this limitation does not apply to NOLs that are being used in a carryforward year. So again, this is another instance of the legislature trying to provide as much tax relief to taxpayers as possible. However, I will note, and participants on the phone, they may have seen that this has already drawn scrutiny. There was, as early as Monday of this week, an article published in Tax Notes Today, in which the Joint Committee on Taxation came out and said that this was a giveaway to the high net worth community. They, just to read the statistic I thought was interesting, they found that 81.8% of those making $1 million or more would benefit from this provision. The provision being the suspension of the excess business loss. And candidate Biden, who at least presumptively seems to be the Democrat nominee, has already come out to say that he finds this suspension to be misplaced effort by the legislature. So, so stay tuned. We’ll see if something happens with it, but again, the hope with this change was to, sort of, level the playing field between C corporations that experienced the loss and partnerships. So, right now there is a suspension on the excess business loss for 18,19, and 20. It will come back into effect in 2021 and is set to expire at the end of 2025, under the original 2017 legislation.

The next, or the last, of the main income tax changes that we saw is on slide seven, which is the 163(j) interest expense limitation. And so for family offices that are exploring ways to fund shortfalls that maybe, that they’re facing because of the current environment, and their existing compensation arrangements not necessarily being sufficient to cover their expected expenses and trying to think through the ways to fund those expenses. This is certainly a benefit that we should have on our radar screens as we’re working with our families on ways to finance. But the previous limitation had been, you could deduct your business interest expense against your business interest income plus 30% of your adjusted taxable income, which was effectively EBITDA without depreciation and amortization having to be taken out. That that piece of it changes in another year or so. And then there are special coordination rules between how a partner and partnership deals with this limitation. So, we’ve been living with that rule for a couple of years now. So what the CARES Act came in and did was to extend the scope of the deduction and allowed to be now 50%, not 30% of adjusted taxable income. So for our family offices that are C corporations that might have, might see increased financing in their future, I think that should be a benefit. Partnerships that change from 30% to 50% doesn’t kick in until 2020. In other words, can’t go back and use it for 2019. Instead, because they just like to make the partnership rules as complicated as possible, you now, in determining the interface between partnerships and partners in terms of—so it’s probably worthwhile spending a quick second on what the pre-CARES change rules said. I’ll greatly simplify. If a tax partnership had fully deductible business interest expense, because it had enough, had enough business interest income for the year, and it had actually excess taxable income. That was called ATI and that could carried forward at the partnership level and partners could pass—I’m sorry, could be passed on to the partners, and they could use it going forward. If you didn’t have enough business income at the partnership level, you could deduct what was allowed, and then you would carryforward a disallowed interest expense for something called EBIE, excess business interests expense. So this was interest expense the partnership had but couldn’t use but couldn’t offset it against its income. And the original, the historic rule said you can carry that forward and use it again—the partnership can use it against future years excess taxable income. So, what the main change for partnerships was, was they said, listen, that excess business interest expense, the excess amounts of, of interest that you’re paying above the interest income your business have. Well, 50% of that you can just now deduct beginning in 2020. We’re not going to require you partner to line it up against excess taxable income. So it’s a loosening up of that, and a freeing up of 50% of that amount. The remaining 50% is still subject to those coordination rules, but nonetheless it’s an attempt to, to allow taxpayers to take greater deductions than they might otherwise get under these rules. The other thing it allows for is taxpayers in determining the 30% or 50% you can use 2019 adjustable taxable income. With the, the logical thought being that in the current world environment, taxpayers’ API in 2019 is likely to be higher than in 2020. So again, giving taxpayers a few tools to, to increase the amount of interest expense they can deduct. And again on slide eight, we put out the most recent Rev. Proc that talks about some of the elections and processes by which taxpayers can navigate this new tax rule. So again, just stopping for a second. So CARES Act, you know, three important things from an income tax perspective. It liberalized the NOL rules, it removed this excess business loss limitation rule—or suspended that, I shouldn’t say removed, suspended it, and it freed up or increased the likelihood of being able to deduct business interest expense. So when we look at our family offices, we should look to see how each of these three rules can be beneficial. If your family office is structured as a flow through, does the change in the excess business loss rule free up some, some losses that you otherwise weren’t sure you would be able to use? If you’re going to have to use more debt to finance operations, you should think about 163. To Patrick’s point, if there is a purchase agreement or a portfolio company, and once you look at the terms, you realize that there could be a benefit in seeking refunds under the purchase agreement, we want to maximize the amount of the refund. So you want to apply these rules so that whatever refund or you’re going to claim under the purchase agreement, you’ve maximized that amount.

Next slide. Slide nine. There’s been so much press on it, important press on the payroll tax, the payroll benefits that the companies are being offered that we didn’t want to duplicate that here. So we’re not going to get into the PPP program and taxpayers’ ability to seek loans under that program. I want to highlight the Social Security Tax Deferral, which is one that doesn’t seem to tie to hardships. So there doesn’t need to be an affirmative statement as to the hardships of the company. But there, so that might that, might be appealing family offices that might otherwise be sensitive to the idea of publicly making a statement of hardship. But, you know, just be mindful that the ability to defer the social security tax, you know, 50% at the end of this year and next year, you lose that once, if you did a PPP loan and you start to forgive that loan. We just remind you of that. And then the Employee Retention Tax Credit. Again, a lot, a lot of, a lot of ink has been, has been used on these, so we didn’t want to duplicate the wheel here. But we’ve been consulting with family offices that have been not pursuing a PPP SBA loan route but are looking at these other possible benefits to sort of help as they weather the storm here. So, in terms of an overview of the CARES Act, we thought those were the three high, high profile ones we wanted to draw your attention to. And I’ll turn it over to Patrick to talk a little bit about what we’re seeing in terms of profits interest and compensation strategies with family offices.

And Tom before we, before we pivot to that, we had a couple questions on the CARES Act in this first portion.


Maybe you can take a crack at, to the first question, I guess, has anyone seen any possibility of there being a reduction in the capital gains rates? Maybe the short-term and even long-term capital gains rates for individuals and trusts? I guess to help put, you know, money back in the pocket. I guess, I have not seen, I have not seen anything like that. In fact, having followed the Democratic primary pretty closely, a lot of folks, including, you know, presumptive nominee Joe Biden, I think is more going in the opposite direction. That was, you know, a lot of that rhetoric was obviously pre-COVID 19. But I, I would be surprised, I think if there would be a reduction in the capital gains rates, just because if nothing else, I think there’s a political appearance that you know, capital gains are sort of a benefit for the wealthy individuals. But I don’t know, Tom, do you have a resp—have you seen anything?

No, I’ve not seen that. I have seen recent statements by presumptive nominee Biden about revisiting the corporate tax rate and actually increasing that. But, but I have not seen any suggestion of the lowering of the capital gains rate.

And then we had another question about whether, you know, any of the provisions in the CARES Act, whether it be the provisions around net operating losses or the investment expense limitation or anything else, potentially impact the calculation of, you know, the profits interest for a family office, I guess, in prior years or going forward? Maybe we can touch on that in the next section, but my first reaction of that is probably not unless, I guess, there is a connection between the profits interest amount and, you know, the taxable income attributes of the family office. And I guess I’ll speak for Tom and I, that’s not typically how we would, you know, structure a profits interest, really ever look to the underlying tax attributes of the family office itself. But maybe some of you or, you know, work with other advisers that have some connection to the tax attributes of the family office in connection with, you know, the profits interest calculation. But I don’t think, Tom, anything I’ve ever worked on would be affected by—now, the tax liability, obviously, of the family office would be impacted. But I, I haven’t, I can’t think of a case where the profits interest calculation would be.

I can’t think of one either, Patrick, where the profits interest is tied to the tax liability of the family office. And certainly, this might be an environment where, to the extent the profits interest was still reducing return, if the costs of the family office are going down, that would provide an opportunity to start to build up that cash nest egg we always like.


But I have not seen a direct correlation between the profits interest and the tax liability…

And I guess one more question, kind of from me to you. On 461(l), is it right that, I mean, that’s not elective. It’s not an elective change for 2020, right? That just, that just goes away, but I guess for prior years, taxpayers would have the option to, to amend prior returns together.

That’s how I understand it. Yeah, I haven’t seen any guidance come out necessarily on 461(l) change and how to capture prior years. But yeah, that’s how I understand is that you could go back, and as part of a refund claim, take the position that, or not take the position, recalculate using all the losses and not being limited by this rule.

And I’m just wondering whether there could be, maybe, corner cases where not amending returns, and whether it’s the change in tax rates or the change of character of, like, an operating business’s income or something else would cause, you know, look at well, maybe we don’t actually amend, and we somehow use it in a higher tax rate environment. The future of something like that. So maybe, maybe it’s worth looking at. I assume, you know, I know we have clients that have very significant, were very significantly impacted for 461(l) in prior years that I’m sure would want to probably amend…

Yeah. Yes, I agree. I think this is a provision that hopefully there will be a little more guidance in terms of some of the mechanics around how to capture. But I do think this is, yeah, particularly in the family office space, I think this is a welcome change at least for the short-term.

All right, we have another question that I definitely don’t know the answer to. If the taxpayer gets a PPP loan, which I know we’re not going to spend a lot of time on here, although I just filed a loan this morning for a client. But can the taxpayer also take advantage of the employee retention tax credit provision or the are they mutually exclusive?

I believe they’re mutually exclusive. I believe if you’re seeking a loan that you are, that you are limited. But I can, I can confirm that while we’re continuing through the program and circle back at the end. But I believe that they’re mutually exclusive. And then the social security tax deferral is not mutually exclusive, but once you seek loan forgiveness, at that point you lose deferral…

Okay. Great. Let me just see if there’s any other questions we haven’t, yeah. Okay, maybe next slide. We can start talking the profits interest. So this is just, I’m sure maybe all or almost all of you are pretty familiar with, you know, the lender management decision, the test.

I’m sorry, Patrick. I’m sorry to interrupt.

No problem.

One of our participants was kind enough to weigh in on that question and indicated that it’s not mutually exclusive until the loan is forgiven.

Okay. Got it.

So thank you, participant. Appreciate that.

So, so I was saying that, you know, I think most of you are familiar with the lender management decision in December of 2017 that, you know, really changed the game, I think, for many people on how they think about family office structures and compensating family office, and you know, the investment expense limitation after 212. The code was repealed in connection with 2017 act. This is just a picture just to kind of orient, some of you in terms—it’s sort of a hypothetical structure. We have family, you know, we have clients that have some form of this. Obviously, some structures are much simpler, others are much more complicated. But let me just, so that we contextualize some of our comments that will go into the weeds a little bit, I think, at this point, but just to orient, everyone, what we’re talking about. So as, as a profits interest or a family office compensation structure, you know, there’s always a management company. Oftentimes that is, you know what people refer to as the family office. That’s where the employees would be and the, kind of, the operations of usually the investment and administrative functions of the family system. We show it here as a C corp. just for a variety of reasons, but obviously there’s many clients that have, you know, partnerships or S corp. family office or management companies structures as well. And the most tax efficient way to, for that entity to be compensated, sort of following the structure in the lender management phases. Rather than getting you know, a management fee from family trusts or partnerships or being capitalized with through a post-tax dollars from their owners, the management company is typically compensated through a profits interest or a carried interest in one or more, you know, investment vehicles. Oftentimes that’s broken into sort of an illiquid side pocket or structure, or a series of partnerships that hold alternative assets, whether it’s private equity fund, venture capital fund, real estate, direct investment, you know, minority and controlling positions in operating businesses. So there’s the illiquid side, and then, in some ways, I think more directly impacted by COVID 19 and its impact on the public equity market is there’s a liquid partnership, or a series of liquid partnerships that hold, you know, marketable securities, either directly or through interest in hedge funds that in turn out marketable securities. We also have these splitters here, and that’s because a lot of times, in addition to the family office itself, receiving a profits interest. Oftentimes, you know, whether it’s family or nonfamily, key employees will also get the carried interest on some or all of the assets here in the structure. And we just show that being split up at this splitter. But sometimes the employee carrier is directly at the investment partnership structure. Sometimes there’s kind of a tiered entity that allows the splitter to sort of send the carried interest that goes to the key employees one way, and then the profits interest in the management company going the other way. And obviously, some families, some of the employees also have co-investment opportunities, in addition to their profits interest. So, we’re going to talk a little bit about the impact on—and then, I guess, last maybe point is, oftentimes a management company will provide services to private foundations. Sometimes for more of a market-based fee, oftentimes for a minimal, minimal cost as well. So you’ve got the foundation kind of rolled, rolled into the structure. I think we’re going to focus on sort of three buckets. One is the impact of COVID 19 on, I guess, really the public and private equities markets and how that is impacting existing structures. The second will be how it might impact, you know, for some of you are or who’s clients are considering, you know, a profits interest structure, how that may relate. The last is the impact on key employee incentive equity pools. Next slide.

Okay, so here, here’s, you know, kind of, I think, the main topic maybe, in this section of the presentation. Obviously, you know, folks are all over the board from an investment perspective, but I think Tom and I are both seeing, especially on, you know, more liquid and hedge fund investment pools that just COVID 19 and its impact on the indexes in the, in the public equities market is extremely material. I mean, some clients are down a little bit. I guess some clients may be up if they are invested in a particular way that’s more insulated. But you know, we have a lot of clients that their liquid portfolios are down, you know, 30-40% plus. And obviously that has a massive impact on the family office compensation structure, especially if you have a compensation structure that rises and falls with, you know, the public equities market. So, one thing that we are, you know, considering with clients and clients are considering on their own, is whether the dramatic market shift in the first quarter, especially, of 2020 is an occasion to reset a high water mark for the family office in terms of measuring, you know, the profits interest for 2020. And also, I guess, you know, future years, depending on whether the structure involved has sort of been annual reset, or it’s a cumulative kind of high-water mark. And, you know, I’ll let Tom weigh in as well. I mean, I guess, my, my opinion is clearly these structures, I think are not meant to be tinkered with on a yearly basis and, and overly engineered for a variety of reasons including, you know, a concern that a disguised fee risk as opposed to a profits interest. But you know, clearly the, the economic meltdown in 2018 and COVID 19 is in large part unrelated to the, the economic performance of the management company and something that no one really could have predicted. Certainly we did not. And so we do think in limited situations, it’s something, and this this happens in the hedge fund world, it certainly did in 2008-2009, I expect it will happen here as well, is to actually reset the high-water mark. Let’s say as of April 1st, so that the profits interest is measured on post April 1st, appreciation in the liquid pool, as opposed to looking, you know, from January 1st. Where, you know, if the, if the family office is in a 30% or 40% hole and you have a cumulative high-water mark, it may take literally years to get out of the hole for the family office. So, that’s, that’s a big one that I think we’re talking to clients about and seeing is, sort of, resetting the high-water mark.

It’s been, it’s been a question that I’ve gotten multiple times from different, different family offices. And, you know, when we, when we talk about establishing the profits interest, I always say, you know, expect we’re going to live with this for a least a couple of years, unless we can point to a macro economic change. Not an internal, I’m making too much or too little. But the world has just changed, and it’s hard for me to believe that COVID 19 doesn’t fall square within that. So, you know, I do think, you know, the idea of resetting the high-water mark or, or rethinking the compensation arrangement, I think that is something a lot of families are looking at.

And the second point is sort of related. Some profits interest in these structures are calculated just as, I would say as vertical slice 10% of profits sort of full stop or 20% reset every year, or something like that, where it’s just a vertical slice. But some are also the amount of the profits interest for the family office is actually somehow tied to the fair market value of the assets under management. Especially on, like, a liquid pool. So if you think about it, if you go from $100 million on January 1st, and you’re, you know, you’re covering $2 million in expenses, then now you’re looking at a portfolio worth $65 million. You know, one is just the question of whether there’s profits interest or when those will materialize. That’s the point about high-water marks. But the other is, if you have a profits interest that’s tied to AUM, you know, the model starts to maybe get a little rocky because the AUM could have been impacted by 30, 40, 50%. So I think all of these, in some ways the take home to me is just maybe to revisit the whole compensation structure, the whole model. Does it still, you know, does it still all hang together and does it still accomplish covering the expenses of the family office, you know, in a way that, you know, is tax efficient? And those first two, I think, are very material. The third one is just an unfortunate fact of life. Family offices, just like other operating businesses are being just impacted economically in terms of their work, workforce and people are, you know, laying folks off or furloughing, etcetera, tightening, tightening the budget, just like every other business. So if there is a reduction in the underlying budget and that’s expected to go forward, you know, there’s a question about whether, how that’s incorporated into the profits interest structure as well. I mean, if you’re trying to sort of cover less costs and historic, and you expect those budget cuts to be semi-permanent, you know, it’s worth, I guess, exploring that. And in light of the original budget expectations that were put in place, I guess, when the structure was initially put in place. Any comments on that, Tom?

That’s just what I’ve seen.

You know, another point, and I actually have not seen any Q1, sort of, mark to market valuation statements from private equity funds yet. Maybe some of you have, but, you know, certain profits interest, especially relating to illiquid assets, you know, there’s many different approaches to how to calculate a profits interest on an illiquid pool, let’s say, an, an aggregate or various private equity fund investment. Some of them are mark to market. And you, and folks do look at the valuations that are given to the family office from the underlying third-party private equity funds. You know that, I don’t know what how PE funds are going to react to this. I don’t know if anyone has seen any indication. I mean, I think, obviously they’d like to be honest, but I think it’s just an unknown question for many businesses how COVID 19 will affect, let’s say, the March 31st quarterly evaluation estimates. And so, I think it’s just worth sort of tracking the information that comes in, especially if you have a profits interest that’s tied to, you know, revaluations and valuations off illiquid assets. And, you know, mostly venture capital, real estate and private equity funds. Any comments there, Tom?

On that point, the only thing I would have to…

Go back a slide. Sorry, let’s go back.

On that point, you know, kind of just more of a process point. The proposed regulations from the IRS indicate that, you know, when you have illiquid assets, they’re, they’re suspicious if the holder of the profits interest is the determination of value. So, if you do start—so, in that instance, we recommend to clients that, you know, if you’re going to do a mark to market with illiquids, you know, you want to be able to support the file that you’re basing it not on your own independent judgment, but on what you truly believe the facts are in third party manager statements can be good evidence of that. So I guess my thought, the only observation is, if you start to see those manager statements come in and they’re showing you significant write offs or significant write downs, yes, if you are using a mark to market approach, to Patrick’s point, I don’t, I don’t think I, I would, I would caution against may be substituting your own independent judgment against the manager’s judgement. If a manager says to you, hey, Tom Ward. You invested $10 million into my portfolio and I think it’s now worth 8. If I were manage—if I were doing the profits interest, I don’t think I’d say, well, eight’s going to come back to ten, so I’m not going to, I’m not going to worry about it just yet. I just would be, because again, the IRS has signaled to us that there, the determination of profits interest of illiquid assets, you know, they’re, they’re maybe more skeptical on that.

Yeah, I agree completely. So the next bullet is on, you know, the lower tier management fees that are charged out of various private equity hedge funds, venture capital funds. This is sort of a topic in and of itself, but, let me just give two minutes of background on this. So, when we think about the expenses of the family office, I think there’s generally three categories. One would be that direct, what’s called the direct operating expenses. So that’s payroll of all the employees, rents, research, really the operating, you know, in-house operating expenses. The second would be directly paid, you know, investment fees, legal fees, accounting that the family office pays. You know, JP Morgan or Goldman, etcetera, directly for managing, you know, oftentimes a liquid pool and then pays, you know, lawyers and accountants to work and help a family office do a variety of legal, tax and accounting manners. The other one is, and this is more subtle, maybe, but is that many families have a very high amount of investments in private equity and hedge funds. And, and usually those management fees, let’s say the traditional 2 and 20, although I see a lot of different ways now, but in the traditional way that private equity fund managers get paid, you know, they get a management fee of 2% of whether it’s invested or committed capital, and then they get a profits interest, you know, oftentimes 20% after an 8% return for the investors, sort of on a cash on cash basis. There are some funds that will directly build family offices their management fees, if you ask them. In my experience, I think Tom’s is consistent, that is a tough road to slog and a lot of managers will just not agree to any type of direct billing for a variety of reasons. So then there’s the question about is there some other way to access those lower tier management fees as though they were directly paid by the family office? And without going into it too much, I mean, I think we believe there is. And I think the point here is that you if, if you were trying to capture a lower tier K-1 management fees, if they are based on AUM, let’s say, like in a hedge fund or sometimes other fund, you’d have to, again, look at the model and look at whether the profits interests, if it’s designed to, you know, cover those fees as well, you know, is it, is it sort of working as planned if there is a 30, 40, 50% decline in AUM? So that’s just another point about, sort of, examining the fundamental premises of the economic model of a profits interest.

The other thing I would note on this, and this is—someone asked me this question and I thought it was an interesting question, but I don’t know which way it cuts, but after the 2017 tax act was passed and 212 expenses were suspended, you know, it wasn’t unusual to see particularly maybe more of the hedge fund space where all the sudden expenses were becoming, you know, part of the offset to the income, they were taking the trader position. We, we, we trade with enough regularity that we think we’re traders and so our 2% management fee isn’t going to be separately stated on a K-1. It’s instead going to be an offset to other items on the K-1. And someone asked the question, do you, do you think that you’re going to see less of that being reported because people’s trading activities are going to be slowing down? I don’t know if that’s true or not. I, you know, I deal with my own 401 K challenges as it is. So, but I don’t know if this if we’re going to somehow start to see more management fees that maybe in prior years weren’t being separately stated because of the trading position of the fund. If there might be a change there just based on 2020 trading activities, it will be interesting to see, empirically, if that should happen or not.

Yeah, that, that’s interesting. Yeah, because the trader versus investors all facts and circumstances, and I guess really can move by period. I guess the other thing that I maybe would be curious, Tom, your thoughts on is, and this is more, less related to COVID 19 than just the tax reform act. But, I’ve heard rumors, although I haven’t seen this yet directly, that some, even private equity funds that were always historically reporting their management fees that were paid at the fund level as 212 were taking the position now that those were trader business expenses under, I don’t know, some capital or a trader theory or something. Have you seen—you know, it’s one thing when, when there’s a hedge fund that’s clearly, let’s say, clearly, actively trading on a daily basis to say that it’s a, you know, a trader and would net the management fees and that’s not 212. But have you seen some private equity or venture capital funds taking that position as well?

I haven’t. I remember when, I think it was called Sun Capital, when Sun Capital came out, and this is a couple of years ago, and it was and ERISA case. But, to get to the ERISA conclusion, there was a trader of business component of the analysis and at least some read, including myself, that it seemed like to get to that conclusion you had to get, you had to conclude that the PE fund that owned C corps. was in a trade or business.


And while it was not an income tax-based decision at all, it was based on an ERISA plane. There was, I remember some articles coming out saying, well, wait a minute, this seems to go against Whipple and some of those other cases. And then I know there was just another derivation of Sun Capital, like it went back up to the first circuit or something. So I wonder if, if I myself haven’t seen it, I do wonder if there might be a thought that that, that allows for. But historically, I agree. Those type of PE funds usually don’t trade with enough regularity to get to the trader conclusion.

Right. Yep. And then another, the next point, and we actually got a question on this is, you know, obviously that if COVID 19 demonstrated something, it’s just how incredibly volatile, you know, the market, especially public equities market, can be. You know, a lot of profits interest models are based on certain economic return assumptions, and it seems like if we’re starting with, you know, kind of the new normal here, those return assumptions may need to be revisited. And maybe the model just needs to be revisited based on adjusted return expectations, both on public and private equity, you know, pools. And then the question that we got was relating to, I think, volatility as well. You know, we’ve been sort of assuming in this conversation that the, the exclusive way that a family office is going to be compensated is through a profits interest on, sort of, a family investment vehicle. Obviously, many families do that, and even families that have profits interest will sometimes have a fixed management fee component to the compensation as well, just like a private equity fund would to, sort of, keep the lights on. And the question was, based on, you know, the market volatility, do we think that maybe people will go more towards a management fee, or look at, you know, increasing the management fee and maybe reducing the profits interest component of the compensation system? I mean, I think the answer is probably yes. That’s another thing that I think you would put in the blender if you’re just reexamining the structure generally. You know, I think resetting the high-water mark, is sort of designed to potentially avoid the need to do that, if you can somehow capture a lower high-water mark and get, sort of, back on track for 2020. But there’s still no assurance that the market is going to, sort of recover, you know, during 2020 or even next year in the future. So, I do think people, you know, that’s something to keep in mind. You know, when whenever we have clients, we talk about whether a management fee component would make sense. I think it really depends on the whole facts and circumstances of the family dynamic, both politically, economic, the investment program. But obviously that fee would be non-deductible. But there still could be a real benefit to having a fixed, you know, a fixed component here to, sort of, keep, keep the lights on, especially in uncertain economic times. Any thoughts on that Tom?

I think we might see an increase in management fees just for that very reason.

Yeah. So the next point is, and I just put in an email to our hedge fund partners, but I have not seen this yet, I don’t know Tom, if you have or anyone on the call has, but I assume that it’s quite possible that hedge funds will trigger the gates. Which means, you know, oftentimes hedge funds you can withdraw on a quarterly or monthly basis, and they’ll, sort of, honor the request but in down markets because they don’t want sort of a run on the bank. You know, gates will go up and there will be a lock out of, I don’t know, six months or a year basically saying, you know, we’re just going to keep your money and you’re not able to get the liquidity that sometimes people rely on. Let’s say you have a pool of hedge funds, how you’re planning to fund the family office, let’s assume, assuming there is a profits interest is to put in a redemption request for the hedge fund and generate cash to then pay the cash to the family office. You know, clearly, illiquidity here may be limited, both from just a general investment perspective. Is it a good idea to sell and generate cash for direct investments, you know, public equity investments? But also just be aware that, you know, it’s possible that withdrawal requests from hedge funds may go unanswered or delayed or gates put up. I don’t know, Tom, if you’ve seen?

I haven’t, I haven’t heard yet from a client. I’ve bumped into it, but I suspect it’s not question of if, it’s probably a question of when.

I think that, yeah, I think that’s right. But just as you’re thinking about sort of cash flow planning and liquidity, you know, maybe keep that in mind. The second, the second to last item here is, you know, I have seen clients, for various reasons, you know, given the decline in the market, have significant realized capital losses, not just kind of on paper. And, you know, their investors trust and individuals do are able to carry forward, you know, capital losses. So I think there’s a question about, well, if part of the benefit of these structures is, sort of, you know, sheltering portfolio income from taxable investors, if my investors have capital loss carryforwards, doesn’t that mean that the, you know, structure is sort of less tax efficient? And I would just caution you from a quick conclusion around that. But that’s just something to keep in mind. You know, that’s how this virus may have hit the capital loss position of, of your family investors. The last point is, you know, a lot of times on the structures that, you know, Tom and I work with, there’s various, sort of, side pocket structures. So maybe you have a private equity pool and there’s a profits interest to the family office, but it’s not on the entire pool. It’s on the 2018 vintage as a separate calculation, the 2019 vintage or something like that. Or sometimes it’s by industry. Or, I mean, there’s, there’s a million different ways to skin this cat. But, another thing we thought of is, you know, looking at the impact of COVID 19 on the portfolio, is it time to consider whether it’s breaking apart existing pools into separate side pockets, or maybe it’s time to consider merging side pockets to reduce administrative complexity. And there’s a good way to kind of net out a winner position and a loser and just sort of start fresh with essentially a new profits interest branch. So I just wanted to flag that. Anything on that Tom?

Yeah, I mean, I’ve had two or three calls where the focus of the call has been on simplifying the side pocket structure. So, we just thought it made sense to have that on everyone’s list if that’s, if that’s something could make sense for the family, that might be something to think about in this environment.

Next slide. So the next topic is, you know, we do have, and we’re talking to families about that maybe have a family office that gets management fees or, you know, it’s funded with just capital contributions but are not in, sort of, a profits interest compensation structure. And sort of dovetailing into the comment about the high-water mark, you know, it may not be the top priority of the family to do, sort of, tax planning if they’re, you know, operating businesses are down, and it’s not always the top priority in my experience, currently. But it may be a very opportune time to look at this because, especially if you have depressed, you know, market values, it may be a good time to sort of set the high-water mark basically, for, in the profits interest base for the, for the profits interest family office. So it may be, actually, a very good time to, to sort of part a profits interest structure. And then, obviously all the topics that we talked about for existing family office structures would beat into anyone that’s considering, considering this now. And then the final topic is, as we mentioned in the picture a few slides ago, you know, a lot of our family office clients have, you know, key employees that have co-investment opportunities, you know, and/or have a profits interest themselves, in either the liquid pool only or certain invest, direct investments or in a private equity pool. It’s really all over the place. And, you know, for the same reasons why you may want to reset a high-water mark for the family offices profits interest, I mean, if you have a really key person that, you know, through no fault of their own, let’s say, helps manage the, you know, liquid pool for the family, and that liquid pool, as a result of COVID 19 is down 40%. And a large part of that individual’s overall compensation relates to a profits interest on the liquid pool. You know, you don’t want to give them an incentive, if assuming that they’re high quality, otherwise, if, if their profits interest has a high-water mark on it, you know, it could be years until that person sees a dollar after that pool with respect to their carried interest. So, I think it’s the same exact logic as talked about before, but you may want to, the family may want to consider revisiting that structure and resetting the high-water mark, you know, whether it’s April 1st or May 1st or something to basically provide a base, a new floor for determining the profits interest to the key employee. Because in my experience, a lot of times profits interest for key employees are certainly part of it as incentive, you know, you know, creating wealth and aligning incentives. But part of it is just delivering, you know, kind of a portion of the number. If you’re targeting paying that individual $1 million and they have a base salary of $400, you’re trying to really get them $600,000. But if you can get them, you know, long-term capital gains and qualified dividend. So it’s, it’s less about incentive and more just a delivery device to deliver that sufficient compensation for key employees. But there may be no business issue with resetting the high-water mark if the goal is really to get that person back on track. And I guess it’s possible that if you don’t, the person may say, well, wait a minute. It may take me five years to get out from this COVID 19 hole on my carry, and, you know, they may be less incentivized to, frankly, stay. So that, I think, is a big one.

The only thing I want to mention on that one. I agree, agree with Patrick in terms of the economic considerations are not too dissimilar from the family office, but for those key employees who have received a carry, whether it’s been risk of forfeiture provisions, and so they may be made 83(b) elections that you sometimes will see made. You know, if you’re doing, if you’re revisiting those carries and resetting things, you might want to just give some consideration to, do I have a deemed reissuance of the profits interest? And the only, the main effect of that conclusion, if you think that’s the case, is making sure you do another 83(b) election so that you don’t inadvertently find that you have lost the benefit of the 83(b) election. Just again, so if you have, you’re going through this exercise with key employees and they didn’t previously make 83(b) election just, kind of, keep that on your radar screen.

Yeah, yeah. And then I guess another, sort of, point on inventive equity planning for employees is the use of catch-up allocations. And what I mean by that is, you know, maybe the general deal within individuals is they get 2% of, kind of, mark to market gain on the liquid pool. But the goal was really to get them, sort of, a number. And now we’ve had a huge reduction in the AUM and uncertain times, but you still want to kind of get them to something close to a targeted amount instead of giving them 2%, sort of uncapped. You know, you could consider doing a catch-up allocation where, you know, they get a larger percentage of the profit until they received, you know, an amount, and then maybe it flips back into the 2% model. So you’d give them 30% of the next mark to market gain after April 1st until they get X and then they flip back into, you know, the 2% which is sort of the pre-COVID 19 amount. Just because everything has kind of changed. Including the AUM, that may, you know, impact their numbers if their compensation bonus and incentive is based on the family’s tax planning management. I guess the next is not really a tax point, but clearly, the private equity M&A market and, you know, just M&A generally has, I don’t know if it’s stopped. But in my experience, anyway, it’s really ground to a walk from what was a full sprint, I think, probably for five years in a row, up till a couple months ago. So, you know, that if there’s less deals to be had and less direct investment opportunities, you know, how does that relate to incentivizing individuals that may be your employees that are focused on direct investing and the private equity market? So, I guess just a, kind of a general point on that. And then the same as before, you know, the budget considerations and employee compensation and, you know, personnel more generally is obviously impacted here with—by COVID19. So someone’s compensation may be adjusted in some way, which then feeds back into the family office’s budget, which then feeds back into examining the profits interest model, and making sure that’s all kind of hanging, hanging together. So any, any comments on key employee stuff, Tom?

No, I guess I would say pre-COVID I was starting to see a pretty marked trend in terms of seeing more key employee incentive compensation being used. I haven’t, while we’re working with clients on their existing structures, I feel like that, that’s leveled off a little bit. I think, in the sort of reexamination of the environment, people are still trying to figure out what the best, the best approach here. And I think at the end of the presentation, what I want to leave the group here with, and again, thank you for joining us today, is there, there is no one size fits all. There never has been in this kind of planning. There’s always, it’s always actual based on the specifics of the family and the family office and what works best for them. But hopefully this provides everybody with some, some points that you may have already been thinking about, or maybe some additional points to consider. Because again, I think this is such a, you know, a horrible, horrible time for the markets, but in some regards also may be an opportunity to either start on this type of process or revisit your existing structure. You know, maybe you’ve been thinking I should I should really get back into it and tweak this. But, you know, there’s always another pressing demands. Maybe, maybe this is an opportune time to, with these depressed values, to do that.

Great. Thank you, Tom. Thank you, Patrick. Thanks everyone for joining us today for today’s private client virtual forum. We hope you’ll be able to join us as we continue to cut through the chaos and help you emerge from this crisis in the best position possible. For those who are requesting CLE credit in New York, please enter APPLE22 in the event evaluation form that will be circulated today. Thank you again and stay well.


Related Site:     McDermott+ Consulting

Attorney Advertising ©2023 McDermott Will & Emery