Family Offices: US Legal and Tax Considerations

In recent years, the family office landscape has undergone a significant transformation. A primary driver has been a massive concentration of wealth among an elite group of individuals and families. The accumulation of substantial wealth has necessitated a more sophisticated approach to wealth management, prompting the establishment of family offices to safeguard these assets. Flexibility is the foremost benefit of a family office. A family office does not have to heed to third-party investors like a private equity fund and can generally operate free of burdensome regulations.

Essentially, a family office is a private company whose principals manage a family’s assets and investment needs. Generally, the mission revolves around wealth planning to support the current and future needs of multiple generations of family members and help families meet their philanthropic goals. That may require expertise in areas as diverse as trust and estate planning, investment management, accounting, and oversight of homes, private aircraſt or yachts.

A successful family office requires, first of all, a good plan. Best practices for family office management typically include, among others:

Since the top US federal corporate income tax rate was lowered from 35% to 21% in 2018, C-corporations have become the preferred entity type for family offices. Unlike other possible entity types, C-corporations are considered to conduct a business or trade as a primary function of their structure. C-corporations can deduct their expenses under US Tax Code Section 162, as long as they are considered ordinary and necessary to run the corporation.

If the corporate tax rate is raised in the future, limited liability companies may become more favourable for family offices. 

In 2011, the U.S. Securities and Exchange Commission (SEC) adopted a rule commonly referred to as the “Family Office Rule”, which effectively excludes family offices from the broad definition of “investment adviser”.

Satisfying the requirements of the Family Office Rule allows a family office not only to escape the burdens associated with registration under the Advisers Act, but also to completely avoid the Advisers Act’s other numerous provisions, as well as any additional state or licensing requirements applicable to investment advisers.

The Family Office Rule sets forth three requirements that the family office must meet in order to qualify for exclusion from regulation under the Advisers Act. Fundamentally, a family office is a company, including its directors, partners, members, managers, trustees, and employees acting within the scope of their employment.

To be considered a family office that qualifies for the exclusion, it must:

Additionally, the SEC has explicitly indicated that the Family Office Rule exclusion does not extend to family offices serving multiple families – it is only available for single-family offices.

A foreign family office considering an investment in the USA typically wishes to avoid causing the family office to be subject to direct taxation in the United States. Direct taxation would require the family office to file annual US tax returns, which potentially exposes the family office to scrutiny by the Internal Revenue Service (IRS) of both its US and non-US investment activities.

Subject to the discussion below, therefore, a foreign family office often establishes a US “blocker” corporation to make its US investments, which shields the family office from the US taxing jurisdiction. A blocker corporation is subject to US federal income tax at the rate of 21% (plus applicable state and local taxes that vary by state). Dividends paid by a blocker corporation attract a 30% US withholding tax, unless reduced by an applicable bilateral US tax treaty (usually to 5% or 15%). Importantly, however, distributions from a blocker corporation that are made pursuant to a plan of liquidation of the blocker corporation are generally free from any US withholding tax. Thus, it is not uncommon for a foreign-owned US blocker corporation to retain its earnings until the underlying investment is liquidated, at which time the blocker corporation can adopt a plan of liquidation and distribute the retained earnings and any net proceeds from the liquidation of the investment, and thereby limit the US federal income tax on the investment to 21%.

The foregoing structure is recommended for a direct or indirect investment in a US trade or business or in a US real estate asset. If a foreign investor invests in either type of investment without using a blocker corporation, it will generally be required to file US tax returns.

For investments that do not involve either type of investment, a foreign family office may elect to invest directly in the underlying investment (typically via a membership interest in a US limited liability company or a limited partnership interest in a US limited partnership). LLCs and limited partnerships are generally treated as fiscally transparent for US tax purposes, meaning the entity itself does not pay tax, but rather its members or partners pay tax on their share of the entity’s income. As long as the LLC or limited partnership is not engaged or deemed to be engaged in a US trade or business, its foreign members or partners would not be required to file US tax returns with respect to the investment. A member or partner’s share of any US-source income realised by the LLC or limited partnership would be subject to US withholding tax based on the type of income realised (eg, dividends, interest, etc), but assuming the investor can claim the benefits of a US bilateral treaty, the withholding tax should not exceed 15%.

A special safe-harbour rule under US tax law allows a foreign investor to engage in certain investment activities in the USA without being treated as engaged in a US trade or business (and therefore not required to file US tax returns). Investing in US equity and debt securities for the investor’s own account generally does not constitute the conduct of a US trade or business. Likewise, a US investment fund that restricts its activities to investing in equity and debt securities for its own account is generally not considered to be engaged in a US trade or business. By investing directly, without a US blocker corporation under these circumstances, a foreign family office that can claim the benefits of a bilateral US tax treaty should be able to reduce its US withholding tax exposure on dividend and interest income to 15% or less in most cases and should be exempt from US tax on any capital gains realised with respect to the investment.