Advising Family Office Clients on Recurring Legal and ...media.straffordpub.com/products/advising-family...Jul 26, 2017 · funds, sovereign wealth funds and other U.S. and foreign

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Presenting a live 90-minute webinar with interactive Q&A

Advising Family Office Clients on

Recurring Legal and Business Issues Navigating Investment Adviser Act and Broker-Dealer Compliance,

Employment, Executive Compensation, Tax and ERISA Issues

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JULY 26, 2017

Yehuda M. Braunstein, Partner, Sadis & Goldberg, New York

Alex Gelinas, Partner, Sadis & Goldberg, New York

Steven Huttler, Partner, Sadis & Goldberg, New York

Daniel G. Viola, Partner, Sadis & Goldberg, New York

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Advising Family Office Clients on

Recurring Legal and Business Issues

Navigating Investment Adviser Act and Broker-Dealer

Compliance, Employment, Executive Compensation, Tax and ERISA Issues

July 26, 2017

Steven Huttler, Partner

Sadis & Goldberg LLP

Steven Huttler is a partner in the firm’s Financial Services and Corporate Groups. Mr. Huttler has extensive experience in corporate, finance, investment fund and securities matters, including the representation of U.S. and foreign investment funds, underwriters, and private clients in various registered public and private offerings of debt and equity securities totaling in excess of $10 billion.

As part of his investment fund practice, Mr. Huttler has served as corporate counsel to many private investment funds and partnerships based in or domiciled in the United States and in international and offshore jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands, Ireland, Luxembourg, Isle of Man, Jersey, Guernsey, Cyprus, Mauritius, United Kingdom, Austria, Russia, India and Gibraltar. Mr. Huttler's legal practice has exposed him to diverse fund clients with an exceptionally wide range of investment programs and structures, including large mutual funds and hedge fund complexes, private equity firms, real estate partnerships and funds, venture capital funds and funds focused on specialty finance assets. He has also counseled small start-up hedge funds and financial industry entrepreneurs. His practice has included structuring and establishing start-up funds and managed accounts, and structuring investment funds to benefit from U.S. double taxation treaties. He has advised management companies and fund managers on compensation structures, restructured and reorganized funds, structured, negotiated and documented fund trades, negotiated seed, joint venture and start up agreements, and advised on a range of sophisticated transactions. He has also represented financial services providers, such as brokerage firms (including proprietary trading broker-dealers), fund administration firms and third party marketing firms in structuring their operations, reorganizations to achieve tax benefits, advising on disputes with clients, and in the development of forms for their pension, investment, trading, administration and other services to investment funds, equity, debt and option traders and other clients.

6

Alex Gelinas, Partner

Sadis & Goldberg LLP Alex Gelinas is a partner in the firm’s Tax Group. Mr. Gelinas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to U.S. pension funds, sovereign wealth funds and other U.S. and foreign institutional investors in connection with their investments in private equity funds, hedge funds and U.S. joint ventures. He also has extensive experience in providing tax planning advice to high-net-worth individuals and families.

7

Daniel G. Viola, Partner


Daniel G. Viola, Head of the Regulatory and Compliance

Group of Sadis & Goldberg LLP, has a diverse practice,

representing investment advisers, funds and broker-dealers. Mr.

Viola structures and organizes broker-dealers, investment

advisers, funds and regularly counsels investment professionals in

connection with regulatory and corporate matters. Mr. Viola

served as a Senior Compliance Examiner for the Northeast

Regional Office of the SEC, where he worked from 1992 through

1996. During his tenure at the SEC, Mr. Viola worked on several

compliance inspection projects and enforcement actions involving

examinations of registered investment advisers, ensuring

compliance with federal and state securities laws. Mr. Viola’s

examination experience includes financial statement, performance

advertising, and disclosure document reviews, as well as, analysis

of investment adviser and hedge fund issues arising under ERISA

and blue-sky laws.

8

Yehuda M. Braunstein, Partner


Yehuda M. Braunstein heads up the Family Office practice and is also a member of the firm’s Financial Services and Corporate Groups. Mr. Braunstein counsels family office clients in connection with all aspects of their operations, including formation issues, governance and compensation issues, transactional and day to day matters as well as compliance issues.

Mr. Braunstein’s practice also focuses on investment funds, securities, joint ventures, regulatory compliance and investment advisers. He regularly structures and organizes hedge funds, private equity funds (including real estate, distressed and lending funds), funds of funds, separately managed accounts and hybrid funds. Additionally, he advises private fund managers on structure, compensation, employment and investor issues, and other matters relating to management companies. Mr. Braunstein also structures and negotiates seed investments and operating agreements. He provides ongoing advice to investment advisers on securities law issues, including SEC filings. His practice also involves counseling clients in SEC regulatory matters, including compliance issues related to registered advisers, as well as conducting mock audits.

9

Overview I. Family Offices: Types and Structures

II. Regulatory Compliance

a. Legal definition of Family Office

b. SEC Family Office Rule under the Investment Advisers Act of 1940 and its application

c. CFTC registration/Family Office exemption

d. Exchange Act reporting obligations

III. Relevant Investment Assets and Establishing Investment Vehicles for Them (Club Deals, Sidecars, etc.)

IV. Employment/Executive Compensation Issues/Liabilities

V. U.S. and Select Overseas Tax Issues

a. U.S. Domestic: deployment of qualified capital (e.g., Keogh, IRA, pension plan, etc.) and

related issues; increased popularity of insurance dedicated funds (“IDFs”)

b. International: family with individuals in multiple jurisdictions; overseas holdings

VI. ERISA Considerations

a. Investor Onboarding Issues – New ERISA Fiduciary Rule

b. ERISA Plan Assets Issues

10

I. Family Offices: Types and Structures

11

What is a Family Office?

• Commercial and legal responses are different.

• Commercial answer: entity or office established related to provide specific kinds of services to wealthy individuals and/or families.

• Legal/Regulatory answer: under the Investment Advisers Act of 1940 (the “Advisers Act”), an entity that provides investment management services to a narrow group of individuals (mostly related).

• Legal/Tax answer: no definition and no special tax status.

12

Commercial Description of Family Office

• Many descriptions, but most focus on specified services provided.

• For purposes of our discussion, let’s assume that it is entities that provide some or all of the categories of services that appear in the following pages .

• This list provides us with a convenient way to categorize some of the most significant and repetitive legal issues for Family Offices (“FOs”).

13

The Array of Multi-family Office Services

14

Source: Adapted from Forbes Magazine - Forbes Custom Finance and Investing: Considering the Family Office

Non-Investment Services Provided

15

Source: Adapted from Fidelity Investments: Fidelity Family Office Services: Insights on Family Office Compensation, December 2015

Use of In-House and Other Resources

16

Source: Adapted from Fidelity Investments: Fidelity Family Office Services: Insights on Family Office Compensation, December 2015

Commercial Description of Family Office

• Upshot: FOs have tremendous variety of styles, sizes, and services provided.

• However, there is a crucial distinction between “Single Family Office” (“SFO”) and “Multi-family Office” (“MFO”).

• This commercial distinction has strong implications legally, such as under the Advisers Act.

17

Structuring the Family Office:

Basic Issues (1)

a. LLC, LP vs. Corporation as the appropriate entity is the largest discussion in tax and sources.

b. But this is an over-simplification of the discussion: is an entity needed at all? (e.g., if FO is operated together with existing family businesses, it can be more logical not to establish a vehicle at all, and to use the infrastructure of the existing family operating businesses).

c. Further, whatever entity is selected (or even if none is selected as per the above), there will almost always be many other pockets of capital to put to use for investments and family cash and trusts and estate planning, such as:

i. Cash/unencumbered investments;

ii. IRA, Keogh, etc.;

iii. ERISA covered plan monies; and

iv. Trusts, foundations, other T&E and philanthropic planning vehicles.

d. When making investments, or structuring other uses of capital (e.g., philanthropic), must consider which of these sources of money is appropriate. These categories are examples of important consequences for deal structuring as below.

18

Structuring the Family Office: Larger

Thematic Considerations (2)

a. Philosophic: philanthropic vs. wealth preservation and growth.

b. In either case: training of younger generation to manage FOs: research shows that this is one of the greatest worries of FO professionals, whether their inter-generational leadership will be properly groomed to lead into the future; without proper leadership, FOs can fall apart. Younger leaders need to be trained in investments and business, philanthropy (if that is a family value) and exercising roles in a larger family structure.

c. Much effort is required to harmonize T&E planning, transfer of leadership in underlying businesses, if any, into the analysis of what types of entities are needed, and how structured.

d. Further, as discussed earlier, the range of services provided by the FO has dramatic consequences on how it is structured: e.g., if there are many concierge services provided, then much consideration needs to be given to formulas on how to allocate such expenses among family members.

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II. Regulatory Compliance

20

Overview of Regulations for

Registration of Family Offices

• SEC’s Advisers Act – Historically, SFOs didn’t have to register with the SEC because of an exemption provided to advisers with fewer than 15 clients.

• Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Advisers Act, passed in 2010, repealed the so-called “private adviser exemption” but included a provision requiring the SEC to define “FO” and to exclude them from registration under law.

• SEC adopted Rule 202(a)(11)(G)-1 on July 21, 2011 defining FOs as: an entity that has no clients other than family clients; is owned and controlled by family clients; and does not hold itself out as an investment adviser.

• The CFTC provided in November 2012, in Letter 12-37, to exempt FOs whose investment vehicles use CFTC-regulated products from registration as commodity pool operators (“CPOs”). But, did not discuss relief from commodity trading adviser (“CTA”) registration.

21

Legal Definition of Family Office

• The regulatory distinction between SFO and MFO is now much clearer and distinguishable.

▫ SFOs are those that serve only descendants of a common ancestor.

▫ MFOs generally serve a number of smaller family groups that either cannot justify the cost of their own family office, or choose to use the services of an experienced group of professionals as an alternative to, or in conjunction with, their own SFO.

22

Legal Definition of Family Office:

Recurring Issues

• To qualify for the exemption for registration, an SFO must:

▫ Advise only “family clients”;

▫ Be wholly-owned by “family clients’ and exclusively controlled by “family members” or “family entities”; and

▫ Not hold itself out to the public as an investment adviser.

• “Family clients” are “family members” related within ten generations of a common ancestor. The term also includes current and former spouses, “spousal equivalents,” adopted children, foster children and some children under guardianship. In addition, “family clients” includes various trusts for the sole current benefit of family clients, some non-profit and charitable organizations, estates of family members and companies wholly-owned and operated for the sole benefit of family clients. The Family Office Rule treats certain “key employees” of the FO, their estates, and certain entities through which key employees may invest as “family clients” (but not as “family members”). A “key employee” is generally an executive officer, director, or person serving in a similar capacity at the FO or its affiliated FO.

• Implications of being a FO vs. not under Advisers Act.

• Failing to meet the FO exemption may require registration as an investment adviser.

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Investment Adviser Registration

Who is Required to Register? • Investment advisers that manage between $100 million and $150 million in assets that manage

one (1) or more managed accounts must register with the SEC.

• Investment advisers that manage less than $100 million in assets generally must defer to the relevant investment adviser statutes in the state(s) where they conduct business.

• Investment advisers that can rely on the Private Fund Adviser Exemption may still need to become an Exempt Reporting Adviser with the SEC.

• Investment advisers must include all gross assets (including leveraged amounts) in calculating assets under management.

• Investment advisers to private equity funds must include uncalled capital commitments (not just drawn down capital) in calculating assets under management.

24

SEC Registration Requirements for the

Family Office • File Form ADV along with annual updates. Form ADV includes information on ownership, structure

and asset values;

• Prepare a disclosure documents that must be provided to clients on an annual basis;

• Designate or hire a chief compliance officer;

• Maintain books and records as required by the SEC;

• Comply with enhanced custody rules;

• Adopt a code of ethics, a conflict-of-interest policy, a business continuity plan and other operational procedures as required by the SEC; and

• Be subject to examination and information requests by the SEC.

25

CFTC Definition of the Family Office

“A family office is, generally, a professional organization that is wholly-owned by clients in a family

and is exclusively controlled (directly or indirectly) by one or more members of a family and/or

entities controlled by a family. Typically, a family office structure is employed when one or more

direct members of a family create substantial wealth, and share that wealth in whole or in part with

other members of that family, either through direct transfer, inheritance, or similar means. The

family office is then used to provide personalized services to that family, including advice regarding

issues of tax, estate planning, investment, and charitable giving.”

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CFTC Registration

In February 2012, the CFTC promulgated certain amendments to Part 4 of the CFTC’s Regulations. Notable, and at issue here, is the rescission of Regulation 4.13(a)(4), which had previously exempted from registration CPOs who, inter alia, operated a pool for only those individuals who met a certain “qualified eligible person” standard. In general, FOs relied on Regulation 4.13(a)(4) as an exemption from registration. Pursuant to these recent amendments, absent affirmation relief, many FOs would be required to register with the CFTC as a CPO.

The CFTC Letter No. 12-37, dated November 29, 2012, asserts generally, that FOs are not operations of the type and nature that warrant regulatory oversight by the CFTC. That is, because a FO is comprised of participants with close relationships, and there is a direct relationship between the clients and the adviser, such relationships greatly reduce the need for the customer protections available pursuant to Part 4 of the CFTC’s Regulations. Importantly, as a function of these relationships, any disputes that arise between any of the family members concerning the operation of the FO could be resolved within that family unit, or through state courts under laws designed to resolve such family disputes.

27

Family Offices Granted Relief from

Registration as Commodity Trading Advisors

On November 5, 2014, the CFTC issued a no-action letter ("CFTC Letter 14-143") regarding registration requirements for FOs. This letter was similar to CFTC Letter 12-37 which stated that FOs did not have to register as CPOs if they sent a notice to the CFTC identifying themselves as FOs. CFTC Letter 14-143 extended this position to commodity trading advisors ("CTAs"). Thus, FOs that satisfy the SEC’s definition of a "family office" must also notify the CFTC to avoid CPO and CTA registration.

28

CFTC Rules Impact on Private Investment Funds -

Will You Need to Register as a Commodity Pool

Operator?

Background

▫ Any fund trading even a penny of “commodity interests” is considered a “commodity pool,” and its operator must register as a CPO with the CFTC, unless an exemption is available.

▫ “commodity interests” include futures contracts (including security futures), commodity options and retail off-exchange forex transactions.

▫ Most commonly used exemption for operators of private funds has been the 4.13(a)(3) exemption.

29

CFTC Rules Impact on Private

Investment Funds (cont.)

4.13(a)(3) Exemption

▫ typically used by operators of 3(c)(1) funds

▫ permits a de minimis amount of trading of commodity interests

▫ either (i) the aggregate initial margin and premiums required to establish commodity interest positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the fund’s portfolio (taking into account unrealized profits and losses) (the “Margin Test”) or (ii) the aggregate net notional value of the fund’s commodity interest positions does not exceed 100 percent of the portfolio’s liquidation value (the “Net Notional Test”)

▫ the fund may generally not be marketed to the public as a vehicle for trading in commodity interests

Note: The JOBS Act allows general solicitations in connection with Rule 506(c) offerings sold only to accredited investors.

30



4.13(a)(3) Exemption Modified

▫ Claiming this exemption had required a “one-time” filing, but now the filing must be made annually within 60 days after every calendar year end.

▫ “Swaps” will be included as “commodity interests” 60 days after the final rules defining “swap” have become effective.

▫ “Swaps” are expected to exclude swaps on single securities or a narrow index of securities, but are expected to include swaps on a broad-based security index.

31



CPO Registration—Process

▫ The CPO Itself

Must File Form 7-R through the NFA’s Online Registration System (ORS), and concurrently will become a member of the NFA.

Application fee of $200; NFA annual membership dues of $750.

▫ “Associated Persons” of the CPO

Generally, any person that solicits investors (and supervisors thereof).

Must register with the CTFC on Form 8-R, and become an “associate member” of the NFA

$85 application fee; must submit a fingerprint card for an FBI background check.

Must obtain Series 3 license, subject to exemptions.

32



CPO Registration—Process – (cont.)

▫ “Principals” of the CPO

Generally, any general partner, managing member, director, executive officer and 10% owner.

Must file a Form 8-R through ORS.

$85 application fee.

Must submit a fingerprint card for an FBI background check (except for “outside directors”).

Not considered to be registered with the CFTC or members of the NFA; rather, they are “listed” as Principals of the registered CPO.

33



CPO Registration—Ongoing Obligations

▫ Disclosure

A “Disclosure Document” for pool participants must be prepared in accordance with Rules 4.24 and 4.25 and must accompany subscription documents.

The Disclosure Document must be accepted by the NFA prior to use.

▫ Reporting

Distribute to investors unaudited monthly “Account Statements” within 30 days of each month end.

Distribute to investors and file with the NFA audited “Annual Reports” within 90 days after each year end (subject to extension requests).

Annual CFTC registration update.

Annual NFA questionnaire.

34



CPO Registration—Ongoing Obligations – (cont.)

▫ Reporting (cont.)

File Form CPO-PQR

CPOs divided into “small” (less than $150 million), “medium” (between $150 million and $1.5 billion) and “large” (greater than $1.5 billion).

Small CPOs: file NFA Form PQR on quarterly basis within 60 days of the quarters ending March, June & September. Also required to file a year-end report (Schedule A & schedule of investments) within 90 days of the calendar year end.

Medium CPOs: file NFA Form PQR on a quarterly basis within 60 days of the quarters ending in March, June & September. Also required to file CFTC Form CPO-PQR’s Schedules A & B annually, within 90 days of the calendar year end.

Large CPOs: file CFTC Form PQR schedules on a quarterly basis within 60 days of the quarter end. CPOs that file Form PF with the SEC in lieu of CFTC Form CPO-PQR required to file NFA Form PQR with NFA on a quarterly basis within 60 days of the quarter end, except for December 31st quarter, which will be due within 90 days of quarter end.

▫ Recordkeeping

Must make and keep prescribed records in an accurate, current and orderly manner at main business office.

Keep for 5 years; must be readily accessible for 2 years.

Open to inspection by DOJ and CFTC.

35



CPO Registration “Lite”

▫ A Section 4.7 exemption provides relief from many of the requirements of a registered CPO, effectively substituting significantly less onerous requirements.

▫ Requires that every investor in the fund be a “qualified eligible person” (“QEP”).

▫ A QEP includes an entity with total assets in excess of $5 million or an individual that is an accredited investor, provided, in each case, that the person owns securities of issuers not affiliated with such person and other investments with an aggregate market value of at least $2 million.

36

Trade Reporting Obligations

Selected Ongoing Requirements for FOs

I. SEC Regulations – FOs need to assess whether they are subject to reporting requirements under the Securities Exchange Act of 1934:

a. Section 13(f)

b. Schedule 13D and 13G

c. Rule 13h-1 “Large Trader” Reporting Requirements

i. SEC Registration

ii. Registered Broker-Dealer Requirements

d. Rule 105 of Regulation M

37

Broker-Dealer Regulatory Considerations

• Basic Rule: Transaction-based compensation in securities deal requires broker-dealer registration.

• Compensation could be obvious, as in commissions, or “disguised” (e.g., management and incentive fees where no IA services provided).

• Compliance professionals insist on greater compliance with registration.

• SEC itself now very focused on these violations and prosecutes them.

• Issue: club deals may be sponsored by third parties, who are neither existing registered broker-dealers (or broker-dealer reps) or investment advisers.

• Such parties expect to be compensated.

38

Family Offices May be Considered Investment

Advisers for Purposes of FINRA Rule 5131

• On May 9, 2017, FINRA issued an interpretive letter stating that FOs may be considered investment advisers for purposes of meeting the limited exception of FINRA Rule 5131.02(b) (the “Rule”).

• The Rule addresses abuses in the allocation and distribution of “new issues,” or IPO, shares and paragraph (b) of the rule prohibits the practice of “spinning.” Spinning occurs when an underwriter allocates new issue or IPO shares to executive officers and directors of a company as an inducement to award the underwriter with investment banking business, or as consideration for investment banking business previously awarded.

• The Rule provides a limited exception to the spinning provision by permitting underwriters to rely upon written representation obtained within the prior 12 months from a person authorized to represent an account that does not look through to the beneficial owners of an unaffiliated private fund invested in the account, except for beneficial owners that are control persons of the investment adviser to the private fund, if the unaffiliated private fund meets certain conditions. The unaffiliated private fund must:

1) Be managed by a investment adviser;

2) Have assets greater than $50 million;

3) Own less than 25% of the account and not be a fund in which a single investor has a beneficial interest of 25% or more; and

4) Not be formed for the specific purpose of investing in the account.

FINRA noted that despite their exclusion from the definition of “investment advisers” under the Advisers Act, FOs may perform equivalent functions to regulated investment advisers. FINRA also emphasized that the remaining conditions of the Rule must still be satisfied. The interpretive letter is significant because it makes it easier for FOs to purchase new issue or IPO shares.

39

III. Relevant Investment Assets

and Establishing Investment Vehicles

for Them

(e.g., Club Deals, Sidecars, etc.)

40

What Do Family Offices Invest In?

▫ Debt

▫ Equity

▫ Real Estate

▫ Private Businesses/Private Equity

▫ Alternatives (private funds, etc.)

▫ Luxury Items (Vineyards, Art, Racing Cars, Watches, other collectibles).

41

How do Family Offices Invest in Assets?

• How do FOs Invest in these assets?

▫ Through specialized investment funds (e.g., Hedge, PE, VC, RE funds).

▫ Sometimes directly: depending on the depth of expertise in the FO (i.e., how full service is the FO, does it have internal, in-house expertise to acquire and manage different asset classes?).

▫ Through Special Purpose Vehicles (“SPVs”): (i.e., club deals (related broker-dealer issues)).

42

Emerging Developments as Responses to

these Conditions: SPVs • Advantage:

Easier to raise capital for very attractive deal than for “unknown, blind” pool.

• Historical Antecedent:

“Club deals” which were used by large PE funds for a very different purpose: these large fund families with great infrastructure shared deals. Here a manager with minimal or perhaps non-existent infrastructure uses in effect the “club deal” structure in another context.

• Challenges: Liquidity

• How is money raised and in what format?

• Tendency is to use this for HNW not institutions.

• Can you trust capital commitments from HNWs?

• If not, you must overfund at the beginning, for contemplated fees and expenses, which dramatically drags down returns.

43


these Conditions: SPVs (cont.)

▫ Challenge: Track-record “Albatross”

Under relevant SEC law, returns are required to be reported precisely in relevant contexts – no “cherry picking”.

▫ So while you are trying to build a track record, the SPV structure drags down the very return numbers in the track record – which is supposed to help raise more capital.

▫ Further: what if you don’t estimate fees & expenses correctly?

• Alternative: try to rely on capital commitments.

• What if investors don’t honor their capital commitments?

• Deals collapse (initially or subsequently) for lack of funds because of party which doesn’t honor capital commitments.

44


these Conditions: SPVs (cont.)

• Regulatory/broker-dealer Considerations: Introductions to and by FOs.

• Regulatory/disclosure: non-intuitive result – more disclosure required – must give detailed disclosures about target.

• Concentration Risk: if one deal goes bust, your whole track record is marred – risk much greater than for a blind pool.

45

IV. Employment/Executive

Compensation Issues/Liabilities

46

Executive Compensation for Senior

Management of Family Offices:

Basic Business Issues a. Significant factors: wealth management is a particularly important function, especially very

specialized ones in hedge funds, PE/RE/VC fund.

b. Another significant factor: FOs are competing for talent to some extent with investment fund managers, college and philanthropic foundations.

c. Compensation for such senior managers is very similar to those found in the wider money management world: hedge funds, PE funds, etc.

d. Many of these senior managers expect to get paid percentages of increases in assets of FO, as they are paid on the street.

e. Some issues: as noted above, many “pockets” of wealth are not held in partnerships, where managers cannot get performance “allocations” (favorable income tax treatment).

f. Many professionals play multiple roles, including those relating to concierge roles, and there are complaints of misalignment of compensation with services provided.

47

Management Liability Red Flags

Does your FO:

• Have professionals on staff?

• Provide accounting or tax planning services to clients?

• Assist in estate planning for clients?

• Perform investment advisory services for clients?

• Form and maintain private investment funds or investment partnerships?

• Select and oversee outside professionals or outside professional service firms?

• Have individuals who serve as trustees of family trusts?

• Work in conjunction with a private trust company?

• Assist with the placement and management of domestic staff?

• Coordinate the placement of insurance for clients?

• Perform administrative or support services for any family foundations?

• Assist clients with structuring and operating small businesses?

• Have its own pension or 401k plan for employees?

If any of these “red flags” exist, we recommend a comprehensive review by a FO risk specialist.

Source: Adapted from Marsh & McLennan Companies – Family Office Management

Liability Issues to Consider

48

V. U.S. and Select Overseas Tax Issues

49

U.S. Income Tax Issues For High Net Worth

Individuals Investing in Partnerships

U.S. high net worth individuals and their advisers have long known that a great performing investment, including various hedge fund strategies, can sometimes become mediocre once federal and state taxes are taken into account.

Under the tax rules applicable to partnerships, U.S. limited partners are subject to income taxation on their allocable share of the partnership’s net income regardless of whether they receive any distributions or withdraw any funds from such partnership.

Further, many partnership funds pursue trading strategies that generate short-term capital gains, rather than long-term capital gains and qualified dividends which are eligible for favorable income

tax rates.

50


Individuals Investing in Partnerships (cont.)

Trader vs Investor Status. If the partnership in question is not engaged is business, e.g. as a “trader” entity, and is instead classified as a mere “investor” in stocks, securities and other financial instruments, high net worth individuals (as well as trusts and estates) could find that their share of the partnership’s investment-related expenses, including the hefty management fees, are subject to disallowance (in whole or in part) on their own federal income tax returns, since such deductions would be classified as Section 212 deductions (i.e., miscellaneous itemized deductions) rather than Section 162 business deductions. Such deduction limitations include:

2% Floor Rule. Certain itemized deductions of individuals, estates and trusts, including Section 212 expenses, are generally deductible only to the extent that, in the aggregate, they exceed two percent of the taxpayer’s adjusted gross income.

3% Phase-Out Rule. For individuals, otherwise allowable itemized deductions are subject to further reductions by 3% of the amount by which the taxpayer’s adjusted gross income exceeds a specified threshold amount. Up to 80 percent of the taxpayer’s itemized deductions could be disallowed under this rule.

51


Individuals Investing in Partnerships (cont.)

AMT Disallowance. Miscellaneous itemized deductions are also not allowed in calculating the taxpayer’s alternative minimum tax liability.

Other Deduction Limitations: The Code also provides other limitations on deductions for investment interest (which includes short sale expenses), wash sale limitations on losses, and a number of other rules that could be triggered in situations where the high net worth taxpayer is investing through partnership vehicles.

3.8% Tax on Individual’s Net Investment Income. U.S. individuals are also subject to an “add on” 3.8% tax on their net investment income (the “NII Tax”). In general, an individual partner’s share of the partnership’s investment income is subject to this 3.8% tax, and the deduction limitations described above also apply in calculation “net investment income”. Trusts and estates are also subject to a modified form of the NII Tax, on their undistributed net investment income.

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Private Placement Insurance Strategies (with

Underlying Insurance-Dedicated Funds)

In view of such tax inefficiencies in partnership structures for U.S. individuals, some FO managers and advisers have been considering the following alternative investment strategies which may provide a much better tax result for such taxpayers.

The Typical Structure. A U.S. high net worth individual, or a FO investment vehicle, purchases a variable life insurance policy or annuity contract (collectively, a “policy”) from a life insurance company and the insurance company invests in one or more hedge funds or other private investment funds. The private investment funds are held by the insurance company in a segregated asset account (the “separate account”). The assets held by the insurance company separate account provide the investment return to the contract owner. However, under the federal income tax rules applicable local law relating to such insurance products, the insurance company is treated as both the legal owner and the tax owner of the assets of the separate account and the investor in the policy reports his or its income in accordance with the special federal income tax rules applicable to such insurance company contracts.

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Underlying Insurance-Dedicated Funds) (cont.)

Summary of U.S. Tax Advantages.

One of the primary U.S. tax advantages is deferral of income taxes for the investor in the policy. Since the insurance company is the legal and tax owner of the separate account assets, it receives the K-1 forms and Form 1099s each year with respect to such assets.

Long-Term Deferral of Taxable Income. The policy owner has no taxable income to report with respect to the realized or unrealized gains and other income generated by the underlying separate account investments (known as the “inside build up” in the policy) unless the owner withdraws funds from the insurance or annuity policy.

Tax-Free Receipt of Death Benefit. In the event of the death of the insured person under a policy that provides a death benefit, the designated beneficiary would receive such death benefit free of U.S. federal income taxes.

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Underlying Insurance-Dedicated Funds) (cont.)

Other Income. Other income withdrawn from the policy is generally taxed at ordinary income tax rates. However, certain policies can be structured to permit the owner to borrow funds from the insurance company and avoid current income taxation on such amounts. Unlike qualified plan investments, there is no specific federal income tax rule that would require the investor in the policy to begin withdrawing funds once the investor reaches age 70½.

Tax Requirements Which Must Be Met to Achieve Desired Tax Result. In order to qualify for this generous federal income tax treatment, the investor in the policy cannot retain control over the specific underlying investments made by the funds held in the separate account and the account must satisfy certain diversification requirements. Further, in order to satisfy such diversification requirements, the funds in which the insurance company invests have to be “insurance dedicated funds” (“IDFs”), meaning that they are funds offered only to insurance companies and thus not available for direct investment by other investors (other than certain tax-exempt entities). The tax rules permit the investor in the policy to select the IDF or IDFs in which the account will invest (provided the insurance company has decided to offer such IDFs as an available investment option under its policy) and the contract can permit the policyholder to change the allocations of invested funds (e.g., quarterly or semi-annually) from one IDF to other IDFs that the insurance company has made available for selection by policyholders.

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Captive Insurance Company Strategies In cases where the founder and/or family members control a private operating company, tax advisers to such company and the FO should consider the possible income tax, estate tax and financial advantages that could be available if the closely held business were to form a captive insurance company.

Summary of Tax and Non-Tax Advantages. A properly structured and managed captive insurance company (which is required to be a “C” corporation for U.S. tax purposes) could provide some or all the following benefits:

Tax deduction for the parent company for the insurance premium paid to the captive;

Opportunity to accumulate wealth in a tax-favored vehicle (i.e., the insurance company);

Ability to distribute “qualified dividends” (taxable at capital gains rates) to the shareholders of the captive;

Various other tax savings opportunities, including gift tax and estate tax savings;

Asset protection from the claims of creditors of the business and personal creditors;

Reduction in insurance premiums currently paid by the operating company to unrelated insurers;

Access to the lower-cost reinsurance market; and

The possibility of insuring risks that would otherwise be uninsurable.

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Captive Insurance Company Strategies (cont.)

Tax Benefits Available for Small Nonlife Insurance Companies (Code section 831(b)). Qualifying property and casualty insurance companies with net premium income not in excess of specified limits have the ability to elect under Section 831(b) to exclude their premium income from federal income tax and pay federal income tax only on their investment income. Although the maximum net annual premium exemption formerly was $1.2 million, 2015 tax legislation raised this amount to $2.2 million for tax years beginning after December 31, 2016, and such amount is subject to increases in future years in accordance with inflation.

Estate and Gift Tax Advantages. Captive insurance companies can also be used for estate planning purposes. For example, a captive insurance company can be owned at the time of its formation by family members of the parent corporation’s owners or a trust set up for those family members. Assuming the insurance premiums paid to the captive reflect arm’s length terms, the premium payments should not be treated as gifts to the shareholders of the captive. In addition, the future growth in the captive’s net asset value (which could be enhanced if the premium income is exempt from U.S federal income tax under Section 831(b)) will not be included in the estates of the senior family members who own the shares of the parent company.

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Captive Insurance Company Strategies (cont.)

2015 Tax Legislation Also Curtails Certain Estate Planning Strategies. The 2015 amendments to the Code also attempt to curtail certain aggressive estate planning strategies that involve captive insurance companies. Interested parties should consult qualified insurance tax counsel concerning the impact of such legislation, and future regulations interpreting such statutory amendments, before implementing a captive insurance program.

See also IRS Notice 2016-66 (dated Nov. 21, 2016) which classified certain “micro-captive transactions” and substantially similar transactions as “transactions of interest” which therefore must be disclosed in tax filings.

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VI. ERISA Considerations

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New DOL ERISA Fiduciary Regulation Takes Effect; Managers of

Private Investment Funds, Including FOs,

Must Consider Compliance Issues After years of proposals and revisions, portions of the Department of Labor’s controversial “ERISA fiduciary rule” project went into effect as of June 9, 2017. Managers of hedge funds, private equity funds and other private investment vehicles that are not currently operating as ERISA fiduciaries should be aware that the newly adopted definition of “fiduciary” (the “New Regulation”) expands the circumstances under which fund managers, consultants, and advisers to ERISA-covered plans (“Plans”) and Individual Retirement Accounts (“IRAs”) can be classified as “service fiduciaries” under the labor law portion of ERISA (known as Title 1) and the prohibited transaction provisions of Section 4975 of the Internal Revenue Code (“Code”), as a result of providing “investment advice” to a Plan or an IRA (or a participant or beneficiary thereof).

The New Regulation does not change the long-standing ERISA plan asset exemption in the DOL’s plan asset regulation under which many private funds avoid ERISA compliance at the fund level by limiting the aggregate investment in any class of interests by “benefit plan investors” to less than 25% of the investment in such class.

Rather, the New Regulation relates to the circumstances under which a fund manager could be deemed to be providing investment advice in connection with a Plan’s or IRA’s “decision to invest” in the manager’s fund or to “maintain such investment” in such fund, while also providing a safe harbor rule for communications with advisers to certain Plan and IRA investors.

No Specific Exemption for FO Funds. There is no special treatment under the DOL regulation for investment vehicles formed by a “family office” within the meaning of the securities laws. Accordingly, if the FO organizes an investment vehicle, and takes in money from ERISA-covered Plans or IRAs of the family members, care must be taken by the managers to avoid being classified as a fiduciary with respect to the Plan or IRA by reason of the “marketing information” provided to family members concerning the fund.

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Safe Harbor Rule for Advice Provided to Independent

Fiduciaries of a Plan or IRA The New Regulation contains an important safe harbor exception (the “Safe Harbor”) for investment managers (and

other parties) that are dealing with Plan and IRA investors that are advised by a qualified independent fiduciary. Specifically, the New Regulation provides that a fund manager or other person providing investment advice to a Plan or an IRA will not be classified as an ERISA fiduciary solely by such action if: (A) the person provides such advice to an “expert fiduciary” of such Plan or IRA who is independent of the advice provider, (B) the fund manager (or other service provider) receives no compensation for the provision of investment advice with respect to the investor’s decision to invest in the fund, (C) the fund manager (or other service provider) has advised the investor that it is not undertaking to provide impartial investment advice in a fiduciary capacity, and (D) the fund manager (or other service provider) has fairly disclosed its financial interests to the investor.

An expert fiduciary includes the following:

▫ a U.S-regulated bank;

▫ a U.S.-regulated insurance carrier;

▫ a federal or state registered investment adviser;

▫ a U.S.-registered broker-dealer; or

▫ any independent fiduciary (e.g., a Plan’s investment committee) that holds, or has under management and control, total assets of at least $50 million.

Note that this Safe Harbor does not apply to investment recommendations made directly to a Plan or IRA investor even if they have a net worth in excess of $50 million. However, if the investment manager is communicating with a professional adviser of a Plan or the IRA owner, the Safe Harbor will be available if its conditions are satisfied.

The advantage to the investment manager from being able to rely on this Safe Harbor is that the manager can avoid the need to explore the uncertain area where fund marketing stops and investment recommendations begin. Importantly, the New Regulation provides that the service provider can rely on written representations made by the independent fiduciary as to such party’s compliance with the regulatory, financial and other requirements necessary to rely on the Safe Harbor.

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ERISA Considerations Relating to Private

Investment Funds and Co-Investment

Transactions

1. Plan Assets Issues; Fiduciary Status and Prohibited Transaction Issues

If the assets of an entity (e.g., a corporation, partnership or trust) are treated as plan assets of a benefit plan investor that owns an equity interest in such entity, the parties having management authority over the assets of such entity would be treated as fiduciaries under ERISA with respect to such plan investors. In addition, transactions entered into by such plan asset entities would be subject to ERISA scrutiny including complex prohibited transaction rules.

• ERISA imposes strict fiduciary responsibility requirements on parties that are deemed to be fiduciaries of employee benefit plans that are subject to ERISA. The performance compensation arrangements for the managers of a typical private investment fund and the related party transactions that the private investment funds generally engage in would not comply with such ERISA requirements.

• Therefore, ERISA compliance for private investment funds generally consists of entirely avoiding the application of ERISA to the fund’s assets and to the activities of its investment manager by relying on one of the plan assets exemptions in the ERISA regulation which defines “plan assets” for ERISA regulatory purposes (the “Plan Assets Regulation”).

A. General Rules on Plan Assets Status

Under the ERISA plan assets regulations, the assets of an entity in which a plan has an equity interest will not be treated as plan assets if the equity interests are(1) publicly traded securities or (2) a security issued by an

investment company registered under the Advisers Act.

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Transactions (cont.)

In all other cases the assets of the entity will be treated as plan assets for ERISA purposes unless:

(1) the entity qualifies as an “operating company” which term also includes a “venture capital operating company” or a “real estate operating company”; or

(2) the aggregate investment in the equity interests of the entity that are owned by “benefit plan investors” is less than 25 percent of the outstanding equity interests in such entity (the Insignificant Plan Investment Exception”).

As a result of 2006 legislation, the term “Benefit plan investors” no longer includes governmental plans, church plans an non-U.S. plans.

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B. Operating Company Definition

An operating company is defined as an entity that is “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.”

(1) Start-up ventures and companies engaged solely in research and development may not qualify under this definition.

(2) The Venture Capital Operating Company (“VCOC”) and Real Estate Operating Company (“REOC”) exemptions were added later.

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VCOC Definition

To qualify as a VCOC, the entity must satisfy two requirements: First, at least 50% of the entity’s assets (at cost) must be invested in “venture capital investments” or “derivative investments” as defined. Second, the entity must obtain and exercise “management rights” with respect to at least one of its operating company investments. The term “venture capital investment” is defined as an investment in an “operating company” in which the investing entity has obtained management rights.

REOC Definition

The REOC definition is similar to the VCOC definition. In order to be a REOC, the entity must: (1) have at least 50 percent of its assets (valued at cost) “invested in real estate that is managed or developed and with respect to which such entity has obtained the right to substantially participate directly in the management or development activities”; and (2) be directly engaged in real estate management or development activities.

• Many private investment funds rely on the Insignificant Plan Investment Exemption (also known as the “Under 25 Percent Plans Limitation”). This limitation must be satisfied throughout the life of the Fund. Thus it is necessary to police any secondary market transactions in Fund shares to ensure that the benefit plan investor limitation is not exceeded.

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If you have questions, please contact:

Sadis & Goldberg LLP 551 Fifth Avenue, 21st Floor

New York, NY 10176

Steven Huttler

Alex Gelinas

Daniel Viola

Yehuda Braunstein

212.573.8424 212.573.8159 212.573.8038 212.573.8029 [email protected] [email protected] [email protected] [email protected]

mailto:[email protected]




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