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The short answer is yes, but that comes with a few caveats.
Many individuals who have built up wealth over their lifetime hold a substantial portfolio that may include stocks, bonds, private equity, hedge funds, rental property, artworks, etc. Owning these assets also means managing them actively, whether through trading, property oversight or art transactions. An individual with high-value assets requires assistance in actively preserving and monitoring the investment activity of all of their assets.
A common question arises: "Can I deduct the cost of hiring professionals, such as investment advisors, property managers, or accountants, to manage my personal portfolio?" An experienced tax professional might initially say no. But with the right facts and structure, the answer could be yes.
When are investment expenses deductible?
Tax deductions are only allowed when the law specifically permits them. Except as expressly allowed by the US Tax Code, no deduction shall be allowed for personal, living, or family expenses. However, Section 212 of the U.S. Tax Code (Code) does allow deductions that are considered ordinary and necessary expenses for producing income or managing income-generating property. These may include:
- Fees for services of investment counsel
- Custodial services
- Clerical support
- Office rent
and similar costs if they directly relate to managing investments that produce income.
These expenses fall under Section 67 of the Code, which, following the Supreme Court's Loper Bright decision, may be subject to new interpretation. Under recent legislation (H.R. 1), these types of expenses (including investment advisory fees) are no longer deductible.
However, with proper planning, there is still a way to treat these costs as business expenses, allowing them to be deducted against income.
What case law says about family office deductions
Case law has established that expenses incurred for merely managing and monitoring one's own investment does not constitute a trade or business and therefore categorizes those as 212 expenses. However, one case involved a different approach: a family office structured to operate more like a professional investment manager.
In this case, the individual served as the principal of an advisory entity that operated between 2010 and 2012, formed for the purpose of managing the wealth of several family members. The entity was structured similarly to a hedge fund manager. Multiple investment partnerships (LLCs) were formed, and each family member, including the manager, was a limited partner. These LLCs held various investments, including private equity, hedge funds, and publicly traded securities. The advisory entity owned between 0.40% and 8.26% of the LLCs, and the manager's indirect ownership ranged from approximately 3% to 10%.
How this family office operated like a business
The entity received both asset-based fees and a carried interest or performance fee, similar to typical hedge fund compensation structures. Asset-based fees were 2.5% of the net asset value of the LLCs, and performance fees were 25% of the net annual increase in value. Under the profit-based model, no fees were paid if there was no gain. Formal operating and service agreements were in place and agreed to by all parties. Family clients had the legal right to redeem capital from the LLCs on specific dates if dissatisfied with investment management.
All investment decisions were made by the advisory entity with the assistance of a third-party adviser, and the goal was to earn the highest possible return on assets. The entity also provided individualized investment advisory and financial planning services to each client.
The manager worked full-time in this capacity, receiving a guaranteed annual payment as the sole source of income. He referred to the LLC investors as clients, even though they were family members. While he worked from one office location, the entity's other employees, including the CFO, operated out of a separate office. The manager spent his time researching, pursuing investment opportunities, and overseeing existing investments—personally reviewing approximately 150 private equity and hedge fund proposals annually.
Based on the facts, the entity operated with regularity and continuity, earning fees for performing the duties necessary to maintain, preserve, and grow the investment portfolio. Although the manager invested some of his own capital, which is common in the industry, his compensation was tied to overall performance. His personal investment represented less than 10% of the total LLC value, and he stood to earn more through performance-based fees than through his own investment returns.
The entity entered into arms-length agreements, maintained formal operating structures, and treated the family members as clients. The tax court held that the entity was in the trade or business of providing investment advisory services to legitimate clients, despite the familial relationship. It was not considered an individual managing personal investments.
What makes a family office eligible for business expense deductions?
Operating a family office in a way that mirrors a hedge fund structure may allow for full deductibility of business expenses if it meets certain conditions. These include:
- Separating the investment vehicles from the investment manager entity
- Dealing with all family members' interests at arm's length, with formal agreements and substantial risk
- Charging both service and performance fees on all members' interests
- Performing all necessary duties diligently to maximize profits for those interests
- Operating the company as a legitimate, full-time business will yield full deductibility of the costs of running your family office business.
One important factor in the referenced case was that family assets had already passed outright to individual heirs. It also made a difference that family members were geographically dispersed, maintained separate careers and did not coordinate investment decisions. They "did not act collectively or with a single mindset" in managing their wealth. Ultimately, the advisory entity was treated as an independent adviser to the investment partnerships, making it a business relationship and not a personal one.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
