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Exit Planning: Family Offices Need Solid Foundations

Authors: Stephanie Pindyck Costantino, P. Thao Le and Christopher T. Bird

May 2019
Exit Planning: Family Offices Need Solid Foundations

Private foundations can be attractive investment partners, but deals need to be structured with the exit in mind to avoid some tricky tax issues.

This article by Pepper Hamilton originally appeared in The Legal Special 2019 published by Private Equity International (PEI) in May 2019. It is republished here with permission.

This article was published in the July 25, 2019 edition of the Middle Market Growth Weekly newsletter, distributed by the Association for Corporate Growth (ACG).

Family office investment vehicles typically have a diverse pool of investors, both entities and individuals, each with their own unique attributes. Pooling these investors into a common investment vehicle takes advance planning for the exit, especially if private foundations are among the investors.

Private foundations are generally exempt from U.S. tax. But that statement is deceptively simple. Private foundations are subject to U.S. tax on income they derive from the conduct of a trade or business that is unrelated to their tax-exempt purpose. (And, for this purpose, any unrelated trade or business activities of a partnership, like a family office vehicle, are attributed to its tax-exempt partners.)

In addition, private foundations – and, in some cases, their managers – are subject to a litany of penalty taxes on investment income, self-dealing, the failure to distribute income, excess business holdings, jeopardising investments and taxable expenditures. In this article, we introduce topics such as self-dealing and excess business holdings in the context of making an investment in a family office vehicle so that practitioners are able to issue spot and obtain the right advice.

Investment Allocations

When an investment opportunity presents itself, a family office typically will make two allocation determinations: the right size of the opportunity for the family office as a whole and the correct allocation among the family members and entities of the family office. Factors include the size of the investment opportunity, the amount of the family office’s investable capital, the appropriateness of the investment for the family office and its affiliates, the potential hold period for the investment and the potential sources of revenue from the investment opportunity. Additional factors that may be considered when allocating to particular family investors include the domicile of the investor, type of investing entity and the investment mandate or restrictions of the investor.

Investing Through SPVs

An investment opportunity may be pursued by family office vehicles and family office organisations on a co-investment basis. In that case, a single investment vehicle – often referred to as a “special purpose vehicle” – will be formed to aggregate the funds of the family offices for the specific investment. The SPV is often structured as a flow-through entity for tax purposes, such as a limited  partnership or a limited liability company. However, SPVs are structured more frequently as limited partnerships because limited partnerships are more commonly recognised as a legal entity in most jurisdictions (U.S. and non-U.S.). Using co-investment structures (without an aggregator) facilitates use of corporate blockers.

The SPV allows a family office to aggregate investors’ funds, and the SPV, in turn, will make an aggregate investment in the form of debt, equity or any combination thereof. The SPV’s limited purpose is to hold the investment and do any ancillary things until the investment is liquidated.

The beneficial owners of the SPV only need to be disclosed in limited circumstances. For example, to a lender, or if there are “know your customer” requirements.

Some family offices may have an opportunity to invest in investment advisers and broker-dealers. Investment advisors (whether they are registered or exempt reporting advisors) and registered broker-dealers must disclose in a public filing all of their 5 percent owners and each 25 percent owner of any 5 percent owner. As a result, when structuring investments, some family offices may allocate an investment opportunity so that no investing entity or individual owns more than 25 percent of the SPV.

Terms of the SPV

SPVs are generally formed for a specific investment, but can also handle multiple investments. Here, we are focusing on an SPV formed to make a specific investment by investors from a single family office. When an SPV is formed for a specific investment, its terms are relatively simple:

Length of term: The SPV will have an indefinite term but will often have a provision that the SPV will be dissolved once all of its assets are sold and the underlying investment has been liquidated.

Economics: The SPV will often have some type of economic arrangement where the investing entities and individuals will pay for all of the expenses of the SPV (including any expenses relating to the SPV’s investment in the underlying investment and its sale or liquidation). If the SPV has any private foundations as investors, the ability to charge the foundation any management fees or performance fees will be subject to certain IRS self-dealing rules.

Withdrawal rights: Given the limited purpose of the SPV, it rarely provides withdrawal rights to investors without the approval of the SPV’s general partner.

Transfer rights: Even though the SPV is formed to invest the funds of family office vehicles (many, if not all, are related entities), the ability of the investors to transfer their interest in SPVs will be limited and subject to the consent of the general partner.

Since the SPV is formed to make an investment in the securities of an underlying issuer, each beneficial owner will need to be an “accredited investor” as defined in Regulation D of the Securities Act of 1933, as amended.

Private Foundations

Private foundations are subject to myriad penalty taxes on investment income, selfdealing, the failure to distribute income, excess business holdings, jeopardising investments and taxable expenditures. Here we focus only on self-dealing and excess business holdings rules which may impact a private foundation’s ability to participate in an investment.

Disqualified Persons

The discussions below on self-dealing and excess business holdings refer to a private foundation’s “disqualified persons.” This is a broad term and generally encompasses those who control and fund the foundation, and includes these individuals:

  • A “substantial contributor” to the foundation, ie, a person who has contributed or bequeathed more than $5,000 if that represents more than 2 percent of the total contributions and bequests received by the foundation since its creation. Once a person is considered a substantial contributor, that individual generally remains a substantial contributor even if the 2 percent threshold is subsequently no longer met. The person ceases to be a substantial contributor if that individual (and all related people) has not made any contributions to the foundation for 10 years, if that or any related individual was not a foundation manager at any time during that 10-year period, or if the total contributions made are determined by the IRS to be insignificant compared with the total contributions to the foundation by someone else.
  • A “manager” of the foundation, ie, an officer, director or trustee (or an individual having similar powers or responsibilities). In some cases, an employee can be considered a manager with respect to a particular act or failure to act if that employee has final authority or responsibility with respect to the act or failure to act.
  • An owner of more than 20 percent of the combined voting power of a corporation, the profits interest of a partnership, or the beneficial interest of a trust, any of which is a substantial contributor to the foundation.
  • A family member of a substantial contributor, manager or 20 percent owner as described above.
  • A corporation of which more than 35 percent of the total combined voting power is owned by substantial contributors, managers, 20 percent owners or family members.
  • A partnership of which more than 35 percent of the profits interest is owned by substantial contributors, managers, 20 percent owners or family members.
  • A trust, estate or unincorporated enterprise of which more than 35 percent of the beneficial interest is owned by substantial contributors, managers, 20 percent owners or family members.
  • For purposes of excess business holding rules, another private foundation that either (a) is effectively controlled by the same person or persons who control the private foundation in question or (b) received substantially all of its contributions from the same substantial contributors, managers, 20 percent owners or family members who made substantially all the contributions to the private foundation in question. For this purpose, “substantially all” means at least 85 percent.
  • For purposes of the self-dealing rules, certain individuals who at the time of the self-dealing hold certain elected or appointed offices at the federal or state level and acted knowingly.

Given the broad definition of disqualified persons, family offices must be very careful in determining whether a prospective investment and the SPV for such an investment is appropriate for the private foundation and whether it would constitute a prohibited transaction. A transaction between a private foundation and a disqualified person is subject to self-dealing rules which, if violated, could have significant consequences.

Self-Dealing

Generally, all direct and indirect financial transactions between a private foundation and its disqualified persons are subject to an excise tax. There are six categories of self-dealing: (1) sale, exchange or leasing of property; (2) lending money or other extension of credit; (3) furnishing goods, services or facilities; (4) payment of compensation (or payment or reimbursement of expenses); (5) transfer to, or use by or for the benefit of, a disqualified person of any income or assets of the foundation; and (6) agreement to pay a government official. Each of these categories is subject to exceptions.

If a private foundation and a disqualified person engage in an act of self-dealing, then the disqualified individual (other than a foundation manager acting only in this capacity) will be subject to an excise tax equal to 10 percent of the amount involved for each year (or part of a year) in the “taxable period”, ie, the period beginning with the date on which the act of self-dealing occurred and ending on the earliest of either the date of mailing of a notice of deficiency with respect to the initial tax, the date on which the tax is assessed, or the date on which correction of the act of self-dealing is completed. A foundation manager who knowingly participates in the self-dealing will also be subject to an excise tax equal to 5 percent of the amount involved for each year (or part of a year) in the same taxable period, unless the manager’s participation is not wilful and is due to reasonable cause.

If the initial taxes are imposed and the act of self-dealing is not corrected, then the disqualified person will be subject to an additional excise tax of 200 percent of the amount involved, and a manager who refuses to agree to the correction will be subject to an excise tax of 50 percent of the amount involved. A foundation that repeatedly and wilfully engages in self-dealing could lose its tax-exempt status and be required to repay all the tax benefits that the foundation and its contributors have received, which could represent all its remaining assets.

The restrictions on self-dealing can impact family offices with private foundation investors in several ways. For example, a private foundation generally cannot compensate (or pay or reimburse the expenses of) a disqualified person. But a private foundation can compensate a disqualified person for “personal services” that are reasonable and necessary to carry out the foundation’s exempt purposes, provided the compensation is reasonable. Thus, a private foundation can pay reasonable investment management fees and carried interest to a foundation manager or other disqualified person.

As another example, a disqualified person cannot benefit more than incidentally from the use of private foundation assets. Thus, if a private foundation and a disqualified person invested in the same fund, it would be an act of self-dealing for the disqualified person to “piggyback” on the foundation’s contribution to meet a minimum investment requirement. However, the converse is allowed – a private foundation may benefit from using a disqualified person’s investment.

As a final example, a private foundation cannot pay rent for office space owned by a disqualified person – even below-market rent. However, if a private foundation leases office space from a disqualified person and pays no rent, the foundation can pay its fair share of utilities and other related expenses, provided that the payment for these expenses is not made directly or indirectly to the disqualified person. And a private foundation and a disqualified person can share office space owned by an unrelated person, but the foundation and disqualified person should have separate leases and pay rent directly to the landlord.


Pre-Deal Precaution

If a family office is planning to allocate an investment opportunity, and one of the investors is a private foundation, it is important to look at the structure from the bottom to the top before the investment is made. Practitioners must:

  • Look at both the pre-investment and postinvestment ownership of the various layers (assuming the ultimate investment has multiple investment layers) and ascertain both the economic and governance control.
  • Consider the relationship of the parties receiving and paying any fees. 
  • Be prepared to give the allocation to a different investing entity within the family office if the transaction runs afoul of the rules governing the private foundation.

Excess Business Holdings

Private foundations generally are prohibited from controlling a “business enterprise,” either alone or together with their disqualified persons. Thus, if a private foundation and all its disqualified persons collectively own more than 20 percent of the interests of a for-profit business (or 35 percent if the business is effectively controlled by persons other than the private foundation and its disqualified persons), then the foundation will be subject to an excise tax equal to 10 percent of the value of the foundation’s interest above the 20 percent (or 35 percent) threshold for each year (or part of a year) in the “taxable period.”

For this purpose, “taxable period” means the period beginning with the date on which there are excess holdings and ending on the earliest of (1) the date of mailing of a notice of deficiency with respect to the initial tax, (2) the date on which the initial tax is assessed, or (3) the date on which the excess holding is eliminated. In addition, if the initial tax is imposed and the excess holding is not eliminated within a timely period, then the private foundation will be subject to an additional excise tax equal to 200 percent of the value of the foundation’s interest above the 20 percent threshold.

The above rules on excess business holdings are subject to several important caveats. For example, if a private foundation and its disqualified persons do not collectively own more than 20 percent of the voting interests in the business (or 35 percent if the business is effectively controlled by third persons), then the foundation may own any amount of the non-voting interests in the business. (In the case of a business organised as a partnership, a “profits interest” is considered a voting interest, and a “capital interest” is considered a non-voting interest, which is not always easy to differentiate.) In addition, the above rules do not apply if a foundation and its related foundations do not own more than two percent of a business. Moreover, the IRS has the discretionary authority to abate the initial tax when the private foundation establishes that the violation was due to reasonable cause (and not to wilful neglect) and timely corrects the violation.

While family offices and their private foundation investors need to be cognisant of the excess business holding rules with respect to underlying investments, a business enterprise that earns at least 95 percent of its gross income from passive sources is not subject to the excess business holdings rules. Thus, a typical investment partnership (or a typical “blocker” corporation) should not be a business enterprise. In fact, the IRS has held that an investment partnership is not subject to the excess business holdings rule even if less than 95 percent of the investment partnership’s income constitutes passive income.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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