THE LENDER BAGEL STRUCTURE: CAN YOU HARVEST THE TAX SAVINGS?

Single family offices should understand Lender Bagel structures and consider using them if they are not already. Knowledge of this structure has spread like wildfire since the landmark case, Lender Management LLC v. Comm’s. This article equips the reader with an understanding of the core principles of what Lender Bagel structures and how to investigate if it will help the family.

What Is It?

Lender Bagel structures (LBSs) are businesses owned by the family and in the trade or business of providing investment services to family investment vehicles. In short, it is a GP/Manager-like vehicle doing business only with the family.

The exclusive customer base and the active trade or business are the two things that distinguish an LBS from similar enterprises. If the enterprise does business with unrelated parties, it is not an LBS. A passive holder of investments, such as a family limited partnership, which does not provide services, is not an LBS. Finally, a single-family office is not an LBS even though it actively delivers services because the management of your own wealth is not a trade or business. (Higgins v. Commissioner)

When Should You Care?

When your single family office (i) delivers custom and competitive investment services that (ii) are quantitatively significant for tax deductions but (iii) are or will be denied utility because of the AMT calculationⁱ, a properly structured LBS will harvest those denied deductions. While an LBS has practical benefits, most families will not take on the additional complexity and cost unless they harvest significant tax savings. Many families have the facts and circumstances required to support the deductions but lack the proper structuring to claim the deductions. Investigating an LBS will earn those families a benefit they already deserve.

What Is the Catch?

The tax savings are available when the LBS is a trade or business under IRC 162 and a profits interest compensates the LBS. Both items are tough nuts to crack.

Regarding the latter, the family does not own the LBS equally, which means some family members derive more economic benefit from successful investment management. If the family is uncomfortable with this arrangement, does not trust each other, or no one is actively engaged in investment management, then the LBS will not work.

Regarding the former, you need to demonstrate that the investment activities performed by these parties rise to the level of a trade or business. This questions “why” you undertake the activities and warrants more discussion.

Although businessmen and businesswomen conduct business to earn profits, the presence of profit is not quality evidence of business intent because not all businesses are profitable. Indeed, some hobbies are profitable but, nevertheless, are engaged in by the taxpayer for a reason other than to earn a profit. Historically, soliciting customers is the clearest evidence of business intent, which is the difficulty for LBSs.

Soliciting customers is not the only evidence of business intent nor a necessary consequence of a profit motive. A company conducts a trade or business even when not expanding its customer base. Moreover, for smaller organizations, such as single family offices, gathering customers is distracting. Doing so compromises the quality of their core offering and, therefore, they refrain from soliciting new customers. Additionally, there are regulatory issues to consider. Finally, building a customer base is a unique skill set. Businesses desiring constant growth will hire those professionals but a business that does not desire growth will not hire those professionals, which results in a static customer base.

Notwithstanding the foregoing, even in the caseⁱⁱ that found an active trade or business when the only customers were family, the court essentially took notice that the social relationship between much of the family is more like strangers than family. What, then, can be done for families that retain close familial relationships? What external and objective facts illustrate a trade or business other than the presence of seemingly or actually unrelated customers?

Unfortunately, there is no clear answer, yet. Some providers strongly recommend making the LBS a C Corp because they expect the IRS to treat every C Corp as an active trade or business. While C Corps are consistently treated as a trade or business, the reason for this is not derived from the form of taxation. In general, C Corps are deemed a trade or business because they are only used by larger operating trades or businesses not because they are taxed as C Corps. If the LBS falls short of 162 eligibility because it does not conduct a trade or business taxation as a C Corp should not change that conclusion.

What Should You Do?

A potential net financial benefit is a precondition for most families. Start with your CPA to learn what tax savings are possible if you correctly structure your investment affairs. Although an LBS delivers meaningful, practical benefits, it will absorb fees and time. Determine what investment costs the family incurs that are not deducted but will be deducted by the LBS.

If an LBS will produce a net financial benefit, map out the structure to build expectations of and comfort with the required cash flow. Then, identify and document the competitive skills, services, or offerings that justify treatment as a trade or business under IRC 162.

We encourage families to operate the LBS like you would a PE management company by establishing a business plan, a budget, and a company policy regarding the customer base that evidences the non-tax reasons for conducting business primarily (or exclusively) with blood relations. Wisdom suggests you develop the facts and circumstances evidencing the tax position before undertaking the activity.

If the structure produces a net benefit, the facts justify treatment as a trade or business, and circumstances allow the family to implement the LBS, hire an attorney to prepare and implement the necessary entities and documents. The final and ongoing step is the administration of the LBS, which is generally performed by key family members with the assistance of attorneys and reported by the family’s CPA.

ⁱ IRC 212 and other itemized deductions are suspended by the 2017 Tax Cuts and Jobs Act but will return 1/1/2026.
ⁱⁱ See Lender Management

ABOUT WEALTHGATE TRUST

Wealthgate Trust is a client-founded, Nevada-based, multi-family boutique trust company. Born from the founder’s own experiences searching for an ideal trustee solution for his family, Wealthgate Trust partners with ultra high net worth families and their advisory team to create, implement, and administer bespoke trust strategies.

Wealthgate Trust is licensed and regulated by the Nevada Financial Insurance Division (NFID), and audited separately by the NFID and two national CPA firms.

ABOUT THE AUTHOR

Aaron is Wealthgate Trust Company’s Chief Fiduciary Officer and Wealth Strategist, assisting families and their advisors in developing, implementing, and properly administering unique estate planning strategies. He is an attorney licensed to practice in California and Nevada, with over a decade of trust administration, trust planning, and tax planning experience. He can be reached directly at 702.781.8015 or by email, aaron@wealthgatetrust.com.