The value of a family office is derived by simplifying and streamlining wealth management by placing legal, accounting, tax, and investment management under one roof. Creating efficiencies after the new Tax Cut and Jobs Act (TCJA) went into effect in late 2018 you will need the coordination of your full advisory team.
While high net worth individuals did not get all they asked for in the new tax reforms, the changes are mostly favorable. There are many tax efficiencies to be reaped from the new rules, but there is also more complexity. As these changes will affect each member of a family differently, if you are not already part of a family office, this is the time to seriously consider engaging with one. Taxes are one of the most significant drivers of your financial behavior, and these tax reforms are destined to change the dynamics within your financial life.
These sweeping tax changes could affect your charitable giving, estate wealth transfer timing, real estate purchases and sales, business asset purchases and disposals, and many more financial decisions. Keep in mind that the new tax rules are set to revert in 2026. You should carefully consider the following tax changes and how you might restructure your financial planning in light of them to lighten your tax burden.
Family Offices, New Tax Deductions, and the TCJA Tax Rules
The new tax rules have significant implications for wealthy individuals under a family office structure. Especially when considered alongside a recent tax court ruling deeming family offices to be businesses for expense deduction purposes. The case of Lender Management merits a brief overview because it affects the treatment of some of the new tax rules presented below. The IRS did not consider Lender Management—a family office acting as the sole financial planning advisor to three LLCs. Owned by members of the Lender’s frozen-bagel empire. A business eligible to take around $1 million in business deductions each year under Section 162 of the Tax Code. Uncle Sam lost the case and, under TCJA, family offices are even bigger winners.
Lender Management can now deduct expenses related to salaries and wages, rent and depreciation, incurred while engaging in profit-oriented activities and on miscellaneous income. Relatedly, under a trade or business structure (see the Family Office section below), expenses formerly not deductible may be deductible by family members against taxable income. Similarly, the family office advisory fees no longer deductible under TCJA are allowable miscellaneous deductions, according to the Lender ruling. Following is a review of the TCJA tax rules and how they affect high net worth individuals and family offices.
Business and Real Estate Taxes
If you are a sole proprietor, LLC, or S corporation—and therefore taxed directly on the prospects and losses of a business—you can benefit from a new 20 percent reduction in pass-through income on qualified business income (QBI). Pass-through deductions bypass the business entity and tax the owner. The deduction does not apply to investment income (from family office investments, for example) or C-corporations.
If your income exceeds $147,500 for an individual or $315,000 for a married couple, the pass-through deduction cannot exceed:
- 50 percent of W-2 wages paid by the pass-through entity to its workforce
- 25 percent of your W-2 wages paid by the pass-through entity, plus 2.5 percent of unadjusted qualified property.
The family office advisor, however, as one involved in a specified service or trade business that provides legal, accounting, or tax services, would not qualify for the pass-through income deduction. The amount of a business loss applicable in a given year is limited to $250,000 for an individual filer and $500,000 for a married couple. The loss can be carried forward as a net operating loss provision.
How family offices cover expenses could affect family members on a pass-through basis. Expenses could be covered by income earned by the family holding company or passed through to the family members. Here, too, the designation of the family office as a trade or business under Section 162 could have tax implications.
Bonus Depreciation Allowance
Another benefit for business owners is a 100% bonus depreciation allowance on the purchase of business assets, which amounts to double the previous 50 percent. In 2023, this bonus will be reduced by 20 percent each year. Real estate LLCs are expected to be one of the big winners.
Businesses with gross revenues of $25 million can deduct a net interest expense of 30 percent of earnings before interest, taxes, depreciation, and amortization.
Personal Income Tax
State and income taxes are now capped at $10,000 per year. This limit applies to income, property, and sales taxes. Take the cap into consideration when, for example, buying real estate in states with high taxes. The states with the highest income tax are New Jersey, New York, Connecticut, Maryland, Oregon and California, according to the Tax Foundation.
Income Tax Rate Reductions
If your income is over $500,000 and you are filing individually or $600,000 if married and filing jointly, your tax rate drops from 39.6 percent to 37 percent. See the table below for other income brackets.
Other Deduction Changes
Further income deduction changes are as follows:
- The standard deduction has doubled to $12,000 for individuals and $24,000 for married couples.
- However, the personal exemption deduction of $4,150 for the tax filer, spouse, and independents has been eliminated.
- State and local tax deductions are no longer unlimited but capped at $100,000.
- Mortgage interest can be deducted on the first $750,000 on primary and secondary residences, up to two residences.
The deduction is $1 million on previously purchased residences and applied to any real estate debt incurred before December 15, 2017. Mortgage interest paid can now only be deducted if it the debt was incurred to buy, build, or make substantial improvements to the home.
Tax changes to estate, gifts, and trusts provide an incentive to restructure your wealth transfer plans. New exclusion limits could automatically change the terms specified by your estate plans, and therefore a review of all documents is a prudent step.
Lifetime Gift Exclusion
Until 2026, you can benefit from a doubling of the lifetime exclusion by gifting a portion of your estate before then. You can transfer $11.2 million or $22.4 million for a couple without federal tax penalty. The generation-skipping transfer (GST)—whereby state and gift taxes skip a generation and transfer to the next successive generation—also benefits from this exclusion.
Annual Exclusion for Gifts
The annual exclusion for gift tax has increased $1,000 to $15,000.
The investment and asset management fees paid to your family office advisors are no longer deductible under Miscellaneous Itemized Deductions. However, by classifying them as a trade or business expense, these family office expenses could still be deductible. This is a positive outcome of the Lender Management case. To determine whether your family office qualifies as a trade or business, the Lender ruling established six criteria as follows under Section 162. The family office:
- conducts business with continuity and regularity for the purpose of making a profit
- has different ownership and control from the ownership of the family holding companies
- allows the family holding company or family members to make decisions on firings, replacements, service level reductions, and compensation
- engages qualified service providers who can provide services to non-family members
- is compensated separately from and in addition to what it would achieve as a normal investment return on its assets
- has an obligation to provide services to family holding companies and family members
When donating to qualified charities, your cash contributions can now benefit from an adjusted gross income limitation of 60 percent under the new law, an increase from 50 percent. These contributions must be itemized. Though with a reduction in income tax rates, your charitable giving will cost you more. Under the previous tax regime, for income above $500,000, a $10,000 donation would have cost $6,040 (at a tax rate of 39.6 percent). Under TCJA, that same donation will cost $6,300 (at the new tax rate of 37 percent).
Consequently, you may consider reducing your charitable giving, but there are other alternatives. A charitable remainder trust, for instance, would allow you to bequeath trust assets as a gift during your lifetime, which could take advantage of the doubling of the Lifetime Gift Exclusion. Consult your advisors on other ways to make charitable donations under the new tax regime.
These TCJA tax changes should be considered together with the tax implications of the Lender Management ruling.
FBO Services—Harmonizing Complex Tax Changes With Your Financial Life Through a Family Office
The recent tax overhaul is the most sweeping since 1986 and introduces even more complexities for high net worth individuals. As this review reveals, the tax changes will affect your entire financial life–from real estate buying to estate planning.
There is no better time to streamline your family’s financial affairs through a family office structure. Wealth management has embraced family offices because they provide highly customized tax, wealth, and financial solutions that deliver superior results. The potential for additional tax efficiencies from the more favorable tax treatment of family offices as a trade or business resulting from the Lender Management ruling would be foolhardy to pass up.
The wealth management team at FBO Services has the multidisciplinary reach to preserve and grow your family’s wealth now and over future generations. We hand pick our best talent among our highly qualified experts. Spanning tax consultancies, corporate law, estate law, accounting, business administration, personnel management, wealth management to meet your financial planning needs. From the first time your FBO team sits down with you, you will appreciate how our expertise-driven, concentrated approach ensures your assets are working harder for you.
The new tax regime is here today. The earlier you synthesize these tax changes into your financial life, the sooner you will benefit from significant tax savings. To ensure these tax efficiencies are realized, sit down with the legal and financial advisory team at FBO Services and review your tax strategy and restructuring options over the coming months and years.