At a Glance
Under the Tax Cuts and Jobs Act (TCJA), deductions for investment-related expenses under Section 212 were severely limited, effectively eliminating deductibility for family offices that operate as passive investment vehicles. This change has persisted, and the OBBBA permanently extends the suspension of miscellaneous itemized deductions under Section 67(g), making the Section 212 ban permanent.
That cements a hard line in the tax code: family offices operating as passive investment vehicles will bear unrecoverable costs, while those structured as legitimate business enterprises may preserve millions in deductions.
For family offices, the difference between a disallowed expense and a fully deductible one often comes down to structure, documentation, and operational discipline. This article explains what the law requires, how courts and the IRS are applying it, and what steps family offices must take to protect deductibility and reduce audit exposure in a post-OBBBA environment.
Section 162 allows deductions for “ordinary and necessary” expenses incurred in carrying on a trade or business. For family offices, the challenge lies in demonstrating that their investment operations rise to the level of an active business, rather than passive investment management. The IRS and courts apply this standard strictly, particularly when structures appear designed primarily to achieve deductibility.
The 2017 case Lender Management, LLC v. Commissioner remains a leading decision in this area. The Tax Court allowed deductions under Section 162, but only after concluding that the family office was engaged in a bona fide trade or business. Key factors included full-time employees, formal governance, documented investment processes, and the management of capital for multiple family members with varying interests, essentially functioning as a profit-driven investment adviser, not just a personal office.
Since Lender, the IRS has increased scrutiny of family offices claiming trade or business status without comparable substance. Simply adopting the external features of a fund structure, such as management fees or entity layering, is not enough. Courts will evaluate the actual operations, risk-bearing, and independence of the management activity. Substance, not form, determines whether expenses qualify for deduction under Section 162.
One common and effective approach is the bifurcation of investment and management functions. This model borrows from private equity and hedge fund structures, where investment entities are separate from the management companies that oversee them.
In the family office context, the investment vehicles (LLCs, LPs, trusts) hold the family’s portfolio assets, while a separate management company—typically an LLC or S corporation—employs staff, leases office space, and provides administrative, research, and investment services. The management company charges an arm’s-length fee for these services, generating revenue and incurring expenses that may be treated as deductible trade or business expenses under Section 162, if properly structured.
To be respected, the management company must be more than a pass-through. It must operate as a bona fide business. That means it should:
Without these elements, the IRS may recharacterize the relationship as a disguised cost-sharing arrangement, disallowing deductions and potentially imposing penalties for misclassification or underreporting.
Trusts are a common feature in family office structures—not just for estate and generational planning, but also as an important tool in supporting operational separation and tax compliance. When implemented strategically, trusts can strengthen the economic and legal separation between the management company and the investment entities it serves, reinforcing the case for trade or business treatment under Section 162.
In many family offices, one or more trusts own the portfolio-holding entities, which in turn contract with a management company to oversee investment, administrative, and research services. This layering can help establish the arm’s-length relationship required by the IRS and courts when evaluating whether a management company operates as a bona fide business. However, the existence of trusts does not automatically create the necessary separation. Overlapping control, unclear fiduciary responsibilities, or informally documented arrangements can undermine the intended structure.
To be effective, trust planning must be fully integrated with the family office’s operational model. That includes:
Trusts also play a crucial role in aligning tax planning with succession and governance objectives. When combined with a well-structured management company and properly capitalized investment vehicles, trusts can help preserve deductions, limit liability, and support long-term continuity. But as with other elements of family office structuring, substance matters. Courts and the IRS will look beyond formal ownership to evaluate whether the entities operate independently, with appropriate documentation and governance in place.
Documentation is critical. Courts and the IRS look for formal governance, contemporaneous records, and independent operations. Key elements include:
Many family offices fail not for lack of effort but because their operations drift into informality over time. Preserving deductibility requires ongoing compliance, not just good intentions at formation.
Case in Point: Turning Investment Overhead into Business Deductions
Consider a family office incurring $3 million annually in investment-related expenses. Without the right structuring, these costs are non-deductible under Section 212. But by forming a management company that employs staff and performs genuine services for affiliated investment entities, those same expenses can become fully deductible.
If structured correctly, the management company earns $3 million in revenue (from service fees) and deducts the same amount in salaries, rent, technology, and professional services. At a 37% marginal rate, this generates more than $1.1 million in annual tax savings.
This is not merely a planning gimmick: it is a defensible structure grounded in economic substance and aligned with current law. However, failure to maintain appropriate documentation, pricing, or operational independence can undermine the entire strategy.
The One Big Beautiful Bill Act reshapes several areas of tax law relevant to family offices:
Even well-intentioned family office structures can fail under IRS scrutiny if they lack substance, separation, or consistent documentation. Audits often focus less on what was planned and more on what was actually done. Any lapses in execution can invalidate an otherwise sound structure.
Common failure points include:
Family offices should work closely with tax, legal, and operational advisors to ensure their structures remain durable and defensible. That means not just meeting the technical requirements at formation, but maintaining operational discipline year over year. Protecting deductions under Section 162 requires consistent effort, not one-time planning.
The passage of the One Big Beautiful Bill adds urgency to family office planning. While some tax provisions offer relief, the law continues to disallow deductions under Section 212, making Section 162 structuring the only viable path for recovering investment-related costs.
When implemented properly, this strategy converts nondeductible overhead into business deductions, while also supporting long-term operational efficiency and succession planning. Poor implementation, on the other hand, increases the risk of IRS challenge and disallowed deductions.
Sapowith Tax Advisory helps family offices navigate the intersection of tax law, entity design, and operational strategy. With deep experience in structuring management entities, documenting trade or business activity, and preparing for future legislative shifts, we help family offices protect today’s deductions and tomorrow’s flexibility.
Reach out to discuss structuring for your family office that preserves deductions and limits risk.
This article is for general information only; it is not tax, legal, or accounting advice. Reading it does not create a client relationship with Sapowith Tax Advisory. Consult your own qualified advisers before acting on any information contained here. Sapowith Tax Advisory disclaims all liability for actions taken, or not taken, based on this content.