Lender Management, LLC, Marvin K. Lender Revocable Trust, Tax Matters Partner v. Commissioner , 2017 T.C. Memo. 246 ( 2017 )

T.C. Memo. 2017-246UNITED STATES TAX COURT
LENDER MANAGEMENT, LLC, MARVIN K. LENDER REVOCABLE
TRUST, TAX MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
LENDER MANAGEMENT, LLC, KEITH F. LENDER REVOCABLE TRUST,
TAX MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 25617-15, 25618-15. Filed December 13, 2017.
David D. Aughtry, Patrick J. McCann, Jr., and John W. Hackney, for
petitioners.
Christopher D. Bradley, David Delduco, and John W. Sheffield, III, for
respondent.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
KERRIGAN, Judge: Petitioners in these consolidated cases are Marvin K.
Lender Revocable Trust (Marvin Lender Trust) and Keith F. Lender Revocable
Trust (Keith Lender Trust). On July 9, 2015, respondent issued notices of final
partnership administrative adjustment (FPAAs) to Marvin Lender Trust as tax
matters partner for Lender Management, LLC (Lender Management), for tax year
2010 and to Keith Lender Trust as tax matters partner for Lender Management for
tax years 2011 and 2012. In the FPAAs respondent disallowed deductions
claimed pursuant to section 162 and instead allowed the deductions pursuant to
section 212, reflecting respondent’s determination that Lender Management was
not engaged in carrying on a trade or business.
The sole issue for consideration is whether Lender Management carried on a
trade or business within the meaning of section 162 during tax years 2010-12 (tax
years in issue). All section references are to the Internal Revenue Code (Code) in
effect for the tax years in issue, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
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[*3] FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated facts are
incorporated in our findings by this reference. At the time the petitions were filed,
Lender Management’s principal place of business was in Connecticut.
Lender Management is a limited liability company formed under the laws of
the State of Connecticut. It operates as a fund manager and has been in
continuous operation for 25 years. Lender Management elected to be treated as a
partnership for Federal income tax purposes.
I. The Lender Family
Harry Lender (Harry) founded the company that became Lender’s Bagels.
Harry’s sons Marvin Lender (Marvin) and Murray Lender (Murray)1 worked
together with their father and after his death for many years managing Lender’s
Bagels. Harry had three other children that survived to adulthood, and only the
families of Marvin and Murray participated in the partnerships that Lender
Management managed. Keith Lender (Keith), Sondra Lender, and Heidi Lender
are the children of Marvin and his wife Helaine Lender (Helaine). M.L., J.L.,
1
Murray was deceased at the time of trial.
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[*4] D.L., and E.L. are grandchildren of Marvin and Helaine.2 Carl Lender (Carl),
Jay Lender, and Haris Lender are the children of Murray. A.L., R.L., J.R., O.R.L.,
D.L.C., and C.L. are Murray’s grandchildren.
During the tax years in issue Marvin had a residence in Naples, Florida.
The children and grandchildren of Marvin and Murray resided in different States
and some lived outside the United States. Carl resided and worked full time for a
cable communications company in Fort Lauderdale, Florida. Other children of
Marvin and Murray lived in California and South America. The children of
Marvin and Murray all had careers. One of Marvin’s grandchildren lives in Israel.
Marvin’s grandchildren and Murray’s grandchildren are rarely in contact with one
another.
Numerous divorces among Lender family members created tension. Around
2000 Murray divorced his wife, and the divorce affected the financial affairs of
Murray’s branch of the family. Murray’s ex-wife’s taking her share of financial
assets resulted in Murray’s family’s having fewer assets under management with
Lender Management than Marvin’s family.
2
The Court refers to minor children by their initials. See Rule 27(a)(3).
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[*5] II. Lender Management
Initial ownership of Lender Management was vested in two revocable trusts:
Marvin Lender Trust and Helaine G. Lender Revocable Trust (Helaine Lender
Trust). Until December 23, 2010, Helaine Lender Trust owned a 1% interest in
Lender Management and Marvin Lender Trust owned a 99% interest. Marvin,
through Marvin Lender Trust, acted as managing member of Lender Management
until December 23, 2010.
On December 23, 2010, Keith Lender Trust acquired by assignment a 99%
interest in Lender Management and held that interest through December 31, 2012.
After December 23, 2010, and through December 31, 2012, Marvin Lender Trust
owned the remaining 1% interest. After December 23, 2010, Keith, through Keith
Lender Trust, acted as Lender Management’s managing member.
Lender Management reported net losses of $462,505 and $307,760 for tax
years 2010 and 2011, respectively. It reported net income of $376,238 and
$808,302 for tax years 2012 and 2013, respectively.
A. Investment LLCs
During the tax years in issue Lender Management provided direct
management services to three limited liability companies: Murray & Marvin
Lender Investments, LLC (M&M), Lenco Investments, LLC (Lenco), and Lotis
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[*6] Equity, LLC (Lotis) (collectively, investment LLCs). Each of the investment
LLCs elected to be treated as a partnership for Federal income tax purposes.
Lender Management directed the investment and management of assets held by
the investment LLCs for the benefit of their owners. The end-level owners with
respect to M&M, Lenco, and Lotis were, in each case, all children, grandchildren,
or great-grandchildren of Harry.
The following tables show the members of M&M and Lenco, and their
respective interests, as of December 31 for each of the tax years in issue.3
M&M
Member Yearend 2010 Yearend 2011 Yearend 2012
Marvin Lender Family, LLC 89.22% 87.07% 84.02%
Murray Lender Family, LLC 8.79 6.19 5.60
Marvin Lender 1990
Irrevocable Trust 1.59 1.87 2.12
Lender Management 0.40 4.87 8.26
Total 100.00 100.00 100.00
3
All ownership percentages have been rounded.
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[*7] Lenco
Member Yearend 2010 Yearend 2011 Yearend 2012
Marvin Lender Family, LLC 33.78% 32.51% 32.47%
Murray Lender Family, LLC 47.85 48.07 46.58
Marvin Lender 1990
Irrevocable Trust 10.01 10.40 10.63
Murray Lender 1990
Irrevocable Trust 3.75 3.89 3.98
Lender Management 4.60 5.13 6.34
Total 100.00 100.00 100.00
As of and for some time after December 31, 2009, the members of Lotis
were Marvin Lender Family, LLC, Murray Lender Family, LLC, Marvin Lender
1990 Irrevocable Trust, Murray Lender 1990 Irrevocable Trust, and Lender
Management. In 2010 Lotis merged with Lenco, with Lenco as the surviving
entity.
The members of Marvin Lender Family, LLC, and Murray Lender Family,
LLC, were the following individuals and trusts:
Marvin Lender Family, LLC
Member Yearend 2010 Yearend 2011 Yearend 2012
Keith 11.67% 11.72% 10.58%
Sondra Lender 17.54 17.49 17.17
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[*8] Heidi Lender 14.11 14.46 14.48
Marvin Lender
Revocable Trust
Under Agreement (U/A) 4.32 0.78 0.82
Helaine Lender Trust 21.69 22.16 20.30
Marvin & Helaine Lender
Children Grantor Trust 24.64 25.35 26.92
M.L. 2006 Irrevocable
Trust 4.33 4.69 4.86
J.L. Irrevocable Trust 1.38 1.48 1.56
D.L. Irrevocable Trust 0.32 1.88 1.97
E.L. Irrevocable Trust --- --- 1.34
Totals 100.00 100.00 100.00
Murray Lender Family, LLC
Member Yearend 2010 Yearend 2011 Yearend 2012
Carl 6.75% 11.72% 4.69%
Jay Lender 19.59 17.49 16.85
Haris Lender 9.01 8.65 7.20
Murray Lender
Revocable Trust 7.69 --- ---
Murray Lender Family
Irrevocable Trust U/A
Dated April 1, 2003 29.63 30.66 32.45
A.L. Irrevocable Trust 5.75 7.00 7.61
R.L. Irrevocable Trust
U/A 4.85 6.00 6.62
J.R. Irrevocable Trust
U/A 4.94 6.10 7.01
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[*9]
O.R.L. Irrevocable Trust 4.21 5.29 6.15
D.L.C. Irrevocable Trust 5.56 6.80 7.83
C.L. 2007 Irrevocable
Trust 2.03 2.87 3.59
Totals 100.00 100.00 100.00
Marvin owned indirectly interests in the investment LLCs during the tax
years in issue, and Keith owned indirectly interests in the investment LLCs during
the years that he served as managing member of Lender Management. Through
his interests in Marvin Lender Family, LLC, and Marvin Lender 1990 Irrevocable
Trust during the tax years in issue Marvin held combined interests in Lenco of
11.47%, 10.65%, and 10.90%, respectively. Through the same entities he held
interests in M&M of 5.44%, 2.55%, and 2.81%, respectively, during the tax years
in issue. Keith was a member of Marvin Lender Family, LLC. During each of the
tax years in issue Keith owned indirectly less than 4% of Lenco and 10% of
M&M.
1. Structure and Purpose
The investment LLCs were created in 2005 as part of a reorganization of
Lender Management. The goals of the 2005 reorganization were to accommodate
greater diversification of the managed investments and more flexible asset
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[*10] allocation at the individual investor level. As part of the restructuring
Lender Management shifted from a cost-based office model to a profit-based
model.
Lender Management engaged a hedge fund specialist to help it restructure
its affairs and its managed portfolio using a hedge fund, or “fund of funds”,
manager model. Pursuant to the restructuring strategy, Lender Management
divided its managed portfolio into the three investment LLCs, each formed for the
purpose of holding investments in a different class of assets. M&M invested in
private equities, Lenco in hedge funds, and Lotis in public equities.4 From 2005
forward, over one-half of the assets under management were invested in private
equity.
2. Operating Agreements
Lender Management’s operating agreement permitted it, without limitation,
to engage in the business of managing the “Lender Family Office” and to provide
management services to Lender family members, related entities, and “other third-
party nonfamily members.” The operating agreements for the investment LLCs
designated Lender Management as the sole manager for each entity. Lender
4
Lotis merged into Lenco in 2010 because Lender Management determined
that Lenco’s hedge fund investments held enough public equities to meet the
company’s asset diversification goals.
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[*11] Management held the exclusive rights to direct the business and affairs of
the investment LLCs.
Lender Management also managed downstream entities in which M&M
held a controlling interest. Investors in some of these downstream entities
included persons who were not members of the Lender family. It received fees for
managing these entities. For the tax years in issue between 12% and 15% of
M&M’s net investment portfolio consisted of these downstream entities.
Members understood that they could withdraw their investments in the
investment LLCs at any time, subject to liquidity constraints, if they became
dissatisfied with how the investments were being managed. The operating
agreements for Lenco and Lotis provided that members could withdraw all or a
portion of their capital accounts on specified dates of each year or on any other
date approved by the manager. The operating agreement for M&M provided that
members could withdraw all or a portion of their capital accounts with the consent
of the manager in the exercise of the manager’s discretion.
B. Compensation
Lender Management received a profits interest in each of the investment
LLCs in exchange for the services it provided to the investment LLCs and their
members. These profits interests were designated “Class A” interests under the
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[*12] operating agreements for the investment LLCs. The class A interests were
structured concurrent with Lender Management’s reorganization and its shift to a
profit-based office model.
Under the initial terms of the operating agreements, effective August 1,
2005, Lender Management was entitled to receive for its class A interests the
following percentages: (1) from Lenco, 1% of net asset value annually, plus 5%
of any increase in net asset value from the prior fiscal period; (2) from M&M, 5%
of gross receipts annually, plus 2% of any increase in net asset value from the
prior fiscal period; and (3) from Lotis, 2% of net asset value annually, plus 5% of
net trading profits.5 Lender Management received income from the class A
interests only to the extent that the investment LLCs generated profits. Net asset
value was defined as the amount by which the fair market value of the investment
LLC’s assets exceeded its liabilities.
As of December 31, 2010, the operating agreements for M&M and Lenco
were amended to provide Lender Management with increased profits interests.
The class A interests for M&M and Lenco were increased to equal the aggregate
of 2.5% of net asset value, plus 25% of the increase in net asset value, annually.
5
For Lotis, class A interests were entitled to a share of the adjusted profit as
defined in the operating agreement.
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[*13] Similar to the initial terms of the operating agreements, Lender Management
received payments for its class A interests only to the extent that M&M and Lenco
generated net profits. The increased profits interests were intended to more
closely align Lender Management’s goal of maximizing profits with that of its
clients and to create greater incentive for Lender Management and its employees
to perform successfully as managers of the invested portfolios. During the tax
years in issue any payments that Lender Management earned from its profits
interests were to be paid separately from the payments that it would otherwise
receive as a minority member of each of the investment LLCs.
C. Lender Management Services
During the tax years in issue Lender Management made investment
decisions and executed transactions on behalf of the investment LLCs. It operated
for the purpose of earning a profit, and its main objective was to earn the highest
possible return on assets under management. Lender Management provided
individual investors in the investment LLCs with one-on-one investment advisory
and financial planning services.
Lender Management employed five employees during each of the tax years
in issue. It had a total payroll for its employees of $333,200, $311,233, and
$390,554 during the tax years in issue, respectively. For tax year 2011 the payroll
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[*14] included a $123,249 guaranteed payment to Keith. For tax year 2012 the
payroll included a $206,417 guaranteed payment to Keith.
1. Role of Keith
Keith was Lender Management’s chief investment officer (CIO) during the
tax years in issue, and in 2012 he became president. Keith has an undergraduate
business degree from Cornell University and a master’s degree in business
administration (M.B.A.) from the Kellogg School of Management at Northwestern
University. After obtaining his M.B.A. he worked for several years in marketing
and brand management for major corporations. After joining Lender Management
he took continuing education classes in finance and market theory at New York
University and classes at Wharton Graduate School of Business.
Keith joined Lender Management full time in 2005 and participated in its
reorganization. Beginning early in his business career Keith frequently discussed
with Marvin how he could become involved in Lender Management’s activities.
During the tax years in issue Keith worked approximately 50 hours per week for
Lender Management, which included time spent working in the evenings and on
weekends.6
6
During the tax years in issue Keith taught one business class at a private
high school, which met less than weekly.
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[*15] Keith referred to the members of the investment LLCs as the clients of
Lender Management. Lender Management’s clients all had jobs and worked, and
Keith had to be available to communicate with them during nonbusiness hours.
Mostly he worked out of Lender Management’s rented office space in New Jersey.
These offices were rented so that Keith could work close to outside consultants.
Before becoming Lender Management’s managing member in 2010, Keith
received wages for his services. Starting in 2011 he received a guaranteed
payment.
As CIO, Keith retained the ultimate authority to make all investment
decisions on behalf of Lender Management and the investment LLCs. Most of his
time was dedicated to researching and pursuing new investment opportunities and
monitoring and managing existing positions. For example, he discovered a
company in Israel, and Lender Management owned an interest in and participated
in the management of this company.
He reviewed personally approximately 150 private equity and hedge fund
proposals per year on behalf of the investment LLCs. He met with and attended
presentations of hedge fund managers, private equity managers, and investment
bankers. Lender Management is not an active trader, but in a typical year the firm
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[*16] would enter into multiple new private equity deals and make one or two
hedge fund trades.
Lender Management arranged annual business meetings, which were for all
clients in the investment LLCs. These group meetings were held so that Lender
Management could review face-to-face with all of its clients the performance of
their investments at least once per year. The location of the annual meeting
changed each year so that no single investor was repeatedly inconvenienced by
having to travel a long distance. Because of conflicts Keith had difficulty getting
all of Lender Management’s clients to attend these meetings. He would conduct
additional face-to-face meetings with clients who were more interested in the
status of their financial investments at times and locations that were convenient for
them.
Keith interacted directly with Lender Management’s clients. He collected
information from and worked with these individuals to understand their cashflow
needs and their risk tolerances for investment, and Lender Management engaged
in asset allocation based on these and other factors. Lender Management devised
and implemented special ventures known as eligible investment options (EIOs),
which allowed clients to participate in investments more directly suited to their
age and risk tolerance. Keith developed and maintained a number of computer
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[*17] models, including a model that projected the cash needs of individual
investors and a model that tracked and forecasted the cashflows associated with
M&M’s private equity investments.
2. Chief Financial Officer
Lona Flament served as Lender Management’s chief financial officer, chief
operating officer, and controller during the tax years in issue. She is not related to
the Lender family. She worked full time, primarily out of the office in
Woodbridge, Connecticut (Woodbridge). At the Woodbridge office Lender
Management also employed a full-time office manager and, at certain times, other
part-time workers.
Ms. Flament worked closely with Keith. During the tax years in issue they
spoke over the phone three or four times per day and exchanged between 10 and
50 emails per day. They worked from the same office at least one day per week.
Ms. Flament attended manager meetings for investments and assisted Keith in
reviewing and making decisions about new investment opportunities.
One of Ms. Flament’s primary duties was to oversee daily cash
management. She actively monitored the status of current investments to
determine how much cash Lender Management had available, and she had
authority to move cash on behalf of Lender Management and the investment
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[*18] LLCs. She was involved in the process of communicating with individual
clients and forecasting their cash needs for the near future. Close monitoring of
cash positions was critical to meeting the needs of clients and to covering capital
calls that arose in connection with private equity investments.
Lender Management managed M&M’s and Lenco’s revolving lines of credit
during the tax years in issue. As part of her cash management duties, Ms. Flament
would secure necessary capital call funds from these lines of credit. To obtain the
lines of credit, Lender Management had to produce and provide to creditors
extensive financial and other documentation regarding the investment LLCs and
their assets. The lines of credit were collateralized by the investment LLCs’
private equity investments. To draw down on and keep open the lines of credit for
the investment LLCs, Lender Management was required to provide updated
financial information to creditors at least monthly. Ms. Flament prepared monthly,
quarterly, and annual reports regarding the lines of credit.
3. Pathstone
Lender Management interviewed accounting and investment firms to
provide outsourced management services beginning in 2006. It hired Harris
myCFO, a division of Harris Bank, which provided both accounting and
investment advice. In 2010 two of the principals of Harris myCFO formed their
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[*19] own firm, Pathstone Family Office, LLC (Pathstone), and Lender
Management engaged Pathstone on May 6, 2010.7 During the tax years in issue
Pathstone provided Lender Management with accounting and investment advisory
services.
Pathstone’s accounting professionals were based in Atlanta, Georgia. Ms.
Flament spoke with the accounting professionals over the phone between three
and five times per week, and they exchanged between 50 and 100 emails per week.
During the tax years in issue Pathstone prepared Lender Management’s
partnership tax returns. Pathstone also prepared quarterly financial reports for the
investment LLCs.
Keith worked at the same office buildings as Pathstone’s investment
professionals in Englewood Cliffs, and later Fort Lee, New Jersey. He
collaborated with Pathstone’s principal investment adviser in selecting new
investments for the investment LLCs. He presented Pathstone’s advisers with his
own research on investment opportunities, and he often received their advice
7
Lender Management began the process of terminating its relationship with
Harris myCFO in 2009 in anticipation of its move to Pathstone. When discussing
outsourced management services received by Lender Management during the tax
years in issue we refer hereinafter to Pathstone, although the record is unclear as to
whether Lender Management still engaged Harris myCFO in the early months of
2010.
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[*20] before acting on prospective deals. Pathstone’s advisers also presented him
with investment opportunities. Keith exercised ultimate authority over the
investment LLCs’ investments and did not always follow Pathstone’s advice.
Pathstone did not have the authority to move cash on behalf of Lender
Management or the investment LLCs.
III. Lender Management’s Tax Returns
Lender Management reported ordinary business losses for the tax years in
issue. For each of the tax years in issue it claimed deductions for business
expenses pursuant to section 162. It claimed deductions for salaries and wages,
repairs and maintenance, rent, taxes and licenses, depreciation, retirement plans,
employee benefit programs, and other deductions. For 2011 and 2012 it claimed
deductions for guaranteed payments to partners. Lender Management’s total
claimed business expense deductions for the tax years in issue were $1,141,548,
$1,115,893, and $1,184,620, respectively.
Respondent issued two FPAAs: one for tax year 2010 and the other for tax
years 2011 and 2012. Both FPAAs disallowed the business expense deductions
that Lender Management claimed pursuant to section 162 and allowed them
pursuant to section 212.
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[*21] OPINION
I. Evidentiary Issue
Respondent reserved objections to paragraphs 58-60 and 78 of the
stipulation of facts and to Exhibits 11-J and 26-J.8 Paragraphs 58-60 and Exhibit
11-J pertain to tax years prior to those in issue. Exhibit 11-J is an examination
report and no-change letter issued to Lender Management for tax year 2008.
Respondent contends that these paragraphs and the exhibit are not relevant to the
tax years in issue.
Paragraphs 58-60 and Exhibit 11-J arguably show that respondent reached
different conclusions in prior years regarding the tax treatment of the deductions at
issue in these cases. Petitioners contend that the paragraphs and the exhibit are
relevant pursuant to rule 401 of the Federal Rules of Evidence, and they rely upon
De Boer v. Commissioner, T.C. Memo. 1996-174. In De Boer we held that the
taxpayer’s deduction of business expenses under section 162 was incorrect. Id.However, we concluded that for purposes of determining the penalty under section
6662 the taxpayer was not negligent and was reasonable in relying on a no-change
letter as an indication of the Commissioner’s agreement that he continued to be
8
Respondent withdrew objections to paragraph 78 and Exhibit 26-J in
respondent’s posttrial brief.
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[*22] engaged in a trade or business. See id., slip op. at 27-28. In these cases we
are not addressing a section 6662 penalty and therefore De Boer is not relevant.
We have rejected arguments about audits for prior years being relevant for
the tax years in issue. See Roseman v. Commissioner, T.C. Memo. 2009-185, slip
op. at 13. Each taxable year stands alone, and the Commissioner may challenge in
a succeeding year what was condoned or agreed to in a previous year. Auto. Club
of Mich. v. Commissioner, 353 U.S. 180, 183 (1957); Rose v. Commissioner, 55
T.C. 28 (1970). Paragraphs 58-60 and Exhibit 11-J are not admitted.
II. Burden of Proof
Generally the Commissioner’s adjustments in an FPAA are presumed
correct, and the taxpayer bears the burden of proving those adjustments are
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); see also
Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996)
(“Petitioner bears the burden of proving respondent’s determinations in the FPAA
are erroneous.”); Clovis I v. Commissioner, 88 T.C. 980, 982 (1987) (holding that
an FPAA is the functional equivalent of a notice of deficiency). The burden of
proof may shift to the Commissioner if the taxpayer establishes that it complied
with the requirements of section 7491(a)(2)(A) and (B) to substantiate items, to
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[*23] maintain required records, and to cooperate fully with the Commissioner’s
reasonable requests.
Petitioners claim they meet the requirements of section 7491(a) to shift the
burden of proof to respondent regarding the section 162 deductions. The
resolution of this issue, however, does not depend on which party has the burden
of proof. We resolve it on a preponderance of the evidence in the record. See
Dagres v. Commissioner, 136 T.C. 263, 279 (2011).
III. Deductions for Business Expenses
Section 162 allows as a deduction all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business.
Section 212(1) allows an individual a deduction for ordinary and necessary
expenses paid or incurred in connection with an activity engaged in for the
production or collection of income. Although the purpose of these two sections
was “to place all income-producing activities on an equal footing” in terms of
allowable deductions, United States v. Gilmore, 372 U.S. 39, 49 (1963), certain
limitations apply to deductions claimed under section 212 that do not apply to
deductions under section 162, see Green v. Commissioner, T.C. Memo. 2005-250,
slip op. at 27, aff’d, 507 F.3d 857 (5th Cir. 2007).
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[*24] Expenses deducted under section 162(a) generally are subtracted in full
from gross income to arrive at adjusted gross income. However, expenses
deducted under section 212 ordinarily are subtracted from adjusted gross income
to arrive at taxable income and are subject to certain floor limitations in section
67(a). A deduction under section 212 may also be limited by application of the
alternative minimum tax. See sec. 56(b); see also Guill v. Commissioner, 112 T.C.
325, 328-329 (1999). Additionally, net operating losses may carry over under
section 172 from the year in which they were incurred to another year only if the
losses were the result of operating a trade or business within the meaning of
section 162(a). See Todd v. Commissioner, 77 T.C. 246, 248 (1981), aff’d, 682
F.2d 207 (9th Cir. 1982).
The Code does not define the term “trade or business”. Deciding whether
the activities of a taxpayer constitute a trade or business requires an examination
of the facts in each case. Higgins v. Commissioner, 312 U.S. 212, 217 (1941).
To be engaged in a trade or business, “the taxpayer must be involved in the
activity with continuity and regularity and * * * the taxpayer’s primary purpose for
engaging in the activity must be for income or profit.” Commissioner v.
Groetzinger, 480 U.S. 23, 35 (1987). A sporadic activity, a hobby, or an
amusement diversion does not qualify. Id. Although the taxpayer’s activities need
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[*25] not generate an immediate profit or produce a profit for the tax year in issue,
the taxpayer must initiate or carry on the enterprise in good faith for the purpose of
making a profit. Id.; see also Barker v. Commissioner, T.C. Memo. 2012-77, slip
op. at 11.
Certain activities are not considered trades or businesses. An investor is
not, by virtue of his activities undertaken to manage and monitor his own
investments, engaged in a trade or business. Whipple v. Commissioner, 373 U.S.
193 (1963); Higgins v. Commissioner, 312 U.S. at 218. “No matter how large the
estate or how continuous or extended the work required may be”, overseeing the
management of one’s own investments is generally9 regarded as the work of a
mere investor. Higgins v. Commissioner, 312 U.S. at 218. Expenses incurred by
the taxpayer in trading securities or performing other investment-related activities
strictly for his own account generally may not be deducted under section 162 as
expenses incurred in carrying on a trade or business. See id.; Beals v.
Commissioner, T.C. Memo. 1987-171. The taxpayer’s activities as an investor
may produce income or profit, but profit from investment is not taken as evidence
9
An exception to the general rule applies when the taxpayer is also an active
trader of securities. See Moller v. United States, 721 F.2d 810 (Fed. Cir. 1983);
Liang v. Commissioner, 23 T.C. 1040 (1955). Petitioners do not contend that
Lender Management operated as a trader during the tax years in issue.
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[*26] that the taxpayer is engaged in a trade or business. Any profit so derived
arises from the successful conduct of the trade or business of the corporation or
other venture in which the taxpayer has taken a stake, rather than from the
taxpayer’s own activities. Whipple v. Commissioner, 373 U.S. at 202.
A common factor distinguishing the conduct of a trade or business from
mere investment has been the receipt by the taxpayer of compensation other than
the normal investor’s return. Whipple v. Commissioner, 373 U.S. at 202-203.
Compensation other than the normal investor’s return is income received by the
taxpayer directly for his or her services rather than indirectly through the corporate
enterprise. Id. at 203. If the taxpayer receives not just a return on his or her own
investment but compensation attributable to his or her services provided to others,
then that fact tends to show that he or she is in a trade or business. Dagres v.
Commissioner, 136 T.C. at 281-282. The trade-or-business designation may apply
even though the taxpayer invests his or her own funds alongside those that are
managed for others, provided the facts otherwise support the conclusion that the
taxpayer is actively engaged in providing services to others and is not just a
passive investor. Id. at 282, 285-286.
An activity that would otherwise be a business does not necessarily lose that
status because it includes an investment function. Id. at 281. Work that includes
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[*27] investing or facilitating the investing of others’ funds may qualify as a trade
or business. Id. In Dagres we held that “[s]elling one’s investment expertise to
others is as much a business as selling one’s legal expertise or medical expertise.”
Id. Investment advisory, financial planning, and other asset management services
provided to others may constitute a trade or business. See id.A. Positions of the Parties
Petitioners contend that Lender Management’s activities during the tax
years in issue meet the test for an active trade or business under Groetzinger.
They contend that Lender Management provided investment management and
financial planning services to others during the tax years in issue and that these
activities constituted a trade or business. Petitioners also contend that Lender
Management and the investment LLCs must be respected as separate business
entities distinct from their owners and that these entities engaged with one another
at arm’s length.
Respondent contends that Lender Management’s activities did not constitute
carrying on a trade or business. Respondent contends that Lender Management’s
primary activity is managing the Lender family fortune for members of the Lender
family by members of the Lender family.
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[*28] B. Analysis
Groetzinger does not create a single test that would be dispositive in all
cases on the issue of a trade or business. See Commissioner v. Groetzinger, 480
U.S. at 36. This Court has traditionally viewed that case as setting certain uniform
requirements which must be met for all trades or businesses, and we treat it as a
starting point for evaluating all trade or business determinations. See, e.g. Barker
v. Commissioner, T.C. Memo. 2012-77; McManus v. Commissioner, T.C. Memo.
1987-457, aff’d without published opinion, 865 F.2d 255 (4th Cir.1988). In prior
cases we have looked at the following three factors: (1) whether the taxpayer
undertook the activity intending to make a profit; (2) whether the taxpayer was
regularly and actively involved in the activity; and (3) whether the taxpayer’s
business operations had actually commenced. See McManus v. Commissioner,
T.C. Memo. 1987-457.
These three general requirements have been met, and the parties are not
disputing these requirements. The parties dispute whether the activities of Lender
Management constitute a trade or business. First, we will consider the activities of
Lender Management. Second, we will consider the familial aspect of the
activities.
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[*29] 1. Activities of Lender Management
Lender Management provided investment advisory and financial planning
services for the investment LLCs and their individual investors. Its employees
worked full time. Keith’s work involved researching investment opportunities,
negotiating and executing new investments, monitoring existing positions, and
working with individual clients to understand their investment needs.
Ms. Flament assisted Keith in performing his duties, and she was also
responsible for overseeing Lender Management’s financial accounting,
compliance, and cash management. She expended considerable time and effort
keeping open multiple revolving lines of credit, which were necessary for the
investment LLCs’ ongoing investment activities. Lender Management employed a
full-time office manager and part-time employees, and it engaged the services of
an outside firm to supplement its ability to provide its clients a complete set of
investment management services.
The services Lender Management provided to its clients were comparable to
the services that hedge fund managers provide. Lender Management had a
responsibility to provide its clients with sound investments with growth potential
and investments tailored to their financial needs. Lender Management’s activities
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[*30] in these cases went far beyond those of an investor. See Dagres v.
Commissioner, 136 T.C. 263.
In Dagres the management entity provided the facilities and staff to perform
the venture capital business, and this staff helped with identifying and researching
potential investment targets and helped manage the investments. Id. at 268.
Lender Management performed services similar to those in Dagres. Through the
operating agreements Lender Management had the exclusive right to direct the
business and affairs of the investment LLCs. Lender Management and its staff
found various investments, investigated potential investments, managed cashflow,
prepared asset allocations, and performed other related functions.
Lender Management was entitled to profits interests as compensation for its
services to its clients to the extent that it successfully managed its clients’
investments. In Beals v. Commissioner, T.C. Memo. 1987-171, the taxpayer
actively investigated and followed the investments made by him and his family,
but he did not receive compensation attributable to his services for overseeing his
family member’s accounts. He benefited solely from his share of dividends, which
constituted a normal investor’s return, and he operated under the name of a firm
that was previously dissolved. Id. Lender Management was a duly constituted
business entity, and it was entitled to profits interests for services.
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[*31] Lender Management and its managing members during the tax years in
issue held minority interests in the investment LLCs. In Dagres v. Commissioner,
136 T.C. at 285, the management entities held 1% capital interests in the
underlying investment funds. The management entities were also entitled to 20%
profits interests as compensation for their services as the funds’ managers. Id.These profits interests were the primary incentive for the management entities to
work to maximize the funds’ success. Id. We cited the disproportion between the
capital and the profits interests as a reason for concluding that the predominant
activity of the management entities was management of investments for others
rather than investing for their own account. Id. at 285-286.
In Dagres the management entities received management fees of 2% to
2.5% of the total committed capital in the funds. Id. at 268. Lender Management
did not receive similar fees. Lender Management received payment for its
services only if the investment LLCs earned net profits. The absence of fees
motivated Lender Management to increase the net values of the investment LLCs.
To the extent that the net assets of the investment LLCs increased in value,
the operating agreements provided that Lender Management could receive
compensation separate from and in addition to the amounts that it received for its
membership interests. In 2010 the class A profits interests for M&M and Lenco
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[*32] did not offer Lender Management as great an opportunity for earnings as
they did in later years. Nevertheless, the 2010 profits interests represented
potential compensation separate from and in addition to Lender Management’s
normal investor’s return, and these profit interests provided substantial incentive
to deliver high-quality management services.
In 2011 and 2012 the amended class A interests guaranteed Lender
Management a share of potential profits separate from and in addition to what it
would receive with respect to its investments. The contingent nature of the profits
interests does not negate their being compensation for services. Lender
Management’s compensation structure shows that during the tax years in issue its
predominant activity was providing investment management services to others,
rather than passive investing. See id. at 286.
During the tax years in issue Lender Management held membership
interests in Lenco of 4.60%, 5.13%, and 6.34%, respectively, and in M&M of
0.40%, 4.87%, and 8.26%, respectively. Although in most years Lender
Management’s interests exceeded the 1% held by the management entities in
Dagres, these interests each year were far less than what it could have earned for
its services via contingent profits interests payments. Between 91.74% and 99.6%
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[*33] of the portfolios that Lender Management managed for Lenco and M&M
were made up of investments beneficially owned and controlled by others.
Lender Management’s activities were providing investment management
services, which it primarily provided to and for the benefit of clients other than
itself. As in Dagres we conclude that Lender Management was in the business of
providing investment management services to its clients.
2. Family Relationship
These cases differ from Dagres in that a family relationship and connection
existed between the managing members of Lender Management and the owners of
the investment LLCs. Respondent cites this aspect of the relationship between the
entities in support of respondent’s contention that Lender Management’s activities
consisted solely of making investments on its own behalf.
Pursuant to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),
Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648, there are partnership and
nonpartnership items. A partnership item means any item taken into account for
the partnership’s taxable year. Sec. 6231(a)(3). The disputed deductions are
partnership items attributable to Lender Management, and section 6221 provides
that the tax treatment of these items shall be determined at the partnership level.
We examine the facts and circumstances specific to Lender Management, rather
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[*34] than the investment LLCs or their members, to determine whether it carried
on a trade or business. Respondent contends in respondent’s reply brief that this
Court “often considers the relationship between people who interact through
entities for the obvious reason that the relationships between the individuals might
affect how the entities interact with each other”. Respondent further contends that
managing investments for yourself and for members of your family is not within
the meaning of a trade or business for the purpose of section 162.
Generally transactions within a family group are subjected to heightened
scrutiny. Estate of Bongard v. Commissioner, 124 T.C. 95, 119 (2005); Cirelli v.
Commissioner, 82 T.C. 335, 343 (1984). Where a payment is made in the context
of a family relationship, we carefully scrutinize the facts to determine whether
there was a bona fide business relationship and whether the payment was not made
because of the familial relationship. See Commissioner v. Culbertson, 337 U.S.
733, 746 (1949); Martens v. Commissioner, T.C Memo. 1990-42, aff’d without
published opinion, 934 F.2d 319 (4th Cir. 1991). In DiDonato v. Commissioner,
T.C. Memo. 2013-11, we concluded that certain payments between cousin-owned
businesses were not deductible. The payments were not deductible because the
record did not establish that services were actually rendered.
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[*35] We find that Lender Management satisfies a review under heightened
scrutiny. The end-level investors in the investment LLCs during the tax years in
issue were all members of the Lender family. Lender Management’s CIO, Keith,
is a member of the Lender family. His father Marvin was managing member and
99%-owner of Lender Management in 2010, and Keith occupied the same position
in 2011 and 2012. At all relevant times only two members of the Lender family
were owners of Lender Management.
Separate from Lender Management, Marvin owned 11.47% of Lenco and
5.84% of M&M in 2010. Keith owned indirectly less than 4% of Lenco and 10%
of M&M during the years he served as managing member.
There was no requirement or understanding among members of the Lender
family that Lender Management would remain manager of the assets held by the
investment LLCs indefinitely. Lender Management’s investment choices and
related activities were driven by the needs of clients, and its clients were able to
withdraw their investments if they became dissatisfied with its services. Investors
in Lenco and Lotis were entitled to withdraw their capital interests for any reason
at least annually. Although a complete withdrawal from M&M required the
manager’s approval, we are satisfied on the facts before us that there was a
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[*36] common understanding that Lender Management would grant such approval
if any investor became unhappy with how his or her funds were being managed.
Apart from what they received as returns on their respective investments,
Lender Management’s clients generally earned employment income. For example,
Carl worked in sales for a cable communications company. Keith, like Carl,
would have benefited from his membership in the investment LLCs during the tax
years in issue regardless of whether he chose to work for Lender Management.
Keith’s position compensated him for the services that he provided to Lender
Management, and it was his only full-time job during the tax years in issue. As
managing member he was highly motivated to excel and to see Lender
Management receive the benefit of the class A interests.
Although each investor in the investment LLCs was in some way a member
of the Lender family, Lender Management’s clients did not act collectively or with
a single mindset. Lender Management’s clients were geographically dispersed,
many did not know each other, and some were in such conflict with others that
they refused to attend the same business meetings. Their needs as investors did
not necessarily coincide. Lender Management did not simply make investments
on behalf of the Lender family group. It provided investment advisory services
and managed investments for each of its clients individually, regardless of the
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[*37] clients’ relationship to each other or to the managing member of Lender
Management.
In Higgins v. Commissioner, 312 U.S. at 213, the taxpayer maintained two
offices the operations of which were to manage his personally held investments in
real estate, bonds, and stocks. The Commissioner disallowed deductions claimed
for salaries and expenses allocable to the management of the taxpayer’s securities,
and the Supreme Court upheld the Commissioner’s determination, observing that
the taxpayer “merely kept records and collected interest and dividends from his
securities, through managerial attention for his investments.” Id. at 218. Lender
Management was not managing its own money. Most of the assets under
management were owned by members of the Lender family that had no ownership
interest in Lender Management. Lender Management managed investments and
did substantially more than keeping records and collecting interest and dividends.
In Beals v. Commissioner, T.C. Memo. 1987-171, we rejected the
taxpayer’s contention that he was engaged in a trade or business managing
investments owned by him, his wife, and three of his children. In that case there
was no business relationship. By contrast Lender Management had an obligation
to its clients, and it tailored its investment strategy, allocated assets, and performed
other related financial services specifically to meet the needs of its clients.
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[*38] There is no dispute that Lender Management provided services. The profits
interests were provided in exchange for services and not because Marvin and
Keith were part of the Lender family. The Lender family members that
participated in the investment LLCs expected Lender Management to provide
them with services similar to those of a hedge fund manager. The relationship
between Lender Management and the investment LLCs was a business
relationship.
Respondent cites no applicable attribution rules that would require us to
treat Lender Management or its managing member as owning all of the interests in
the investment LLCs. Lender Management carried on its operations in a
continuous and businesslike manner for the purpose of earning a profit, and it
provided valuable services to clients for compensation. For the tax years in issue
Lender Management was carrying on a trade or business for the purpose of section
162.
To reflect the foregoing,
Decisions will be entered
for petitioners.