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Presenting a live 90-minute webinar with interactive Q&A

Advising Family Office Clients/Recurring Legal

and Business Issues: Investment Adviser Act

and Broker-Dealer Compliance, Employment,

Executive Compensation and Tax and ERISA Issues

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, APRIL 6, 2016

Yehuda M. Braunstein, Partner, Sadis & Goldberg, New York

Alex Gelinas, Partner, Sadis & Goldberg, New York

Steven Huttler, Partner, Sadis & Goldberg, New York

Daniel G. Viola, Partner, Sadis & Goldberg, New York

Frank Viola, Esq., Counsel, O+D Builders, New York

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Advising Family Office

Clients/Recurring Legal and

Business Issues:

Structure, Deal Structuring, Investment Advisers Act and

Broker-Dealer Compliance, Tax and ERISA Issues

April 6, 2016

Steven Huttler, Partner

Sadis & Goldberg LLP

Steven Huttler is a partner in the firm’s Financial Services and Corporate Groups. Mr. Huttler has extensive experience in corporate, finance, investment fund and securities matters, including the representation of U.S. and foreign investment funds, underwriters, and private clients in various registered public and private offerings of debt and equity securities totaling in excess of $10 billion.

As part of his investment fund practice, Mr. Huttler has served as corporate counsel to many private investment funds and partnerships based in or domiciled in the United States and in international and offshore jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands, Ireland, Luxembourg, Isle of Man, Jersey, Guernsey, Cyprus, Mauritius, United Kingdom, Austria, Russia, India and Gibraltar. Mr. Huttler's legal practice has exposed him to diverse fund clients with an exceptionally wide range of investment programs and structures, including large mutual funds and hedge fund complexes, private equity firms, real estate partnerships and funds, venture capital funds and funds focused on specialty finance assets. He has also counseled small start-up hedge funds and financial industry entrepreneurs. His practice has included structuring and establishing start-up funds and managed accounts, and structuring investment funds to benefit from U.S. double taxation treaties. He has advised management companies and fund managers on compensation structures, restructured and reorganized funds, structured, negotiated and documented fund trades, negotiated seed, joint venture and start up agreements, and advised on a range of sophisticated transactions. He has also represented financial services providers, such as brokerage firms (including proprietary trading broker-dealers), fund administration firms and third party marketing firms in structuring their operations, reorganizations to achieve tax benefits, advising on disputes with clients, and in the development of forms for their pension, investment, trading, administration and other services to investment funds, equity, debt and option traders and other clients.

6

Alex Gelinas, Partner

Sadis & Goldberg LLP Alex Gelinas is a partner in the firm’s Tax Group. Mr. Gelinas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to U.S. pension funds, sovereign wealth funds and other U.S. and foreign institutional investors in connection with their investments in private equity funds, hedge funds and U.S. joint ventures. He also has extensive experience in providing tax planning advice to high-net-worth individuals and families.

7

Daniel G. Viola, Partner

Sadis & Goldberg LLP

Daniel G. Viola is the Head of the Regulatory and Compliance

Group of Sadis & Goldberg LLP, a leading New York based law

firm with a diverse practice, representing investment advisers,

funds and broker-dealers. Mr. Viola structures and organizes

broker-dealers, investment advisers, funds and regularly

counsels investment professionals in connection with regulatory

and corporate matters. Mr. Viola served as a Senior Compliance

Examiner for the Northeast Regional Office of the SEC, where he

worked from 1992 through 1996. During his tenure at the SEC, Mr.

Viola worked on several compliance inspection projects and

enforcement actions involving examinations of registered

investment advisers, ensuring compliance with federal and state

securities laws. Mr. Viola’s examination experience includes

financial statement, performance advertising, and disclosure

document reviews, as well as, analysis of investment adviser and

hedge fund issues arising under ERISA and blue-sky laws.

8

Yehuda M. Braunstein, Partner

Sadis & Goldberg LLP Yehuda M. Braunstein practices in the firm’s

Financial Services and Corporate Groups. Mr.

Braunstein’s practice focuses on investment funds,

securities, regulatory compliance and investment

advisers. He regularly structures and organizes

hedge funds, private equity funds (including real

estate, distressed and lending funds), funds of funds,

separately managed accounts and hybrid funds.

Additionally, he advises private fund managers on

structure, compensation, employment and investor

issues, and other matters relating to management

companies. He also structures and negotiates

seed investments and provides ongoing advice to

investment advisers on securities law issues and

regulatory matters.

9

Frank Viola, Counsel

O + D Builders Currently serving as counsel for a growing Manhattan-based general contractor and construction manager, O + D Builders, Mr. Viola’s professional and academic career has been rich and varied. As a former member of two New York commodity futures exchanges, Mr. Viola developed a robust legal practice representing NYMEX members and member firms while simultaneously building a general practice law firm based in New Jersey with satellite office in New York’s financial district. Mr. Viola remains of counsel to his former law firm, Viola, Benedetti & Azzolini, LLC, which now continues providing legal services as Azzolini and Benedetti, LLC.

After selling his interest in the law firm to his partners, Mr. Viola earned graduate degrees in American Studies and History and Culture from Columbia and Drew where he examined terrorism in an historical context. Mr. Viola’s award-winning doctoral dissertation investigated aspects of President Jimmy Carter’s nuclear weapons policy and executive decision making.

In addition to these achievements, Mr. Viola, a member of the National Italian American Foundation, has kept watch over certain Viola Family Office investments and endeavors spanning maritime law, real estate, securities, commodities, technology, airlines, professional sports, and closely-held corporate structures. As a former Marine Corps Captain and advisor to the Combating Terrorism Center at West Point, Mr. Viola continues writing and exploring the intersection of military and civilian policy in contemporary affairs.

10

Overview of Presentation

I. Family Offices: legal and commercial categories

II. Structuring Family Offices

III. Executive Compensation Structures for Family Offices: Special Issues

IV. Employment Law Issues: Special Issues

V. Structuring Family Office Investments

VI. Regulatory Compliance

a. SEC Family Office Rule under the Investment Advisers Act of 1940 and its application

b. CFTC registration/Family Office exemption

c. Trade reporting obligations

d. Investment company exemptions

e. Broker-Dealer registrations.

VII. US and select overseas tax issues

a. US domestic: deployment of qualified capital (e.g., Keogh, IRA, pension plan, etc.) and

related issues; increased popularity of private placement insurance and IDFs (“insurance dedicated

funds”)

b. ERISA consideration

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I. What is a Family Office?

• Commercial and legal responses are different

• Commercial answer: entity or office established related to provide specific kinds of services to wealthy individuals and/or families

• Legal answer: under U.S. Investment Advisers Act, an entity that provides investment management services: to a narrow group of individuals (mostly related)

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Commercial Description of Family Office

• Many descriptions, but most focus on specified services provided

• For purposes of our discussion, let’s assume that it is entities that provide some or all of the categories of services that appear in the following pages

• This list provides us with a convenient way to categorize some of the most significant and repetitive legal issues for Family Offices (“FOs”)

13

The Array of Multifamily Office Services

14

Source: Adapted from Forbes Magazine - Forbes Custom Finance and Investing: Considering the Family Office

Non-Investment Services Provided

15

Source: Adapted from Fidelity Investments: Fidelity Family Office Services: Insights on Family Office Compensation, December 2015

Use of In-House and Other Resources

16

Source: Adapted from Fidelity Investments: Fidelity Family Office Services: Insights on Family Office Compensation, December 2015

Commercial Description of Family Office

• Upshot: FOs have tremendous variety of styles, sizes, and service provided

• However, there is a crucial distinction between “Single-family Family Office” and “Multi-family Family Office”

• This commercial distinction has strong implications legally, such as under the Investment Advisers Act.

• Good segue to legal definition

17

Legal Definition of Family Office

• “Dodd Frank” definition – July 21, 2011:

“Family offices” are entities established by wealthy families to manage their wealth and provide other services to family members, such as tax and estate planning services. Historically, FOs have not been required to register with the SEC under the Advisers Act because of an exemption provided to investment advisers with fewer than 15 clients.

The Dodd-Frank Act removed that exemption so the SEC can regulate hedge fund and other private fund advisers. However, Dodd-Frank also included a new provision requiring the SEC to define FOs in order to exempt them from regulation under the Advisers Act.

The rule adopted by the SEC enables those managing their own family’s financial portfolios to determine whether their “family offices” can continue to be excluded from the Investment Advisers Act.

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Legal Definition of Family Office (cont.)

• The regulatory distinction between “Single-family Family Office” and “Multi-family Family Office” is now much clearer and distinguishable.

▫ Single-family offices (“SFOs”) are those that serve only descendants of a common ancestor.

▫ Multi-family offices (“MFOs”) generally serve a number of smaller family groups that either cannot justify the cost of their own family office, or choose to use the services of an experienced group of professionals as an alternative to, or in conjunction with, their own single-family office.

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Legal Definition of Family Office: Recurring Issues

• To qualify for the exemption for registration, an SFO must:

▫ Advise only “family clients”

▫ Be wholly owned by “family clients’ and exclusively controlled by “family members” or “family entities” and

▫ Not hold itself out to the public as an investment adviser

• “Family clients” are “family members” related within ten generations of a common ancestor. The term also includes current and former spouses, “spousal equivalents,” adopted children, foster children and some children under guardianship. In addition, “family clients” includes various trusts for the sole current benefit of family clients, some non-profit and charitable organizations, estates of family members and companies wholly owned and operated for the sole benefit of family clients. The Family Office Rule treats certain “key employees” of the FO, their estates, and certain entities through which key employees may invest as “family clients” (but not as “family members”). A “key employee” is generally an executive officer, director, or person serving in a similar capacity at the FO or its affiliated FO.

• Implications of being an FO vs. not under IAA

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II. Structuring the Family Office: Narrow

Technical Points (1)

a. LLC, LP vs. Corporation as the appropriate entity is the largest discussion in tax and sources

b. But this is an over-simplification of the discussion: is an entity needed at all? (e.g., if FO is operated together with existing family businesses, it can be more logical not to establish a vehicle at all, and to use the infrastructure of the existing family operating businesses)

c. Further, whatever entity is selected (or even if none is selected as per the above), there will almost always be regardless of many other pockets of capital to put to use for investments and family cash and trusts and estate planning, such as:

i. Cash/unencumbered investments;

ii. IRA, Keogh, etc.

iii. ERISA covered plan monies

iv. Trusts, foundations, other T&E and philanthropic planning vehicles

d. When making investments, or structuring other uses of capital (e.g., philanthropic), must consider which of these sources of money is appropriate. These categories are examples of important consequences for deal structuring as below

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II. Structuring the Family Office: Larger Thematic

Considerations (2)

a. Philosophic: philanthropic vs. wealth preservation and growth

b. In either case: training of younger generation to manage FOs: research shows that this is one of the greatest worries of FO professionals, whether their inter-generational leadership will be properly groomed to lead into the future; without proper leadership, FOs can fall apart. Younger leaders need to be trained in investments and business, philanthropy (if that is a family value) exercising roles in a larger family structure

c. Much effort is required to harmonize T&E planning, transfer of leadership in underlying businesses, if any, into the analysis of what types of entities are needed, and how structured

d. Further, as discussed earlier, the range of services provided by the FO has dramatic consequences on how it is structured: e.g., if there are many concierge services provided, then much consideration needs to be given to formulas on how to allocate such expenses among family members

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III. Executive Compensation for Senior Management of

Family Offices

a. Significant factors: wealth management is particularly important function, especially very specialized ones in hedge funds, PE/RE/VC fund

b. Another significant factor: FOs are competing for talent to some extent with investment fund managers, college and philanthropic foundations

c. Compensation for such senior managers is very similar to those found in the wider money management world: hedge funds, PE funds, etc.

d. Many of these senior managers expect to get paid percentages of increases in assets of FO, as they are paid on the street

e. Some issues: as noted above, many “pockets” of wealth are not held in partnerships, where managers cannot get performance “allocations” (favorable income tax treatment)

f. Many professionals play multiple roles, including those relating to concierge roles, and there are complaints of misalignment of compensation with services provided

g. Professionals have to be careful not to blow the “Family Office Exemption” of a Single Family FO

h. Prohibited Transactions/ERISA/IRC

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Management Liability Red Flags

Does your FO:

• Have professionals on staff?

• Provide accounting or tax planning services to clients?

• Assist in estate planning for clients?

• Perform investment advisory services for clients?

• Form and maintain private investment funds or investment partnerships?

• Select and oversee outside professionals or outside professional service firms?

• Have individuals who serve as trustees of family trusts?

• Work in conjunction with a private trust company?

• Assist with the placement and management of domestic staff?

• Coordinate the placement of insurance for clients?

• Perform administrative or support services for any family foundations?

• Assist clients with structuring and operating small businesses?

• Have its own pension or 401k plan for employees?

If any of these “red flags” exist, we recommend a comprehensive review by a FO risk specialist.

Source: Adapted from Marsh & McLennan Companies – Family Office Management

Liability Issues to Consider

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IV. Employment Law/Contract Issues

a. Ensure that agreements address the multiple roles of the FO and not just the wealth management side (that’s easy to forget for law firms servicing these businesses)

b. Example: confidentiality/non-disparagement agreements don’t only cover special deal flow and wealth management and tax techniques, but also private information about the family

c. Example: other restrictive covenants, need also to keep in mind concierge and other services (e.g., tax), not just investment deal flow, etc. Non-solicit of investors is of least concern, compared to these issues.

d. As noted above, highly bespoke structures for tax optimization of family goals will limit to some extent the flexibility to put it in place for management.

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V. Structuring Investments with Family Office Capital

26

What do Family Offices Invest in: Implications for

Legal Advisers

• See as an example among many online: Opalesque interview with Terry Beneke, Chief Investment Officer of Family Office Antares Capital - Opalesque.TV

• Upshot: argument that Alternative Investments are Very Important for FOs

• In his case, he argues why Hedge Funds are the best aligned with FOs

• But in any case, it is clear that most FOs include a much wider allocation to “Alternative Assets” than “mere mortals”

• Such assets include: Private Equity, Hedge, Real Estate, Venture Capital, and “Alternative Alternatives”

27

What do Family Offices Invest in:

Alternative Alternatives • Wine/vineyards

• Art

• Yachts

• Luxury cars

• Professional sports teams

• Real estate

• Investment funds for all of these categories

• Important to distinguish between investment and personal use of these assets

28

What do Family Offices Invest in: Implications for

Legal Advisers

• General observations: legal advisers need to have meaningful legal experience in advising on all or many of these asset classes, or ways to bring it to bear on their legal service offering (i.e., through relationships with other service providers)

• Corporate/fund knowledge of typical terms

• Tax knowledge of relevant structures and issues and how to invest in these vehicles

29

Structuring Investments: Hypothetical Investment #1

FO considers acquiring an apartment to use as office.

▫ 401K/IRA – Not best “bucket” for this purchase.

Income tax and prohibited transactions issues with personal use

Complicated money to use but can be best for high return investments

Tax issues when you purchase something with debt financing

Best for assets you expect high growth from since money grows tax free but you pay ordinary income tax when money is distributed. At a certain age the money must start to get distributed.

Consider advising clients to create some Roth money which grows tax free but also when you distribute the money it comes out tax free.

Entire amount in such plans is subject to estate tax at death unless you leave it to your spouse and then it is taxable at their death (also mandatory distributions for the spouse).

30



▫ Personal Funds

Easiest to use

Can set up an entity such a an LLC to shield it

May want to set up an entity that is owned by husband and wife or by client and children

▫ Sets up its own tax return

▫ If owned by children then the appreciation will not be in the client’s estate at death

Or set up a trust (see next sheet)

▫ Depending on structure it doesn’t have to have its own tax return

▫ Can be set up so that at death out of estate

▫ Can be set up so that income tax advantages of ownership can pass to the client who sets up the trust

If used as an office and a mortgage is taken out – then interest payments (not amortization) are deductible for income tax purposes since its for business purposes. So are all of the expenses regarding the apartment (taxes, maintenance, insurance).

31



▫ Trusts (either as beneficiary (e.g., parent or grandparent set up a trust and client is beneficiary) or as settlor/grantor (the person who sets up the trust)).

Does the client have a family? Does the client want to minimize the taxes paid at his or her death in return for adding some complexity?

Depending on the structure, it doesn’t have to have its own tax return

Can be set up so that at death, it is out of estate

Can be set up so that tax advantages of ownership can pass to the client who sets up the trust

Can be a good form of prenuptial/postnuptial

Trust assets can be shielded from creditor claims

Can afford the head of the FO to maintain tremendous control but still assets out of estate

Generally the tax structure is similar as to personal assets except no estate tax

We believe that trusts are not deployed enough, in our view, in deal structures

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▫ Company/Personal funds

If assets are owned by an SPV, there is simple and cheap creditor protection. To elaborate, if they have a management entity, consider suggesting that the apartment be owned by a separate entity and have the management company pay rent.

Management company structures are advantageous. But they do add complexity and additional entities and costs. Gives the client a trade name, business cards, entity to pay expenses out of hire people, etc.

Is it a corporation or LLC? What are the benefits of each?

Generally it would be in estate at time of death unless company is owned by a trust

Generally no tax deferral (i.e., not 401K)

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Hypothetical Investment #1: Preliminary Conclusions

• Probably can’t use 401K (issues with use of apartment and debt).

• Trust should be explored.

▫ Does the client need the proceeds of a sale of the apartment for retirement purposes (it can be complicated but there are ways to set up a trust where your spouse can be a beneficiary bit is definitely limited)?

If no, then a trust can be very attractive

Can also set up trust where the money to buy the apartment is a loan from the client to the trust so that only the appreciation is outside the estate.

▫ There are some limitations on personal use. So you need to consult with T&E counsel

▫ Remember: by suggesting that the client consider a trust.

Apartment is shielded from creditors and potentially spouse at divorce

Apartment will pass to next generation estate tax free

Generally can be set up so that has same income tax characteristics as using personal funds

If the client is interested in exploring a trust, you then need to get T&E professionals involved (questions regarding family, net worth, prior gifting and existing estate plan are all included in figuring this out).

• If Trust is not of interest to the client then Company funds or personal funds is the best way to own this asset either through an LLC

• Going through this analysis with a client shows the client that you are adding value. It also forces you to learn about your client.

34


FO wants to invest in a VC fund.

▫ Good options: 401K/IRA either with Roth or without Roth

401K/IRA with a Roth

Money grows tax free and comes out without taxes

At death assuming you leave money to your spouse – money passes estate tax free to spouse and then as it is distributed it is tax free

If don’t have ability to use 401K/IRA money with or without Roth, then again consider a Trust so at very worst, appreciation is outside the client’s estate

This is the same analysis you go through on all investments. The more you go through the analysis, you will become more experienced in the analysis and you will learn more about your client. It also creates the situation that the client begins to see you more as a

trusted adviser than just as a one dimensional lawyer that is used just to set up a fund.

35

What do FOs Invest in: Implications for Legal

Advisers

• How do FOs Invest in these assets?

▫ Through investment funds (e.g., Hedge, PE, VC, RE funds)

▫ Sometimes directly: depending on the depth of expertise in the FO (i.e., how full service is the FO, does it have internal, in-house expertise to acquire and manage different asset classes)

▫ Through Special Purpose Entities (“SPVs”): i.e., club deals (BD issues to be discussed later)

36

Emerging Developments as Responses to these Conditions:

SPVs • Advantage:

Easier to raise capital for very attractive deal than for “unknown, blind” pool.

• Historical Antecedent:

“Club deals” which were used by large PE funds for a very different purpose: these large fund families with great infrastructure shared deals. Here a manager with minimal or perhaps non-existent infrastructure uses in effect the “club deal” structure in another context.

• Challenges: Liquidity

• How is money raised and in what format?

• Tendency is to use this for HNW not institutions (who have limitations disclosed earlier).

• Can you trust capital commitments from HNWs?

• If not, you must overfund at the beginning, for contemplated fees and expenses, which dramatically drags down returns.

37


SPVs (cont.)

▫ Challenge: Track-record “Albatross”

Under relevant SEC law your returns are required to be reported precisely in relevant contexts – no “cherry picking”.

▫ So while you are trying to build track record, the SPV structure drags down the very return numbers in the track record – which is supposed to help you raise more capital.

▫ Further: what if you don’t estimate fees & expenses correctly?

• Alternative: try to rely on capital commitments.

• What if investors don’t honor their capital commitments?

• Deals collapse (initially or subsequently) for lack of funds because of party which doesn’t honor capital commitments.

38


SPVs (cont.)

• Regulatory/disclosure: non-intuitive result – more disclosure required – must give detailed disclosures about target.

• Concentration Risk: if one deal goes bust, your whole track record is marred – risk much greater than for a blind pool.

39

Investment Adviser Considerations

• Many sponsors, when made aware of the broker dealer regulatory considerations, and the difficulty of meeting requirements, often turn quickly to alternatives

• Most frequent alternative: sponsor acting as investment adviser and collecting management and/or incentive fees

• However, the SEC would regard a sponsor who does not provide any investment advice as a disguised broker dealer, and the fees as disguised commissions

40

Investment Company Act

• Need for exemption under ICA

• Often overlooked because vehicle is not a “blind pool”(conventionally thought of as a fund)

• Classic Exemptions of 3(c)(1), 3(c)(5), 3(c)(7) would be most relevant

• Increased possibility of availability of 3(c)(5)

• Such increased availability may even serve as a rationale for using the whole SPA/structure

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VI. Regulatory Compliance

42

CFTC Registration

“A family office is, generally, a professional organization that is wholly-owned by clients

in a family and is exclusively controlled (directly or indirectly) by one or more members of a

family and/or entities controlled by a family. Typically, a family office structure is employed

when one or more direct members of a family create substantial wealth, and share that wealth in

whole or in part with other members of that family, either through direct transfer, inheritance, or

similar means. The family office is then used to provide personalized services to that family,

including advice regarding issues of tax, estate planning, investment, and charitable giving.

In February 2012, the Commission promulgated certain amendments to Part 4 of the

Commission’s Regulations. Notable, and at issue here, is the rescission of Regulation

4.13(a)(4), which had previously exempted from registration Commodity Pool Operators

(“CPOs”) who, inter alia, operated a pool for only those individuals who met a certain “qualified

eligible person” standard. In general, FOs relied on Regulation 4.13(a)(4) as an

exemption from registration. Pursuant to these recent amendments, absent affirmative relief,

many FOs would be required to register with the Commission as a CPO.

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CFTC Registration (cont.)

The CFTC Letter No. 12-37, dated November 29, 2012, asserts generally, that FOs are not operations

of the type and nature that warrant regulatory oversight by the Commission. That is, because a family

office is comprised of participants with close relationships, and there is a direct relationship between

the clients and the adviser, such relationships greatly reduce the need for the customer protections

available pursuant to Part 4 of the Commission’s Regulations. Importantly, as a function of these

relationships, any disputes that arise between any of the family members concerning the operation of

the family office could be resolved within that family unit, or through state courts under laws

designed to resolve such family disputes.”

44

Trade Reporting Obligations

Selected Ongoing Requirements for FOs

1. SEC Regulations – FOs need to assess whether they are subject to reporting requirements under the Securities Exchange Act of 1934.

1. Section 13(f)

2. Schedule 13D and 13G

3. Rule 13h-1 “Large Trader” Reporting Requirements

1. SEC Registration

2. Registered Broker Dealer Requirements

4. Rule 105 of Regulation M

45

Broker Dealer Regulatory Considerations

• Basic Rule: Transaction based compensation in securities deal requires broker-dealer registration

• Compensation could be obvious, as in commissions, or “disguised” (e.g., management and incentive fees where no IA services provided)

• Compliance professionals insist on greater compliance with registration

• SEC itself now very focused on these violations and prosecutes them

• Issue: Club Deals may be sponsored by third parties, who are neither existing registered broker dealers (or broker dealer reps) or investment advisers

• Such parties expect to be compensated

46

VII. Taxation of Investment Activities: How do

Family Offices invest most efficient different kinds

of assets and funds. Focus on Insurance

Dedicated Funds

47

1. U.S. Income Tax Issues For High Net Worth Individuals

Investing in Partnerships

U.S. high net worth individuals and their advisors have long known that a great performing investment, including various hedge fund strategies, can sometimes become mediocre once federal and state taxes are taken into account.

Under the tax rules applicable to partnerships, U.S. limited partners are subject to income taxation on their allocable share of the partnership’s net income regardless of whether they receive any distributions or withdraw any funds from such partnership.

Further, many partnership funds pursue trading strategies that generate short-term capital gains, rather than long-term capital gains and qualified dividends which are eligible for favorable income tax rates.

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Investing in Partnerships (cont.)

Trader vs Investor Status. If the partnership in question is not engaged is business, e.g. as a “trader” entity, and is instead classified as a mere “investor” in stocks, securities and other financial instruments, high net worth individuals (as well as trusts and estates) could find that their share of the partnership’s investment-related expenses, including the hefty management fees, are subject to disallowance (in whole or in part) on their own federal income tax returns, since such deductions would be classified as Section 212 deductions (i.e., miscellaneous itemized deductions) rather than Section 162 business deductions. Such deduction limitations include:

2% Floor Rule. Certain itemized deductions of individuals, estates and trusts, including Section 212 expenses, are generally deductible only to the extent that, in the aggregate, they exceed two percent of the taxpayer’s adjusted gross income.

3% Phase-Out Rule. For individuals, otherwise allowable itemized deductions are subject to further reductions by 3% of the amount by which the taxpayer’s adjusted gross income exceeds a specified threshold amount. Up to 80 percent of the taxpayer’s itemized deductions could be disallowed under this rule.

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Investing in Partnerships (cont.)

AMT Disallowance. Miscellaneous itemized deductions are also not allowed in calculating the taxpayer’s alternative minimum tax liability.

Other Deduction Limitations: The Code also provides other limitations on deductions for investment interest (which includes short sale expenses), wash sale limitations on losses, and a number of other rules that could be triggered in situations where the high net worth taxpayer is investing through partnership vehicles.

3.8% Tax on Individual’s Net Investment Income. U.S. individuals are also subject to an “add on” 3.8% tax on their net investment income (the “NII Tax”). In general, an individual partner’s share of the partnership’s investment income is subject to this 3.8% tax, and the deduction limitations described above also apply in calculation “net investment income”. Trusts and estates are also subject to a modified form of the NII Tax, on their undistributed net investment income.

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2. Private Placement Insurance Strategies (with

Underlying Insurance-Dedicated Funds)

In view of such tax inefficiencies in partnership structures for U.S. individuals, some family office managers and advisors have been considering the following alternative investment strategies which may provide a much better tax result for such taxpayers.

The Typical Structure. A U.S. high net worth individual, or a family office investment vehicle, purchases a variable life insurance policy or annuity contract (collectively, a “policy”) from a life insurance company and the insurance company invests in one or more hedge funds or other private investment funds. The private investment funds are held by the insurance company in a segregated asset account (the “separate account”). The assets held by the insurance company separate account provide the investment return to the contract owner. However, under the federal income tax rules applicable local law relating to such insurance products, the insurance company is treated as both the legal owner and the tax owner of the assets of the separate account and the investor in the policy reports his or its income in accordance with the special federal income tax rules applicable to such insurance company contracts.

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Underlying Insurance-Dedicated Funds) (cont.)

Summary of U.S. Tax Advantages.

One of the primary U.S. tax advantages is deferral of income taxes for the investor in the policy. Since the insurance company is the legal and tax owner of the separate account assets, it receives the K-1 forms and Form 1099s each year with respect to such assets.

Long-Term Deferral of Taxable Income. The policy owner has no taxable income to report with respect to the realized or unrealized gains and other income generated by the underlying separate account investments (known as the “inside build up” in the policy) unless the owner withdraws funds from the insurance or annuity policy.

Tax-Free Receipt of Death Benefit. In the event of the death of the insured person under a policy that provides a death benefit, the designated beneficiary would receive such death benefit free of U.S. federal income taxes.

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Underlying Insurance-Dedicated Funds) (cont.)

Other Income. Other income withdrawn from the policy is generally taxed at ordinary income tax rates. However, certain policies can be structured to permit the owner to borrow funds from the insurance company and avoid current income taxation on such amounts. Unlike qualified plan investments, there is no specific federal income tax rule that would require the investor in the policy to begin withdrawing funds once the investor reaches age 70½.

Tax Requirements Which Must Be Met to Achieve Desired Tax Result. In order to qualify for this generous federal income tax treatment, the investor in the policy cannot retain control over the specific underlying investments made by the funds held in the separate account and the account must satisfy certain diversification requirements. Further, in order to satisfy such diversification requirements, the funds in which the insurance company invests have to be “insurance dedicated funds” (“IDFs”), meaning that they are funds offered only to insurance companies and thus not available for direct investment by other investors (other than certain tax-exempt entities). The tax rules permit the investor in the policy to select the IDF or IDFs in which the account will invest (provided the insurance company has decided to offer such IDFs as an available investment option under its policy) and the contract can permit the policyholder to change the allocations of invested funds (e.g., quarterly or semi-annually) from one IDF to other IDFs that the insurance company has made available for selection by policyholders.

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Captive Insurance Company Strategies

In cases where the founder and/or family members control a private operating company, tax advisors to such company and the family office should consider the possible income tax, estate tax and financial advantages that could be available if the closely held business were to form a captive insurance company.

Summary of Tax and Non-Tax Advantages. A properly structured and managed captive insurance company (which is required to be a “C” corporation for U.S. tax purposes) could provide some or all the following benefits:

Tax deduction for the parent company for the insurance premium paid to the captive;

Opportunity to accumulate wealth in a tax-favored vehicle (i.e., the insurance company);

Ability to distribute “qualified dividends” (taxable at capital gains rates) to the shareholders of the captive;

Various other tax savings opportunities, including gift tax and estate tax savings;

Asset protection from the claims of creditors of the business and personal creditors;

Reduction in insurance premiums currently paid by the operating company to unrelated insurers;

Access to the lower-cost reinsurance market; and

The possibility of insuring risks that would otherwise be uninsurable.

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Captive Insurance Company Strategies (cont.)

Tax Benefits Available for Small Insurance Companies (Code section 831(b)). Qualifying property and casualty insurance companies with net premium income not in excess of $1.2 million have the ability to elect under Section 831(b) to exclude their premium income from federal income tax and pay federal income tax only on their investment income. Although the maximum annual premium exemption is currently $1.2 million, 2015 tax legislation raises this amount to $2.2 million for tax years beginning after December 31, 2016, and such amount will be subject to increases in future years in accordance with inflation.

Estate and Gift Tax Advantages. Captive insurance companies can also be used for estate planning purposes. For example, a captive can be owned at the time of its formation by family members of the parent corporation’s owners or a trust set up for those family members. Assuming the insurance premiums paid to the captive reflect arm’s length terms, the premium payments should not be treated as gifts to the shareholders of the captive. In addition, the future growth in the captive’s net asset value (which could be enhanced if the premium income is exempt from U.S federal income tax under Section 831(b)) will not be included in the estates of the senior family members who own the shares of the parent company.

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Captive Insurance Company Strategies (cont.)

2015 Tax Legislation Also Curtails Certain Estate Planning Strategies. The 2015 amendments to the Code also attempt to curtail certain aggressive estate planning strategies that involve captive insurance companies. Interested parties should consult qualified insurance tax counsel concerning the impact of such legislation, and future regulations interpreting such statutory amendments, before implementing a captive insurance program.

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ERISA Considerations Relating to Private Investment

Funds and Co-Investment Transactions

1. Plan Assets Issues; Fiduciary Status and Prohibited Transaction Issues

If the assets of an entity (e.g., a corporation, partnership or trust) are treated as plan assets of a benefit plan investor that owns an equity interest in such entity, the parties having management authority over the assets of such entity would be treated as fiduciaries under ERISA with respect to such plan investors. In addition, transactions entered into by such plan asset entities would be subject to ERISA scrutiny including complex prohibited transaction rules.

• ERISA imposes strict fiduciary responsibility requirements on parties that are deemed to be fiduciaries of employee benefit plans that are subject to ERISA. The performance compensation arrangements for the managers of a typical private investment fund and the related party transactions that the private investment funds generally engage in would not comply with such ERISA requirements.

• Therefore, ERISA compliance for private investment funds generally consists of entirely avoiding the application of ERISA to the fund’s assets and to the activities of its investment manager by relying on one of the plan assets exemptions in the ERISA regulation which defines “plan assets” for ERISA regulatory purposes (the “Plan Assets Regulation”).

A. General Rules on Plan Assets Status

Under the ERISA plan assets regulations, the assets of an entity in which a plan has an equity interest will not be treated as plan assets if the equity interests are(1) publicly traded securities or (2) a security issued by an

investment company registered under the Investment Company Act of 1940.

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Funds and Co-Investment Transactions (cont.)

In all other cases the assets of the entity will be treated as plan assets for ERISA purposes unless:

(1) the entity qualifies as an “operating company” which term also includes a “venture capital operating company” or a “real estate operating company”; or

(2) the aggregate investment in the equity interests of the entity that are owned by “benefit plan investors” is less than 25 percent of the outstanding equity interests in such entity (the Insignificant Plan Investment Exception”).

As a result of 2006 legislation, the term “Benefit plan investors” no longer includes governmental plans, church plans an non-U.S. plans.

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B. Operating Company Definition

An operating company is defined as an entity that is “primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.”

(1) Start-up ventures and companies engaged solely in research and development may not qualify under this definition.

(2) The Venture Capital Operating Company (“VCOC”) and Real Estate Operating Company (“REOC”) exemptions were added later.

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VCOC Definition

To qualify as a VCOC, the entity must satisfy two requirements: First, at least 50% of the entity’s assets (at cost) must be invested in “venture capital investments” or “derivative investments” as defined. Second, the entity must obtain and exercise “management rights” with respect to at least one of its operating company investments. The term “venture capital investment” is defined as an investment in an “operating company” in which the investing entity has obtained management rights.

REOC Definition

The REOC definition is similar to the VCOC definition. In order to be a REOC, the entity must: (1) have at least 50 percent of its assets (valued at cost) “invested in real estate that is managed or developed and with respect to which such entity has obtained the right to substantially participate directly in the management or development activities”; and (2) be directly engaged in real estate management or development activities.

• Many private investment funds rely on the Insignificant Plan Investment Exemption (also known as the “Under 25 Percent Plans Limitation”). This limitation must be satisfied throughout the life of the Fund. Thus it is necessary to police any secondary market transactions in Fund shares to ensure that the benefit plan investor limitation is not exceeded.

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If you have questions, please contact:

Sadis & Goldberg LLP 551 Fifth Avenue, 21st Floor

New York, NY 10176

Steven Huttler

Alex Gelinas

Daniel Viola

Yehuda Braunstein

212.573.8424 212.573.8159 212.573.8038 212.573.8029 [email protected] [email protected] [email protected] [email protected]

mailto:[email protected]




FRANK VIOLA

Director of Operations/Counsel

O+D BUILDERS

133 West 25th Street, 6th Floor

New York, N.Y. 10001

O: (212) 929-8320

F: (646) 380-4181

E: [email protected]

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