How to Plan a Family Office

Mark from New York asks: “Over the past year or so, I have had many colleagues of mine encouraging me to open a family office. I am a retired physician (current business owner) and most of the details as to how to open a family office are out of my scope of expertise. How do I plan a large family office and what may be some issues involved? What is the best strategy for how to plan a family office?”

Joel Nagel: Mark, thank you for the question. Family offices are most certainly being talked about more than ever in the world of endless investment vehicles. The benefits to structuring a family office will surely have a major impact on your finances.

Family offices and multi-family offices are the fastest-growing investment vehicle for high net worth families (those managing over $100 million in assets). It’s difficult to estimate how many family offices there are in the world, but experts believe there are at least 3,000 single-family offices and at least half of those were set up in the last 15 years.

Building a tax efficient family office requires consideration of U.S. tax issues, transfer pricing, access to trading platforms, ordinary income vs. capital gains on profit sharing, and licensing necessary in multiple jurisdictions.

Some very large family offices have trading desks in Panama and Singapore. That gets you tax deferral, but it often requires that the assets remain offshore. Also, this provides no tax savings for the principals. Even if they move offshore, the only benefit is the $100,000 Foreign Earned Income Exclusion on ordinary income from salaries earned abroad.

The issues offshore are obvious. Licensing, a need for U.S. banking, time zone differences, and access to quality English-speaking labor. For this reason, the majority of offshore family offices are based in Panama. This country won’t tax foreign source income, and quality labor and banking are available.

Since 2015, the most popular jurisdiction for large family offices has been the U.S. territory of Puerto Rico. From a regulatory perspective, your U.S. licenses are valid (assuming you aren’t offering services to locals, of course), banking can remain in the United States, and Puerto Rico has an amazing tax deal available to family offices, managers, and family members.

First, let’s review the license. Puerto Rico is working hard to encourage hedge funds, family offices, and international banks to set up in the territory. Their International Financial Entities License has specific sections authorizing family offices. This license can also be used by banks and others, but the largest number are issued to family offices.

When used by a family office that’s not offering service to the general public, compliance costs and regulatory burdens are reduced. The services most commonly provided in the license are:

• Asset management,
• Management of activities related to the investment of private capital,
• Management of hedge funds and high-risk funds,
• Management of pools of capital, of trusts utilized for converting different types of assets into securities (such as REITs),
• Management of Escrowed fund for persons who are not residents of Puerto Rico.

To structure an IFE family office in Puerto Rico, you’ll need $550,000 in capital and a minimum of 4 employees on the island. I generally recommend you start with 5 in case you lose one. You’ll also need a detailed business plan, financial statements, background information on the operators of the family office, origin of funds, and to negotiate the terms of the license with the government.

The tax benefits of operating a family office from Puerto Rico are as follows:

1) A 4% rate on corporate profits that’s guaranteed for 20 years and can’t be modified or taken away by future administrations or the U.S. government. This tax rate applies to business income generated in Puerto Rico (PR sourced income, not U.S. sourced income).

2) Puerto Rico sourced income can be retained in the PR corporation tax deferred.

3) Family office traders and managers, as well as family members, who move to Puerto Rico and qualify under Act 22, pay zero tax on dividends from the IFE and zero tax on capital gains earned on assets purchased after becoming a resident of Puerto Rico.

To qualify for Act 22, you need to move to Puerto Rico, make it your home base, spend at least 183 days on the island, and buy a home here. Both family members and operators of the family office can benefit from Act 22.

The offer from Puerto Rico is basically the reverse of that available offshore. Operators of family offices will pay standard tax rates on their salary from the business and zero on dividends and capital gains from their share of the profits. For more, see this comparison of the FEIE and Puerto Rico.

4) Only Puerto Rico can offer these tax deals to American family offices.

All foreign countries are treated equally under U.S. tax law. It doesn’t matter whether you set up a family office in Panama or Cayman Islands, it’s all the same when it comes to U.S. tax laws.

Only Puerto Rico is different. Puerto Rico is U.S. territory and Puerto Rico source income is expressly exempted from U.S. taxes under Section 933 and Section 937 of the code.

This all means that Puerto Rico is free to make its own tax laws. It also means that the 20 year guaranteed tax holiday can’t be modified by changes in the U.S. IRS and Internal Revenue Code.

I’ll end by saying that operators of family offices who are licensed as IFEs, and are residents of Puerto Rico under Act 22, will pay no U.S. tax when they return to the United States or repatriate their money. As a territory, Puerto Rico offers you tax free, while offshore offers you only tax deferral.

If you’re running a large family office, and you would like to cut your tax rate, maximize profits, and operate under a more “relaxed” set of regulations within the United States, this post is for you.

We offer services and structures that can help you represent your clients more efficiently…for example, by converting a defined benefit plan into an IRA and moving it offshore. We can also assist with offshore UBIT blockers, captive insurance companies, master-feeder funds, and other advanced international planning tools.

Note that the International Financial Entities in Puerto Rico are governed by Act 273. Some of the links above cover Act 20 and 22. Act 22 applies to the owners and managers of the 273 licensed office. Act 20 is a different tax deal available to tech companies.

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