Press Room: Tax Release

June 28, 2011

SEC Finalizes Family Office Rules for Registering as Investment Advisor

Family offices can now breathe a momentary sigh of relief when considering how the new Securities and Exchange Commission (SEC) Family Office Rule might affect them. The requirement that some family offices register as an investment advisor has effectively been delayed until March 30, 2012. This allows a family office ample time to determine if it meets the requirements to be excluded from the definition of “investment advisor.” Those not excluded will need to make changes to fit into the exclusion or register as an investment advisor by March 30, 2012. 

The other good news is that the SEC’s final rule is much more accommodating to a typical family office’s ownership structure and clientele. The only bad news is that all those well-meaning accommodations may require a fair amount of analysis to determine if your particular circumstances will allow you to avail yourself of the exclusion.

Permissible Clients

The definition of “family members” who can be advised without the family office registering has been broadened significantly. By dropping the proposed “founder” test in favor of a common ancestor test, a family office can advise ten generations of family without regard to whether the generation that initially accumulated the wealth is also the generation that established the family office. That is, family offices are not penalized if, for example, the grandchildren of the initial wealth builder formed the legal entity that is the family office. Family members include lineal descendents of a common ancestor, who may be living or deceased, up to ten generations. Family members also include current and former spouses or spousal equivalents of those descendants; current and former step children; and children through adoption, foster care or legal guardianship. With a rule that reaches further up the family tree, a family office may effectively have more distant relatives as clients.

In addition to family members, a family office may also advise certain “family clients” as defined. For advised assets held by family companies, trusts, estates, charities and non-profits, determining if they can be advised without registering is a bit more cumbersome and less intuitive. For some of these structures, the people who funded the advised account is determinative. For others, it can turn on who owns the entity or account, who controls it or who are the current beneficiaries. In certain circumstances, there is a grace period to divest nonconforming clients’ interests without resorting to fire sales.

Permissible family clients are as follows: 

  • Key Employees – must be an executive officer, director, trustee or general partner, or hold a similar position in the family office. A key employee also includes an employee of the family office who has been participating in the investment decisions of the family office for at least 12 months. A key employee’s jointly held spousal assets, certain trusts, and investments in family office-advised private funds, charitable organizations or other family entities are also permissible.
  • Former Key Employees – must have invested with the family office during employment; may not make additional investments after no longer employed.
  • Irrevocable Trusts – must have as current beneficiaries only family clients (i.e., may have non-family contingent beneficiaries). If the current beneficiaries are non-family non-profit organizations, charitable foundations, charitable trusts or other charitable organizations, the trust be must be funded exclusively by family clients.
  • Revocable Trusts – must only have family members as the sole grantors; beneficiaries do not need to be family members.
  • Estates – may advise the executor of a family member’s estate regardless of whether the estate will be distributed, in part, to non-family members.
  • Non-Profit and Charitable Organizations – generally must be funded exclusively by family clients.
  • Charitable Lead Trusts – must be funded exclusively by family clients, and the current beneficiaries must be other family clients or charitable or non-profit organizations.
  • Charitable Remainder Trusts – must be funded exclusively by family clients, and the current beneficiaries must be other family clients or charitable or non-profit organizations.
  • Family Entities – must be wholly-owned by one or more family clients and operated for the sole benefit of family clients. This may include pooled investment vehicles as long as the requirements are met.

Permissible Ownership and Control

For the second prong of the exclusion from registration, the family office must be wholly-owned by family clients and exclusively controlled by one or more family members or family entities. This requirement accommodates typical family office situations such as where a key employee has a stake in the company, or where a non-family member owns the company for tax purposes. Thus, key employees may have a non-controlling ownership stake as part of an incentive compensation package. The rule does not require the family office to be run on a not-for-profit basis. This permits the family office to distribute investment gains as dividends to key employees and other family clients who own the family office.

Holding Out as an Investment Advisor

The third requirement to fit the family office exclusion prohibits a family office from holding itself out to the public as an investment advisor, as doing so suggests the family office is seeking out non-family clients. This requirement should be easy for most family offices, but bear in mind that marketing a non-public offering to non-family clients would be inconsistent with this requirement.

No Relief for Multi-Family Offices

The exclusion does not extend to a family office that advises two or more families unrelated to a common ancestor. The SEC has warned that cloning a multi-family office entity onto several single family offices that are otherwise substantially staffed and operated as one office will not satisfy the exclusion’s requirements.

Action Steps

To avail your family office of the exclusions from registration as an investment advisor, consider the following steps: 

  • Determine which common ancestor should be used to establish who are eligible family members. This ancestor may change over time.
  • Assess whether any advised individuals are neither family members nor family clients. Consider steps to divest those non-conforming clients.
  • Assess whether the appropriate ownership, funding, control, or beneficiary requirements are satisfied for any advised trusts, estates, closely-held companies or pooled investment vehicles, or charitable or non-profit organizations.
  • Family run charities and non-profits that receive investment advice from the family office should stop accepting non-family client contributions by August 31, 2011 (unless the pledge was made before then).
  • Assess all non-family client contributions made to family run charitable and non-profit organizations. Determine the amount that has been spent following those contributions. If non-family client contributions exceed subsequent expenses, make plans to spend the excess amount by December 31, 2013, for the organization to remain eligible as a family client.
  • Assess whether the family office ownership structure meets the ownership and control tests.
  • Review any marketing materials, stationery or website if applicable to ensure they do not cause your family office to be holding itself out as an investment advisor.

Family offices should make assessments now to change structures, ownership and clientele prior to March 30, 2012. WTAS can help make recommendations to fit the exclusion. If it is determined that fitting the exclusion is impractical or impossible, other changes may be considered to help mitigate the information that becomes publicly disclosed when registering as an investment advisor.

The final rule detailing the family office exclusion can be found here. More information as to the requirements of registering and operating as a registered investment advisor are here.