Family offices, largely unknown twenty-five years ago, have emerged as the twenty-first century global best-in-class solution for affluent families striving to achieve long-term wealth management and preservation. The global proliferation of ultra-highnet-worth (UHNW) families in recent years has fueled the establishment and development of these offices. Moreover, family offices of all types are expected to increase in number.
A family office can generally be defined as a private family business designed to manage and preserve the wealth of the proprietary family. Using this definition, numerous entrepreneurial merchant families in the nineteenth and twentieth centuries established various businesses that could be called family offices. Moreover, these family office enterprises were used by affluent families during the Industrial Revolution to manage and invest in new business opportunities.
Some scholars have even suggested that family offices began during the Roman Empire.
These historical family office structures were intimately tied to the businesses that created the wealth of these highly affluent families. Family offices and family businesses are inextricably tied together; the family office is simply another business enterprise run or retained by the entrepreneurial family. In the United States, 55% of all families with single-family offices (SFOs) run one or more operating businesses.4 As a result of this connection, most early family office structures, commonly organized in one of two different arrangements, were defective in important ways.
One defective structure typical of early family offices is often called the “upside-down” model. This structure resulted from the use of trusts as the primary vehicle for holding assets in the nineteenth and early twentieth centuries. The trustees, often together with family member beneficiaries, would determine to establish a family office. The trustees, already in complete control of the assets, established many of these early family offices. These structures then left the trustees still in complete charge of family assets as well as the newly established family offices. This left affluent families clearly in a distinct second position behind the trustees, especially given the limited options that family members had for holding trustees accountable under the trust designs common before the late twentieth century.
The most common problem with this structure occurred when the family, acting through the family office, made a decision with respect to the investment or distribution of its assets, only to be vetoed by the trustee in complete frustration of family objectives. The upside-down element of the structure, then, is that decision-making authority does not rest with the private family through its family office, but with the trustees alone. The second defective structure is commonly referred to as the “embedded” family office because no separate family office legal structure actually exists.5 Instead, its functions are carried out inside one or more family business enterprises. In effect, the family office operations are embedded inside the family operating businesses.
This practice of carrying out family office operations inside a family operating business, using business employees and business resources, is often attended by numerous breaches of contract, breaches of fiduciary duty, conflicts of interest, tax reporting violations and ERISA6 violations without precise cost accounting allocations and authorizing legal documents.7 The simple reality is that the use of business personnel or resources for personal uses, investment or asset management is actionable self-dealing. Similarly, operating companies cannot deduct expenses incurred for investment, asset protection, personal tax planning, estate planning or similar purposes on their income tax returns.
21st century family office structures begin to emerge
SFOs are dedicated to the long-term wealth management of a single family. As SFOs slowly began to take hold primarily in North America and Europe in the post-World War II environment, these modern family office enterprises were almost universally structured as stand-alone business entities, often with a single purpose. Such enterprises were primarily investment advisory businesses that were rarely integrated with a family’s income tax planning, estate planning, asset protection planning and premarital planning objectives and structures.
Beginning in the late 1980’s, these enterprises began to evolve into more sophisticated structures which continue to serve as the hub for coordinated, comprehensive and integrated long-term wealth management strategies. Concurrently, wealth management firms and SFOs began to morph into multi-family offices (MFOs), which manage the wealth of two or more unrelated families and create synergies and economies of scale among them. A subset of MFOs has been called the “affiliated multi-family office” because it is affiliated with a financial institution, trust company or bank.8 Virtual family offices (VFOs), family offices with the functions of an SFO contained within legal structures, but without separate office facilities, were created as some SFOs began outsourcing all or most traditional family office services. This result was obtained largely due to the escalating costs and declining margins being experienced by VFOs and SFOs as the super-UHNW market began to mature. Other compelling reasons supporting the proliferation of VFOs are to provide accounting integrity and to serve a defensive function against common noncompliant business practices.
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