Investment Firm as FSO?

What are everyone's thoughts on whether a company that provides investment advisory and asset management services would be a "service organization" under the ASG rules?

Under the regs (which I recognize are still just proposed), while such a company would not appear to fall within any of the enumerated fields in 1.414(m)-2(f)(2) (except maybe "consulting," but I think that is a stretch), it seems to me that it would easily qualify as a "non-capital intensive organization" under the general definition in 1.414(m)-2(f)(1), according to the last sentence (i.e., the gross income of the business consists principally of fees, commissions, or other compensation for personal services performed by an individual).

However, there is a specific carve out in 1.414(m)-2(f)(1) for "banks and similar institutions," which are deemed to be capital intensive.  So, I guess the ultimate question is whether an investment advisory and asset management business constitutes a "bank or similar institution" within the meaning of 1.414(m)-2(f)(1)?

I tend to think yes, but I could be persuaded.

If you're talking about a firm that is paid a fee to recommend investments to someone else, I don't think so.

The test is whether capital is a material income-producing factor, i.e., does the company have to use its money to make more money. My impression is that a "bank or similar institution" refers to a company that uses money to make more money by, for example, loaning its money to another business who repays it with interest. I don't think a "similar institution" would be any company in the financial field; I would interpret the "similar institution" along the lines of other non-bank lenders (e.g., payday lenders, factoring companies, etc.). 

A financial advisory firm presumably wouldn't be using its own money to make more money. Rather, its income production would consist of the fees received for the personal services of its employees making recommendations to its clients. 

3 hours ago, BTG said:

What are everyone's thoughts on whether a company that provides investment advisory and asset management services would be a "service organization" under the ASG rules?

Under the regs (which I recognize are still just proposed), while such a company would not appear to fall within any of the enumerated fields in 1.414(m)-2(f)(2) (except maybe "consulting," but I think that is a stretch), it seems to me that it would easily qualify as a "non-capital intensive organization" under the general definition in 1.414(m)-2(f)(1), according to the last sentence (i.e., the gross income of the business consists principally of fees, commissions, or other compensation for personal services performed by an individual).

However, there is a specific carve out in 1.414(m)-2(f)(1) for "banks and similar institutions," which are deemed to be capital intensive.  So, I guess the ultimate question is whether an investment advisory and asset management business constitutes a "bank or similar institution" within the meaning of 1.414(m)-2(f)(1)?

I tend to think yes, but I could be persuaded.

This may be helpful to you (from Derrin's book, WTE):

Q 13:5 What is a service organization?   

The Code defines a service organization as an organization which primarily performs services. [Code §414(m)(3)] The proposed regulations are more helpful. They give two alternate categories of service organizations:

• An business is automatically a service organization if it engages in the fields of:

   

  • health,

  • law,

  • engineering,

  • architecture,

  • accounting,

  • actuarial science,

  • performing arts,

  • consulting, or

  • insurance.

   

   

  However, an organization is not described above if it merely manufactures or sells equipment and supplies used in the field or does research or publishing in the area. Nor is a business described above simply because it has an employee who performs those functions "in house," but the organization does not provide those services for the public. [Prop. Treas. Reg. §1.414(m)-2(f)(2)]

   

   

  Simply listing the fields involved leaves many questions open whether a particular business is engaging in one of the listed fields. There have been no rulings under Code §414(m) defining these fields.

   

   

  However, there may be another source for guidance. Code §448, which deals with ability to use the cash method of accounting, contains a virtually identical list of fields. [Code §448(d)(2)(A)] There is no particular reason that the "consulting" field should mean different things in the two contexts, especially when the list of fields is the same in both. There are rulings and temporary regulations interpreting the fields in that context.

   

   

  The definition of "consulting" is particularly open to interpretation. The Code §448 regulations define consulting as the provision of advice and counsel, not sales or brokerage. The regulations contain numerous examples of what constitutes consulting. [Treas. Reg. §1.448-1T(e)(4)(iv)]

   

   

• Alternatively, a business is a service organization if capital is not a material income-producing factor. [BL 130] Whether or not capital is a material income producing factor is decided on the basis of all facts and circumstances. The regulations give three examples to illustrate this point:

   

  • Capital is a material income-producing factor for banks and similar institutions.

  • Capital is a material income-producing factor if there is substantial investment in inventories, equipment, plant, and machinery.

  • Capital is not a material income-producing factor if the income of the business comes primarily from fees or commissions for personal services performed by one or more individuals. [Prop. Treas. Reg. §1.414(m)-2(f)(1)]

   

   

Given this definition, most all manufacturers, retailers, and wholesalers will not be service organizations, because capital is a material income-producing factor in their business. [BL 76; BL 77]

The type of entity involved, (e.g., sole proprietorship, partnership, corporation, etc.) is immaterial. Any type of business can be an "organization" for the service organization rules. [Prop. Treas. Reg. §1.414(m)-2(e)(1)] However, the author believes performing service as an individual partner or as a common-law employee does not constitute a separate organization for this purpose. [BL 107; BL 126]

The definition of "service organization" is one of the most crucial issues in dealing with traditional ASGs. Only service organizations can be FSOs or A-Orgs. Because of its importance, we will present several examples of businesses and determine whether they are service organizations:

Example 13.5.1 Bob is an actuary. His business is a service organization because he is in the field of actuarial science. It does not matter whether capital is a material income-producing factor.

Example 13.5.2 Clayton plays baseball professionally, and has set up a professional corporation under contract to his team. Sports are not listed in the fields that are always service organizations. It is not a "performing art." [Treas. Reg. §1.448-1T(e)(iii)] However, Clayton’s corporation is nonetheless a service organization because capital is not a material income-producing factor. Most of the revenue of the business comes from Clayton’s personal services.

Example 13.5.3 Henry is an eye doctor. He has invested over $500,000 in laser equipment used in his practice. Without the equipment, he could not practice. Even though capital is a material income-producing factor, Henry’s business is a service organization, because health is one of the listed fields.

Example 13.5.4 Lindsay Leases is a corporation that rents and sells medical equipment, such as crutches and wheel chairs. It is not in the field of health, per se, because it primarily sells and rents equipment. Because of its inventory, capital is a material income-producing factor. It is not a service organization.

Example 13.5.5 EastLaw prints law books. It is not in the field of law because it primarily engages in publishing. Inventory and equipment costs are substantial, so capital is a material income-producing factor. EastLaw is not a service organization.

Example 13.5.6 Katherine is a freelance author writing for a variety of publications. She has a computer she uses to type her material, and other normal office equipment, but otherwise does not have a substantial investment. Katherine is not in one of the listed fields, but capital is not a material income-producing factor. Her business is a service organization.

Example 13.5.7 Allcity is an insurance company. Although the capital in its business is enormous, Allstate is a service organization because it is in the field of insurance.

Example 13.5.8 Rebecca owns a veterinary corporation, which has substantial investment in its physical plant. Although "health" is not defined, arguably veterinary science is health related. For Code §448, the IRS has ruled veterinarians are engaged in the health field. [Rev. Rul. 91-30] The revenue of the corporation comes primarily from personal services performed by individuals, and hence capital is not a material income-producing factor, notwithstanding the physical plant. The corporation is a service organization.

Example 13.5.9 A partnership operates a health spa. There is a substantial investment in the physical plant, and capital is a material income-producing factor. The question is whether this is in the health field. Although not binding for Code §414(m), the analogous Code §448 temporary regulations define "health" as the performance of medical services by doctors, nurses, dentists, etc. Health clubs and spas are excluded from being in the health field. [Treas. Reg. §1.448-1T(e)(4)(ii)] The spa partnership would not be a service organization.

Example 13.5.10 Ashley is a performer, singing at numerous rock concerts during a year. She has invested heavily in musical instruments, costumes, and electronic gear to put on her shows. Since she is a performing artist, her sole proprietorship is a service organization. CD Talent, Inc. manages Ashley and other singers. The management company is not in the field of performing arts, but capital is not a material income-producing factor in its business. Hence, the management company is a service organization. Radio station KRAS regularly plays Ashley’s music. With the equipment required to operate a radio station, capital is a material income-producing factor. It is not in the performing arts field. [Treas. Reg. §1.448-1T(e)(4)(iii)]

Example 13.5.11 The Rams Head Inn is a restaurant. It derives its income from the sale of its inventory. There is also substantial investment in equipment, furniture, etc. Capital is a material income producing factor, and it is not a service organization.

Example 13.5.12 A hospital is in the field of health. While it is true that capital is a very material income producing factor, a hospital is a service organization. [BL 203]

Example 13.5.13 Ray is an independent real estate broker. He operates his brokerage as a sole proprietorship. Brokerage is not regarded as consulting, so he is not in one of the listed fields. However, Ray’s investment in capital is minimal. Income primarily comes from his rendering personal services. His business is a service organization.

Example 13.5.14 Worldwide is a huge real estate brokerage company, with offices in every American city with over 40,000 people. It has a large computer network which it uses to list and sell properties. Because of the significant investment in plant and equipment, capital would likely be an income producing factor, and so Worldwide would not be a service organization.

Example 13.5.15 Andrew retired and sold his company to a third party. As part of the sales agreement, Andrew receives $30,000/year for consulting services to the buyer. He is available to help with the transition, make suggestions, and provide institutional memory. Assume he is an independent contractor in that role. Consulting is one of the listed services and accordingly Andrew’s consulting business is a service organization.

Example 13.5.16 Chris owns a public relations/advertising agency. She consults extensively with her clients on the program best for them, produces some advertising in-house using her own equipment, and places the ads with the media. Chris’ clients pay her for the production and she receives a commission for ads she places. According to the §448 regulations, Chris is not in the consulting business, principally because she is not paid separately for her consulting work. [Treas. Reg. §1.448-1T(e)(4)(iv)(B), Example 9]

Example 13.5.17 Melvin advises clients about their computer needs. He reviews their information processes and goals and makes recommendations on equipment to purchase and systems to implement. He does not provide additional programming or sales services and is paid strictly for his time. Melvin is in the consulting business. [Treas. Reg. §1.448-1T(e)(4)(iv)(B), Example 2]

Example 13.5.18 GrabEm is a private equity firm. It acquires other businesses, sometimes holding them for long periods, and other times repackaging and selling them. GrabEm is not a service organization. Capital is not merely a material income producing factor; it is the only material income producing factor. [BL 338]

On 7/30/2020 at 12:51 PM, BTG said:

What are everyone's thoughts on whether a company that provides investment advisory and asset management services would be a "service organization" under the ASG rules?

Under the regs (which I recognize are still just proposed), while such a company would not appear to fall within any of the enumerated fields in 1.414(m)-2(f)(2) (except maybe "consulting," but I think that is a stretch), it seems to me that it would easily qualify as a "non-capital intensive organization" under the general definition in 1.414(m)-2(f)(1), according to the last sentence (i.e., the gross income of the business consists principally of fees, commissions, or other compensation for personal services performed by an individual).

However, there is a specific carve out in 1.414(m)-2(f)(1) for "banks and similar institutions," which are deemed to be capital intensive.  So, I guess the ultimate question is whether an investment advisory and asset management business constitutes a "bank or similar institution" within the meaning of 1.414(m)-2(f)(1)?

I tend to think yes, but I could be persuaded.

SO SORRY!  This should have been NO IT ISN'T!!!!

 See my longer response with Derrin's material from Who's The Employer.

Thank you both for the thoughtful responses.  Larry, I think the closest example from Derrin's book is the private equity firm in 13.5.18.  However, I think EBECatty draws a reasonable distinction based upon whose money is being invested.  My particular situation involves (on an oversimplified basis):  Entity A owns 49% of Entity B.  Entity B's exclusive business is to provide investment advice and manage Entity A's money.  Because Entity B is essentially rendering investment services for a fee, I think I am persuaded byEBECatty's analysis that it can be distinguished from the traditional bank or the private equity firm in Derrin's material, which are using their own money to make money.

On a related note, do you think such investment advisory/asset management services would constitute a "management function" under 414(m)(5)?  If so, the first inquiry may be irrelevant.  (Of course, we have even less guidance on 414(m)(5).)

On 7/30/2020 at 4:28 PM, BTG said:

Thank you both for the thoughtful responses.  Larry, I think the closest example from Derrin's book is the private equity firm in 13.5.18.  However, I think EBECatty draws a reasonable distinction based upon whose money is being invested.  My particular situation involves (on an oversimplified basis):  Entity A owns 49% of Entity B.  Entity B's exclusive business is to provide investment advice and manage Entity A's money.  Because Entity B is essentially rendering investment services for a fee, I think I am persuaded byEBECatty's analysis that it can be distinguished from the traditional bank or the private equity firm in Derrin's material, which are using their own money to make money.

On a related note, do you think such investment advisory/asset management services would constitute a "management function" under 414(m)(5)?  If so, the first inquiry may be irrelevant.  (Of course, we have even less guidance on 414(m)(5).)

So sorry; I went back and re-edited my prior short answer, because I meant to say the answer is NO.  Derrin's examples (I thought) were right on and this is not a capital intensive business.  Sorry for the confusion. 

As to a management function: I don't see this meeting that criteria.

Do banks loan their own money?  Or is it the depositor's money?  (That's why banks pay people interest--the bank uses the customers' funds to lend out.  The interest on the loans is paid to the bank, which passes on a lower rate to the depositors.)

1 minute ago, BG5150 said:

Do banks loan their own money?  Or is it the depositor's money?  (That's why banks pay people interest--the bank uses the customers' funds to lend out.  The interest on the loans is paid to the bank, which passes on a lower rate to the depositors.)

Banks create money when they loan. They aren't loaning their own money or their customers money. But they do have regulatory capital requirements that they have to meet if their loan balances grow.

21 hours ago, Bill Presson said:

Banks create money when they loan. They aren't loaning their own money or their customers money. But they do have regulatory capital requirements that they have to meet if their loan balances grow.

Having both an undergraduate and masters in economics, I remember being amazed in my first Money and Banking course to find out how banks really work. They really do CREATE money utilizing what is known as the fractional reserve system.  Economics is called the dismal science, and most people's eyes glazed over when us eco majors started talking to non majors in school about the things we now knew, but I still find it fascinating and often think I would have gone on for my doctorate IF the field of Behavioral Economics existed as such when I graduated my MBA in the late '70s; it didn't, and thus the career I did have.....

21 hours ago, BG5150 said:

Do banks loan their own money?  Or is it the depositor's money?  (That's why banks pay people interest--the bank uses the customers' funds to lend out.  The interest on the loans is paid to the bank, which passes on a lower rate to the depositors.)

The interest paid by the bank is equivalent to "rent" of those resources.  Just like my brick and mortar store pays rent to the owner of the property, we then use that asset to make even more money by selling products and services people are willing to pay for at a rate that more than covers our "rent". The banks do the same thing, but their operation actually allows them to create money where there was none before.  That's why a bank actually can afford to have major defaults and still make money. I remember the mystification when I first learned how that all works, and I know now why so many folks want to start banks (I was offered the opportunity twice to be a bank founder and I didn't go for it; one was a hit and the second is still trying to find its way....).

I'm with EBECatty on this one, at least without further facts. Very likely a service org, although the facts are insufficient to reach a conclusion. In my experience, "investment advisory and asset management services" probably means people in an office, with computers and nice furniture and décor, but making money entirely from fees and commissions earned by advising other people, called clients, about their investments. The phrase would typically not be used to describe the business of a partnership or LLC, like a PE or hedge fund, in which the "managers" all have equity stakes and get K-1's. I would advise BTG to get a more complete description of the business of the entity in question. Ideally, BTG could review copy of the business's financial statements and look at the ratio of revenue to invested capital, but they may not want to share.