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As a founder of a private equity (PE) fund, you are likely more interested in sourcing new deals and successfully getting your fund off the ground than thinking about proactive estate planning. This is understandable, but the reality is that a PE fund interest, specifically the carried interest (often referred to as “carry”) earned as general partner, is an ideal asset to gift for estate planning purposes. The main reason is because of its high potential for appreciation and low initial value.

What is carried interest and why is it an attractive asset to transfer?

PE funds, as well as hedge funds, make money by charging a management fee and a performance fee to limited partners wanting to invest with them. Carried interest is a percentage of this performance fee, specifically the profits earned by the general partner of the fund over time. Founders of a PE fund receive a percentage of this carried interest as compensation and will also hold an ownership interest, tied to their contribution towards the fund’s initial capital.

Carried interest can be a powerful candidate to gift outside of your taxable estate because it is both an asset and future income stream. The value of the carried interest will be lower during the early stages of a fund’s life cycle since it is tied to the fund’s performance itself. Early on, there is little to no performance history for a new fund. But as a successful partner generates positive returns for his or her fund, the potential growth of the carried interest can be very high. Assets with a low initial value and high potential for appreciation are well suited to gift to loved ones, allowing not only the removal of the asset but also the future growth from your taxable estate!

What is a taxable estate? What are the current Federal Estate/Gift/GST tax rules?

Our firm has written extensively on these topics and has a Federal and State Estate & Gift Tax “cheat sheet”, along with a helpful explanation of how transfer taxes and exemptions work in real life. In short, the gift tax is applicable to transfers made during lifetime, whereas the estate tax applies to bequests made after death. The GST tax applies to transfers made to skip persons, defined as someone two or more generations or 37.5 years younger than the transferor. The exemption amounts available for gift, estate, and GST tax are used to offset an applicable tax otherwise due.

Should I just gift my carried interest, given the advantages?

Yes, but the IRS scrutinizes such transfers closely, and added a chapter to the tax code in 1990 addressing them. IRC Section 2701 looks closely at transfers involving partnerships and corporations with multiple classes of ownership interests, including a PE fund where individual partners have both an ownership interest and a carried (profits) interest. A consequence of Section 2701 is that gifting only the carried interest but retaining the more stable ownership interest may lead the IRS to treat the transfer as a deemed gift. This would mean that, in addition to the carried interest actually transferred, significantly more or potentially all the of the partner’s other interests in the fund could be included by the IRS as part of the transaction – even when not actually gifted. This would require the use of valuable federal gift tax exemption and/or paying a 40% gift tax, depending on the size of the gift and exemption amount available to offset the tax.

Is there a safe way to gift my carried interest?

Yes, IRC Section 2701 allows a safe harbor that avoids triggering disadvantageous valuation rules described in the previous section when gifting carried interest. This is commonly referred to as the ‘vertical slice’ rule and requires that the transferor (and/or senior family members, if applicable) proportionately reduce all of his or her interests in the fund when making such a gift to a junior family member. A helpful example is to think of a PE fund as a layered cake with the ownership interest on top and carried interest underneath: the vertical slice rule would require both interests to be proportionally reduced when “sliced” and ultimately gifted. To gift a portion of carried interest, the fund partner therefore must gift an equivalent portion of all his or her interests in the fund to avoid the risk of a deemed gift result.

  • Consider John, who has a $1 million commitment to his PE fund and a 10% carried interest which he would like to gift a portion of. If he wants to gift half of the carried interest (5%) to a trust set up for the benefit of his children/grandchildren and retain the remaining half, the ownership interest must be split too such that both John and the trust each have a $500k commitment after the transfer.
  • The PE fund is only in its second year. Based upon a valuation firm’s appraisal, the value of 1% of carried interest is determined to be $50k. The transfer would result in a taxable gift of $250k to the trust for the carried interest, more if John also needs to gift cash to the trust to make future capital commitments.

The advantage of the vertical slice rule is that it is relatively straightforward to implement and relying upon it is a well-trodden path trusted and used by many estate planning practitioners. The downside is that it makes the gift of carried interest more expensive than it otherwise would be, requiring more use of gift tax exemption.

Are there alternatives to the ‘vertical slide’ rule?

Yes, there are several alternatives to the ‘vertical slice’ rule. A common one includes the creation and sale of a cash-settled option from the partner, usually to a trust for the benefit of his children and grandchildren, tied to the upside (or downside) performance of the carried interest. The cash-settled option, thus, does not involve transferring the actual carried interest itself and avoids the ‘vertical slice’ rule. At first glance, this technique can seem more complex but can be simpler from a practical standpoint to execute and appropriate in the right circumstances. An example would be a successful PE fund in existence for some time, where making a transaction relying on the ‘vertical slice’ rule is prohibitively expensive.

  • Instead of gifting half of his 10% carried interest early in the life of the PE fund, John decides to move forward with the transfer several successful years later. The value of 1% of John’s carry is now $500k, meaning a taxable gift of $2.5M on top of the required portion of his capital commitment.
  • An alternative John could consider is creating and selling a cash-settled option to the trust, tied to the economic performance of his carry. The trust would exercise the option after a term of years with significant value transferred if the PE fund has done well over that period. The taxable gift would be the value of the option premium, lower than the value of the carried interest itself.

In a proposed gift of PE fund interests, there are a number of additional factors to consider including fund structure, fund ownership, the need for an appraisal, and overall estate planning goals that should be discussed with a qualified and experienced attorney, along with your financial advisor. The bottom-line is to recognize that the powerful appreciation potential of carried interest, which can make it so profitable for PE fund partners, also makes it a good asset to gift to the next generation.

 

Wealthspire Advisors LLC is a registered investment adviser and subsidiary company of NFP Corp.
This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Wealthspire Advisors cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. © 2020 Wealthspire Advisors
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Kevin Brady, CFP®

Kevin is an advisor in our New York City office.