Unlocking Gift Planning for Carried Interest

Private equity or hedge fund principals are in a unique position when transferring their fund interests either to family members directly or in trust. What makes their position so unique is the nature of the basket of economic rights that they own which often includes the potential for carried interest. A key principle of any strategic estate plan is an objective to transfer assets out of a taxable estate before those assets appreciate significantly in value. If planned correctly, private equity and hedge fund assets (which often include GP interests and the associated carry) are subject to valuation discounts (e.g. due to lack of marketability or minority interests) that allow you to leverage your lifetime exemption and transfer more wealth to family tax-free. These discounts reduce the value of gifted assets for tax purposes, allowing more wealth to be transferred within the exclusion limits. Considering the natural impulse to utilize the potential value disparity in these interests to make strategic gifts, tax statutes exist that force the consideration of all of your retained interests prior to making gifts of any part of your interests. Careful and sophisticated planning is necessary to ensure conformity with the law.

Three Strategies to Preserve Wealth through Carried Interest Giving

Private equity and hedge funds are generally structured as limited partnerships, with the organizers and fund managers owning units of the general partner and management company in addition to limited partnership interests. The fund manager’s interest in the general partner usually includes their capital contribution as well as their future right to receive carried interest, a share of the fund’s profits.

During a fund’s initial stages, when valuations are low, a fund manager’s carried interests are often the most attractive assets to transfer to family members before valuations and cash flows increase. Without careful planning, however, the transfer of these interests to family members can cause inadvertent and seriously adverse tax consequences. Carried interest transfers are subject to the Internal Revenue Code’s Special Valuation Rules under Chapter 14^[1] (particularly Section 2701), which can treat the transferor as if they gave away their entire interest in the fund instead of a portion of it. The danger of running afoul of Chapter 14 is an invalidation of the entire transaction resulting in potentially material gift taxes. To avoid the imposition of the Chapter 14 valuation rules, fund principals looking to make transfers of their carried interests to their family should use a planning technique that serves as a safe harbor under Section 2701 (the "vertical slice”) or use techniques that focus on the expected value of their carried interest cash distributions to transfer the appreciation out of their estate.

Here are three common techniques leveraged to maximize the effectiveness of carried interest gifting:

1. Proportionate Transfer Exception or “Vertical Slice” Approach – In my opinion, many practitioners would point to the vertical slice as the most common approach. The potentially onerous tax implications of Chapter 14 (Section 2701) can be bypassed by transferring a proportionate amount of all the transferor’s economic interests in the fund to their family member(s) or trusts for their benefit. This exception is expressly indicated in the tax regulations.

2. Carried Interest Derivatives – Those who find the vertical slice method too cumbersome may opt to engage in a derivative strategy based on the performance of the carried interest. A carried interest derivative is a specific type of derivative that bases its value on your carried interest. It is settled with cash, meaning the buyer is paid in cash when the contract ends. The carried interest derivative allows you to transfer wealth to the buyer (e.g. a family trust) based on how well the carried interest performs over time.

3. Grantor Retained Annuity Trusts (GRATs) – GRATs are statutorily sanctioned trusts that allow for the transfer of assets with little to no gift tax value as long as the grantor receives an annuity stream essentially equal in value to the property transferred. The creator of a GRAT with carried interests is counting on an outcome where carried interest distributions exceed the required annuity payments thereby resulting in a benefit to family.

These three strategies do not represent the entire universe of strategies that can be deployed. While each of these strategies are intricate as they attempt to navigate a complex set of laws and regulations, each one provides an essential means of transferring carried interest or its appreciation at different stages of the development of a fund. They are often combined with the use of irrevocable trusts (for making gifts and installment sales), such as grantor trusts that may also be spousal lifetime access trusts (SLATs) and/or dynasty trusts. To ensure a desired (but still advisable) measure of control and access to the fund assets, properly drafted, flexible trusts and other estate vehicles (e.g. LLCs) are often employed.

Finding the Right Strategy that Works for You

Due to the unique characteristics of carried interest, finding the right estate planning approach in advance is crucial and can potentially result in a tax-efficient transfer of material wealth to future generations. These strategies are a way to navigate a particularly complicated section of the tax code (Chapter 14). As with all advanced planning techniques, experienced advice is critical. Our Wealth Planning team is skilled in guiding hedge fund and private equity principals through the intricacies of tax and estate planning. We unlock the right strategies to transfer your wealth - aligned with your objectives and legacy goals - in a tax-efficient manner.