Estate Planning with Carried Interest: The Last Frontier of Favorable Tax Treatment for Fund Managers?

I. Overview of Private Investment Funds and Carried Interest

Although brought to the spotlight in the last presidential election, favorable income tax attributes available to “carried interest” have been under attack for some time. Various forms of legislation have been proposed to curb the favorable income tax treatment afforded to carried interest. However, managers of private investment funds, which can encompass everything from real estate funds to venture capitalist funds, should consider the estate planning opportunities associated with carried interest.

Managers of private investment funds receive two forms of compensation: a management fee for managing the fund (frequently 2% of the value of the fund’s assets) plus carried interest. Carried interest is the portion of a private investment fund’s profits that are allocated to the fund manager for achieving certain rates of return on the underlying assets of the fund. Fund managers often hold the carried interest in a general partnership that also owns a capital interest in the fund.

The management fee is taxed to the fund managers as ordinary income, typically at a top rate. The carried interest is a “profit interest” in the fund’s underlying assets. This income flows through to the fund managers, but the character of the income is determined by the underlying assets in the fund and may be taxed at the favorable capital gains rate. The carried interest is capable of enormous appreciation depending on the performance of the fund, which allows fund managers to significantly reduce their effective income tax on their interests in the fund.

II. Making Gifts of Carried Interest

A primary goal of estate and succession planning is to remove substantial appreciation from the client’s estate before the appreciation occurs. Because the carried interest is a profit interest—an interest in a contingent future return—the value of the carried interest is generally relatively low in the beginning stages of a private investment fund but may appreciate exponentially compared to the initial value. The issue, of course, becomes how to effectively remove the potential appreciation in the carried interest from the client’s estate.

In a perfect world, making gifts of a portion of just the carried interest in the early stages of the fund would allow the client to transfer significant appreciation at a relatively low gift tax cost. Unfortunately, § 2701 of the Internal Revenue Code will typically prevent this efficient transfer by causing the deemed value of the gift to be the value of the carried interest plus the value of the retained interest (i.e., the value of the capital interest in the fund). For instance, assume that at the time the fund manager desires to make a gift to a family member, the value of the manager’s carried interest is $100,000 and the value of the manager’s capital interest in the underlying fund is $1,000,000. Section 2701 would cause the value of the carried interest gift to be $1,100,000 for gift tax purposes and thus utilize a significant portion of the fund manager’s applicable exclusion amount or even cause gift tax if the fund manager has used her applicable exclusion amount.

To avoid the application of § 2701, the fund manager may make a proportional gift of the carried interest and the capital interest. Again, assume that the value of the manager’s carried interest is $100,000 and the value of the capital interest is $1,000,000, and also assume that the goal is to transfer 50% of the carried interest to family members of a younger generation. If the manager makes a gift of 50% of the value of the carried interest, the fund manager will also make a 50% gift of the capital interest. By making proportional gifts of the carried interest and the capital interest, the fund manager would be able to remove 50% of the appreciation in the carried interest from the manager’s estate at a total gift tax cost of $550,000. This transfer technique is sometimes called the “vertical slice” transfer method. It is extremely important to capture a “slice” of all interests in the fund in order to adequately make a true vertical slice transfer.

While the vertical slice approach is a potential way to transfer a carried interest, it can be somewhat administratively inconvenient. Sometimes there are multiple interests, with a proportionate portion of each interest needing to be transferred. It is also important to maintain a vertical slice approach throughout the life of the fund. This means that additional transfers may be needed at a later date. In addition, if valuations are adjusted after the transfer, the proportionate value of each transferred interest may change, resulting in a non-vertical slice transfer. One option to avoid the administrative burdens of a vertical slice approach would be to implement a so-called derivative contract approach.

Under the derivative contract approach, a financial instrument (i.e., a financial contract) can be prepared to structure a right to payment to an individual. Typically, the right to payment only occurs if certain financial hurdles are met. The hurdles can be related to a period of time, how well an asset performs, or any other reason. After the derivative is created, it can be valued as an asset. The asset can then be transferred by gift or sold to a recipient, typically a trust. Because the derivative is based on the performance of the underlying fund, and because the derivative is the actual “thing” that is transferred, § 2701 should not be applicable. In other words, the carried interest itself was not transferred. Instead, the contract based on the performance of the carried interest is the asset that was transferred.

Great care should be taken when drafting the derivative contract. This is a complex document, but it can be prepared with great flexibility to fit virtually any financial goal situation. The derivative contract approach avoids running afoul of the vertical slice requirement if the actual carried interest itself is transferred. It is often viewed as a potentially “cleaner” approach.

III. Conclusion

From an estate planning perspective, removing carried interest from a fund manager’s estate is extremely beneficial because of the dramatic appreciation often seen in carried interest. However, great care must be taken in structuring the plan. Additionally, an appraiser will likely need to be engaged to determine the fair market value of the transferred interests and/or derivative contract. Despite the intricacy and requirements of executing an effective plan, tremendous potential estate planning benefits are achieved from properly planning with carried interest. If you have any questions regarding this approach, please contact one of our attorneys.