Key Takeaways
• Differences in how gifts and estate are taxed create opportunities for efficient tax planning.

• By gifting carried interest to descendants or trusts for their benefit, you can greatly increase the net wealth passed on to the next generation.

• Don’t overlook the vertical slice rule, which limits how we can divide and gift interests.

• Derivative contracts can be an excellent planning tool for highly compensated fund managers. Just don’t be a do-it-yourselfer here.

“By failing to plan you are planning to fail.”—Benjamin Franklin

When it comes to carried interest, volumes have been written about its controversial income tax treatment. But the gift and estate tax implications of carried interest for highly compensated managers is under-discussed and often misunderstood. And that knowledge gap is causing many planning opportunities to be missed.

As many of you know, your gift and estate taxes are the result of a 40% tax rate and your lifetime gifts and estate—less the exemption amount. Gifts are taxed at fair market value (FMV) at the date of the gift, but your estate is taxed at FMV upon the date of your death. By gifting highly appreciating assets such as stock options and carried interest, we can lock in lower values than you would have in your estate, whether directly or fungibly in a bank account.

The Planning Clock Is Ticking
The current exemption level (about $13 million for singles, $26 million for married couples) is expected to be cut to roughly $7 million/$14 million when many provisions of the 2017 Tax Cut & Jobs Act sunset at the end of 2025. This creates a one-time “use it or lose it” planning scenario for highly compensated managers of hedge funds, private equity funds and venture capital funds over the next two years. I’m talking about the opportunity to transfer up to $2.8 million/$5.6 million (40% of $7 million or $14 million) to your heirs and preserve your legacy. In a vacuum, this is a huge one-time opportunity, but when coupled with the perennial opportunity of gifting carried interest, the benefit can be five to 10 times greater.

Carry is valued at around 10% to 20% of its future value at or near the start of the fund. This range is an industry standard rule of thumb and is consistent with our firm’s financial models. About 90% of the valuations I do in this sector are at “times zero,” i.e. at the start of the fund, or even at “pre-zero.”

By gifting carried interest to descendants or trusts for their benefit, you can greatly increase the net wealth passed on to the next generation. This is a great conversation to have with the principals when starting a new fund. Talk to the GPs about their estate planning needs. Can we synergize compliance costs of the process  and maximize the benefits? You need to allow at least a few months to run up the project. This includes engaging an appraiser and estate attorney who are experienced in this niche. You also want to keep the tax accountant in the loop. The gift tax filing does not require a ton of work, so it shouldn’t drive the project.

The gift can be made as soon as decisions are relatively set about the fund. Not everything needs to be locked in place in order to move forward with the planning, as long as we have investment strategies, and limited partnership agreements (LPAs), etc. in place.

I’ve found a good time to make a carried interest gift is between the time of the initial closing and the time of the final closing. That’s when the private placement memoranda are done, LPAs are drafted or finalized, and we can roughly project capital raising. We can work from those assumptions as long as they are reasonable, and we’ll be in good shape to proceed. Gifting during the first year of the fund is viable as well, but if you wait much later, the benefit of this strategy tends to drop off.

Carried Interest Derivative Contracts
I realize most people don’t enjoy having estate planning conversations, but now is the time to have those uncomfortable dialogues since time (and money) is on your side. Consider carried interest derivative contracts as a planning tool.

A common pitfall when it comes to carried interest tax and estate planning is the vertical slice rule (aka vertical slice safe harbor) under IRC 2701, which limits how we can divide and gift interests. Basically, it states if we want to gift the carried interest in our fund, then we must also gift a proportional amount of any other interest in the fund, typically as a direct interest or sometimes as a deemed contribution. This makes the gift much less efficient from a tax standpoint, because the direct interest or deemed contribution has much less appreciation potential. It might also cause us to run into issues with partnership admittance as well as the administrative challenges of making a trust a partner of the fund.

The derivative contract would be one that is explicitly made between the individual partner and his or her trust. It would stipulate that the carried interest paid from the fund—in excess of a hurdle amount—would be paid to the trust by the individual partner. Additionally, we can stipulate multiple specific dates of payment, maximum payment amounts, or any other factor that fits your personal needs.

Technically the trust would “buy” the derivative contract at fair market value from the partner with a gift in cash for the same amount. Derivatives are a great way to address the Vertical Slice rule and eliminate the need to deal with partnership issues. The value of the derivatives themselves are typically about 30% to 50% of the carry value, depending on a variety of factors. Again, these are industry standard rules of thumb which are consistent with our firm’s financial models. I like the fact that the derivative contact frees us from the often-restrictive timeline of the fund.  

Derivative contracts are a smart and powerful tool I see used frequently in private equity. I’m surprised it’s not being used by more hedge fund managers. They give the partner far more control and flexibility to address their specific goals than most other tax and estate planning tools.

Real World Example
Let’s take the case of John Doe, a principal in ABC Fund, a $500 million PE fund. John and his fellow GPs account for 1% of capital commitments to the Fund and John’s portion represents $1 million. Additionally, he owns 20% of the carried interest to be realized in the Fund.

In our first scenario, John is interested in making a transfer of his carried interest to a trust for his children. Assuming we are at “time-zero,” then the value of John’s carried interest would be around $2 million. However, given the previously discussed Vertical Slice rule, if John transfers his carried interest to a trust for his children then he’d also make a safe harbor transfer of his direct interest. The value of John’s unfunded direct interest would be zero, however he’d need to fund the trust with cash to make future capital calls. That creates an inefficient estate planning maneuver. Overall, John would still benefit from the transfer and pay around $1.2 million in gift tax, but let’s explore an even more optimized example.

In our second scenario, John employs the use of a derivative agreement. Under some simplified assumptions regarding its terms, the derivative contract would be worth around $800,000. Additionally, John could transfer (via a sale with matching cash gift) the derivative contract without making any transfer of his direct interest. This would result in a great estate planning play and would only incur $300,000 in gift tax.

In a third, less ideal scenario, John and his advisors would not do any estate planning. On the plus side, he would not have to pay any gift tax, however his interests (whether directly or fungibly) would greatly increase his eventual estate tax bill. Without taking advantage of time and appreciation when he had it, John’s estate tax would increase by an estimated $15 million. That implies 12.5x and 50x returns on the above scenarios 1 and 2, respectively.

Conclusion
As Ben Franklin famously said: “An investment in knowledge always pays the best interest.” If you or someone close to you has concerns about gifting carried interest or other complex assets.

Anthony Venette, CPA/ABV, is a senior manager of business valuation and advisory at DeJoy & Co., CPAs and advisors in Rochester, New York. Venette provides business valuation and advisory services to corporate and individual clients of DeJoy.