Don’t Get Carried Away: Estate Planning with Carried Interest Under “Safe Harbor” and Other Planning Options

Carried interest can be a valuable part of the profits earned by an individual from a private equity or venture capital fund. General partners in a fund have an opportunity to gift their carried interest to use some of their federal estate tax exemption amount prior to the potential sunset of the Tax Cuts and Jobs Act, which would reduce the exemption amount from $13.99 million in 2025 to about $7 million to $7.5 million in 2026.

While general partners cannot gift the carried interest and retain their initial amount invested in the fund (the capital interest), a general partner can take a “vertical slice” of her ownership interests and transfer this slice to family members outright or, more likely, into an irrevocable trust for their benefit. Another option involves entering into a derivative contract for the carried interest between the general partner and a grantor trust. Both strategies require careful estate and tax planning with coordination among the general partner’s tax adviser, financial planner, and attorney.

Carried Interest

A private equity fund manager (the GP) typically manages large pools of capital by controlling a fund which generates profits that are measured against an agreed-upon minimum return in exchange for the manager’s services. This share of profits is typically referred to as carried interest, which is separate for purposes of the distribution waterfall from the return of the investors’ invested capital and preferred return, as well as the GP’s catch-up distributions.

This carried interest, however, reflects the potential success of a fund through the efforts of a GP, and carried interest’s significant appreciation potential makes it an ideal asset to transfer during the GP’s lifetime, particularly early in the fund’s lifecycle and through estate planning techniques. Harsh gift tax consequences must be carefully avoided through coordinated planning.

Gifting Carried Interest

Internal Revenue Code Section 2701 generally restricts a GP’s ability to gift carried interest in a fund to others while retaining the capital interest in the fund. The GP cannot retain an “applicable retained interest,” which is an equity interest that either offers the holder an extraordinary payment right or a distribution right. These extraordinary payment rights include any right to compel liquidation of the fund or entity that could affect the value of the retained interest.

It is this discretionary right that triggers the valuation of the transferred interest. Therefore, if the retained interest must be exercised at a specific time and at a specific price, Section 2701 will not be triggered. Similarly, a transferor should avoid retaining a distribution right to receive distributions for the retained equity interest unless its interest is junior to or the same as the rights of the transferred interest. Thus, a GP should avoid either having discretionary control over influencing the entity’s liquidation or having a distribution priority in her retained equity interest.

Being subject to Section 2701 could result in a GP’s transfer of her capital interest being a transfer of her entire interest in the fund, rather than just the carried interest, by assigning a zero value to any extraordinary payment right and any distribution right (unless classified as a qualified payment right). The application of this zero-value rule treats the GP as having transferred her entire equity interest for gift tax purposes rather than just the carried interest that was actually transferred, resulting in a much larger taxable gift that could potentially incur gift tax liability.

Planning Strategies

Several safe harbor exceptions to Section 2701 are outlined in the applicable Treasury Regulation. One of the most common strategies is the vertical slice exception. Under Treasury Regulation Section 25.2701-1(c)(4), the vertical slice exception provides that Section 2701 does not apply to a transfer to the extent that such a transfer proportionately reduces each class of equity interest held by the transferor and her applicable family members in the aggregate after such transfer. Therefore, for a gift to work appropriately, the GP must transfer not only some of her carried interest, but also some of her other equity interests in the fund, such as her capital interest.

One option to accomplish this vertical slice is for the GP to transfer all of her equity interests to a new limited liability company (LLC), after which she can transfer her desired portion of such LLC. This gift of an LLC interest will transfer a proportionate share of the GP’s equity interests in the fund, a gift which can be made outright or to an irrevocable trust.

One concern, however, is that this vertical slice could result in the GP using a substantial amount of her federal gift tax exemption. The GP could mitigate this outcome by investing some of her capital investment directly in the portfolio companies on a side-by-side basis with the private equity fund, rather than through the fund, but at the potential cost of decreased potential appreciation.

Therefore, another option is to create a grantor trust, funded with cash or marketable securities, that enters into a carry derivative contract with the grantor. This contract provides certain conditions or hurdles that must be met before the trust is required to make payments, such as the carried interest reaching a specified dollar threshold or a certain percentage return. The contract typically settles upon the earlier of either the contract’s expiration date or the grantor’s death, and is timed to capture most of the gain from the fund’s back third of its life when the carried interest portion is typically growing in value.

The payments due from the trust on the contract typically depend on the third-party qualified appraisal of the fair market value of the derivative, based on the time horizon and the hurdles.

The contract settles when the grantor exercises the option and she pays the trust equal to the carried interest referenced in the derivative contract, plus any distributions made to the GP net of any clawbacks.

For example, if the carry is valued at $3 million with a contract price of $1 million with a $3 million hurdle price, but at the settlement date the carry is worth $5 million with $9 million of distributions, then the grantor would transfer $11 million but will have used only $1 million in her federal exemption amount. Some of the risks are that the IRS would contest the fair market value of the derivative contract and that the carry might not outperform the hurdle rate by the settlement date. These risks might be mitigated by choosing a proper time horizon and hurdle rate, as well as potentially using the powers of substitution in the grantor trust prior to the settlement date.

Conclusion

Carried interest can be a tricky but important potential asset on an individual’s personal balance sheet. Valuable estate planning techniques might help mitigate the effects of estate tax, especially with potentially lower federal estate exemption amounts available. By coordinating the proper structuring of gifting carried interests to avoid Section 2701 through collaboration among attorneys, financial advisers, accountants, and business valuation experts, clients can navigate the safe harbors and avoid getting carried away with potential gifts of their carried interest.

Brian M. Balduzzi, JD, LLM (Taxation), CFP, is an attorney with Faegre Drinker Biddle & Reath LLP in Philadelphia and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at brian.balduzzi@faegredrinker.com.