Overview
Private equity, venture capital, hedge fund and real estate fund professionals often hold their most valuable assets in forms that ordinary estate planning does not address: carried interests, profits interests, general partner commitments, co-investments and interests in the management company. These interests can grow dramatically in value, which makes them among the most effective assets to transfer to family trusts, provided the transfer is structured correctly.
The Section 2701 Problem
Fund professionals typically hold both a capital interest, from their commitment to the fund, and a carried interest. A gift of the carried interest alone, while keeping the capital interest, can fall under Section 2701 of the Internal Revenue Code, a special valuation rule for transfers of interests in family-controlled entities. In that case, the retained capital interest may be valued at zero for gift tax purposes, so the taxable gift can be far larger than the value of what was actually given.
The Vertical Slice Solution
The most common way to avoid Section 2701 is a “vertical slice” transfer. Instead of giving away only the carried interest, the donor transfers the same percentage of every interest held in the fund, both capital and carry. Because the transfer is proportionate, Section 2701 does not apply, and the gift is valued at its actual appraised value. A vertical slice does mean transferring a share of the capital commitment as well, so the plan must account for the trust’s ability to fund future capital calls.
Other Planning Strategies
Depending on the fund, the interests held and the family’s goals, a plan may also use:
- Spousal lifetime access trusts and dynasty trusts, to hold transferred interests for a spouse and future generations
- Grantor retained annuity trusts, to shift appreciation above the IRS assumed rate with little or no gift tax cost
- Sales to grantor trusts, to transfer larger interests in exchange for a promissory note
- Interests in the management company, which may be transferred separately from fund interests
- Early in a fund’s life, you hold a $2 million capital interest and a carried interest appraised at $500,000.
- You give a 25% vertical slice of both to a family trust, a gift valued at $625,000.
- If the fund ends with your capital worth $3 million and your carry worth $10 million, the trust’s share is worth about $3.25 million, all outside your estate.
Hypothetical illustration using assumed values and the 40% federal estate tax rate and, for New York residents with a taxable estate, a combined federal and New York rate of about 50%. Because the transfer is proportionate, Section 2701 should not apply. It ignores future capital calls funded by the trust. Not a prediction or a result for any client; actual results depend on many factors.
Considerations
- Valuation. Transfers should be supported by a qualified appraisal, and gift tax returns should adequately disclose them.
- Fund documents. Partnership and operating agreements often restrict transfers or require consent, so planning must be coordinated with fund counsel.
- Capital calls. A trust that holds a capital interest needs a source of funds for future capital calls.
- Income tax. The income tax treatment of carried interests, including the three-year holding period that applies to them, should be confirmed with your tax adviser.
Every fund and family is different, and these transfers reward early, careful structuring.
We advise on the gift and estate tax aspects of transfers of fund interests and work alongside each client’s tax adviser and fund counsel, who handle the income tax treatment and entity documents.