Typically, the sponsors of private equity funds are focused on the fundraising process and the initial launch of the fund, and little attention is devoted to the estate planning opportunities that may be best exploited at the beginning of the life of the fund. Interests in private equity funds, especially the carried interest, are particularly good assets to transfer for estate planning purposes because of their significant potential for appreciation. This article briefly discusses some of the techniques that can be successful. 

The Gift and Estate Taxes

Every person may gift during his or her lifetime or bequeath at his or her death up to US$5.45 million (US$10.9 million for married couples, and indexed for inflation) free from federal gift and estate tax. Any amounts gifted or bequeathed in excess of this exemption are taxed at a maximum rate of 40% (plus any state estate or inheritance tax).

Therefore, it is a good idea for individuals with substantial wealth to begin transferring assets to children or grandchildren so that the assets—and the increase in value on those assets—are not part of their taxable estate. Some of the best assets to gift to maximize the use of the lifetime exemption are those that are discounted for valuation purposes and have the most potential for appreciation.

Transfer of Carried Interests and Capital Interests

A carried interest in a private equity fund is a logical choice to transfer during one’s lifetime because of its low value at the formation of the fund and its significant potential for appreciation. A capital interest in the fund does not have quite the same promise for appreciation, but may still be discounted for valuation purposes and will hopefully increase in value. The transfer of carried interests and capital interests involves complex estate and gift tax rules, but if done correctly (and, of course, if the fund is successful), it can produce tremendous results.

Techniques

There are various techniques that can be used to transfer these interests. Because of certain gift tax rules, in certain circumstances an individual may be required to transfer an equal percentage of both his or her capital interest and carried interest—what we will refer to as a “vertical slice”—when making any transfer. Consideration must also be given to appraisal costs, valuation risks and vesting issues. Finally, most of the techniques involve the use of trusts where the original owner of the assets continues to pay income tax on the assets transferred; therefore, it is important to consider the legislation that is continually proposed that would alter the income taxation of the carried interest.

The following is a very brief summary of four techniques that may be used.

Direct Gift

A simple technique is to transfer a portion of an interest in the fund to a trust for family members (referred to as a “family trust”). This technique may require gifting a “vertical slice” of carried and capital interests and can only be completed with interests that are vested. The value of the gift would be determined by an appraiser, and the donor’s (and possibly his or her spouse’s) lifetime gift tax exemption(s) would be reduced by the value of the interest transferred. The family trust would be a grantor trust for income tax purposes, which means the donor would remain taxable on the income generated by the family trust and the family trust would grow tax-free. At the time of death of the donor, the assets in the family trust, including any increase in value from the date of the gift (which could be significant if the fund is successful), would not be subject to estate tax.

Sale of Interest

A second option is to sell to a family trust (that has been funded with a certain amount of property) a “vertical slice” of carried and capital interest in exchange for a promissory note. The benefit of the sale transaction is that any increase in value in excess of the interest rate on the note will be retained by the family trust free from estate and gift tax. The sale of the “vertical slice” to a family trust will not use any of the donor’s lifetime gift tax exemption. The sale price must be at fair market value and can only be completed with vested interests. 

Grantor Retained Annuity Trust (“GRAT”)

A GRAT is a trust to which an individual contributes property and retains the right to receive a fixed annu¬ity payment for a specified term of years. The retained annuity is large enough so that the value of the gift to the GRAT is zero. Any appreciation in the value of the assets contributed to the GRAT above the interest rate set by the government each month is transferred to the family trust at the end of the term of the GRAT. In order to use the GRAT technique, often a transfer of a “vertical slice” of capital and carried interest is required and the interests must be vested.

The most attractive features of the GRAT are:

  • that no lifetime gift exemption is used to create the GRAT, as the value of the gift is zero, and
  • there are no valuation risks. 

Cash-Settled Option

The cash-settled option technique allows the transfer of the economics of the carried interest (as opposed to the actual carried interest) without transferring the capital interest, and without having to wait for the carry to vest. An individual would sell an option to the family trust that would allow the family trust to purchase the economics related to a portion of the individual’s carried interest.

This technique is particularly effective. However, as with all of the techniques, there are important tax risks to consider.