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, taxed at a top rate of 39.6%. 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 net 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.
ESTATE PLANNING WITH 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 gift to be $1,100,000 for gift tax purposes and thus utilize a significant portion of the fund manager’s 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.
Although there are additional estate planning techniques involving carried interest, making proportional gifts as described above involves the least amount of risk and provides benefits that other techniques do not, such as beneficial generation-skipping transfer tax planning.
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. Despite the intricacy and requirements of executing an effective plan, tremendous potential estate planning benefits are achieved from properly planning with carried interest.