Estate planning for private equity managers

Jul 16, 2020
Private client services

Planning with carried interests has long been an integral component of the estate plans of private equity fund managers. These interests can be excellent wealth transfer candidates because, if done as early in the life of a fund as practicable, they will typically have both a low gift tax value and significant appreciation potential. Now, with today’s volatility and uncertainty in the markets, managers have an unprecedented opportunity to transfer those interests, and other significant assets, at historically low tax cost.

Among the factors creating this opportunity are depressed asset values that reduce the gift tax cost of transferring those assets, bottoming of the interest rates variously associated with valuing a gift or setting the bar for appreciation needed to make the transfer successful, the continuing availability of popular planning techniques, and valuation discounts that can reduce the gift tax cost of wealth transfer. Finally, although today’s high estate, gift and generation-skipping transfer (GST) tax exemptions are not scheduled to sunset until 2026, the upcoming election could accelerate that sunset and, with it, the elimination of some of those popular wealth transfer planning techniques.

In a typical scenario, we start with a manager who owns, directly or indirectly, both a carried interest and a committed capital interest, which is often held as, and we will refer to it as, a “limited partner (LP) interest”. The manager will transfer the carried interest to the next generation. This is sound, fundamental wealth transfer planning for two reasons. First, the speculative nature of the carried interest could support a very low value for gift tax purposes, despite potential for significant appreciation. Second, the manager likely wants to retain the LP interest for its capital value and preferred return. Said another way, the objective is to transfer growth at minimal tax cost but retain the present day value of the fund, represented by the LP interest. There is a rub. Under section 2701, if a manager transfers only the carried interest, but retains the LP interest, he or she would be deemed to make a taxable gift of his or her entire stake in the fund—both the carried and LP interests. The carried interest would be ascribed no value, but the LP would be ascribed all of the value in the interests transferred. This is obviously not the intended result.

Among the most common techniques for dealing with section 2701 is for the manager to transfer a proportionate part of all of his or her equity interests in the fund. In essence, the manager is taking a ‘vertical slice’, which requires the manager to transfer, proportionately, all equity interests in the applicable entity. While the vertical slice approach is frequently used, it can be problematic for any manager who is willing to give away the carried interest but does not want to give away the current and/or future benefits associated with the LP interest. What’s more, the fund itself could be structured in a way that the approach is difficult to implement.

A variation on the theme of vertical slice planning calls for the manager to create a family limited partnership (or LLC), transfer the respective carried and LP interests to it and then transfer interests in the new entity to a trust by gift, GRAT or sale. The interest in the new entity could qualify for discounts under general valuation principles. This approach, if respected under anti-abuse doctrines, could enable the individual to achieve his or her estate tax planning objectives while allowing him or her to maintain some measure of control over the interest that was transferred.

Wealth transfer techniques

Managers can choose from several tax-efficient techniques to transfer wealth. However, as will become evident in a moment, some of those techniques better suit a given manager than the others. The key is to work with the manager and his or her other advisors to determine the one or more techniques that match up well with the legal, tax and economic attributes of the interest transferred, all in the context, of course, of the manager’s personal objectives and risk tolerance. Because a manager has options for how to structure the transfer, meaning use a vertical slice or an entity that owns the respective fund interests, we will refer to the asset transferred in the discussion that follows as an “interest”.

gift removes all future appreciation in the transferred asset from the taxable estate from the date of the transfer. Therefore, an asset with a currently depressed value but an impressive future is a good candidate for a gift. Managers and other individuals who make a significant gift typically transfer the asset to trusts for the benefit of their children rather than to the children outright. These trusts are often designed as “intentionally defective grantor trusts” (IDGT), a construct in which the individual who established the trust, the grantor, is taxed on the trust’s income and capital gains as though he or she still held them individually. The IDGT actually creates a wealth transfer multiplier effect because the grantor’s payment of the tax on the trust’s behalf is not a gift by the grantor, thus enabling the trust to grow much faster than if it had to pay those taxes with its own funds. What’s more, the trust could be designed as a generation-skipping “dynasty” trust that could provide economic benefits to the manager’s children but not be included in the children’s estates when they pass away and the trust continues to benefit the grandchildren.

We note that the TCJA injected added income tax uncertainty to wealth transfer planning with fund interests. Under the TCJA, capital gains on the sale of a carried interest in certain investment funds (as well as the partner’s share of the fund’s capital gains) may be taxed as short-term capital gains, if the carried interest and/or the underlying assets have not been held for more than three years. Special rules apply to gains from sales of a carried interest to a related party. This rule may also apply to the donee of a carried interest if the donee is related to the manager whose services originally gave rise to the carried interest. Unfortunately, it is not clear how these new rules may apply to gifts or the other the wealth transfer strategies we discuss. We expect Treasury and the IRS to release regulations that will provide needed guidance for the selection and design of those strategies. As of this writing, the regulations have cleared review, but release timing is unknown.

Grantor Retained Annuity Trust (GRAT) can appeal to managers who want to transfer wealth, retain income and take a measured approach to tax risk. With a GRAT, the manager transfers an interest to an irrevocable trust, reserving the right to receive a payment from the trust (the annuity) for a term of years. If the manager survives the term, assets remaining in the GRAT at the end of the term pass to the children (or remain in trust for their benefit) and will not be included in the manager’s taxable estate. If the manager does not survive the term, the assets in the GRAT will be included in the taxable estate. GRATs are typically designed to virtually eliminate any taxable gift when the GRAT is funded, something that is a lot easier to do when asset values are depressed and the interest rate the IRS uses to determine the value of the annuity is low, as it is today. If the GRAT succeeds, any appreciation above the returned annuity passes to the children gift and estate tax free.

An alternative to the GRAT is a sale to an IDGTThe manager creates an IDGT, seeds it with a gift of cash or property and then sells an interest to the IDGT for an installment note bearing interest at the applicable federal rate (AFR) for the month in which the transaction occurs. The transaction freezes the value in the estate by converting an appreciating asset into a fixed income instrument. Appreciation above the AFR remains in the trust, excluded from the manager’s estate. Properly structured, meaning among other things that the sale and note are respected as such by the IRS, there is no capital gain triggered on the sale, the interest payments are not taxable to the manager (or deductible by the trust) and the manager’s payment of the IDGT’s income tax is not a gift. Only the unpaid balance of the note is included in the manager’s estate, which contrasts favorably with the GRAT and its mortality risk. The sale’s design flexibility also contrasts favorably with the more rigid design requirements of the GRAT.

The last technique to consider is a derivative contractSubject to variations, the manager sells to an IDGT an option to receive a sum in excess of the carried interest’s return by a date certain. The derivative approach is attractive because it does not involve an actual transfer of the interest, which a manager may prefer. It also may avoid any section 2701 issues. The approach has its own issues, including valuation of the option and the associated implications if the IDGT is deemed to have underpaid for it. Still, a derivative may be preferred to an actual interest transfer.

Managers interested in wealth transfer planning for their carried interests have a variety of planning techniques to choose from that can help them strike a balance between near-term concerns and longer-term objectives. As always, managers should work with their tax professional and other advisors to make well informed decisions with respect to both the selection and design of these techniques.

RSM contributors

  • Ben Wasmuth
    Senior Manager