Estate Planning with Carried Interests: Navigating I.R.C. §2701
Recently, business development boards throughout Florida have ramped up efforts to lure to Florida private equity firms and hedge funds1 headquartered throughout the country. With no state or local income tax and no state gift or estate tax, high net worth individuals, such as private equity fund managers (fund managers), can reap significant tax savings by relocating to Florida. The state is already home to over 130 private equity firms and hedge funds, and it appears that the southern migration may just be getting underway. In light of this influx of fund managers to Florida, it is imperative that our estate planners understand the intricacies of I.R.C. §27012 to ensure that our fund manager clients do not inadvertently fall prey to its harsh gift tax consequences.
Structure and Economics of a Standard Private Equity Fund
A private equity fund is an investment vehicle, typically structured as a limited partnership, formed by fund managers to invest large pools of capital in various portfolio companies. The general partner (GP) of the fund is typically structured as a limited liability company (LLC). The fund managers are typically the members and managers of the GP and, thus, the fund managers control the fund via their control of the GP. A fund typically allocates and distributes to the GP a percentage of the fund’s overall profits (generally 20 percent) in excess of a minimum return in exchange for the services the fund managers provide.3 The GP’s share of profits is commonly referred to as a “carried interest.” In addition to providing services to the fund (in exchange for the carried interest), the fund managers also may invest their own capital in the fund, either through the GP or in the fund directly as an LP. The LPs of the fund typically consist of outside investors, such as pension plans, university endowments, insurance companies, and wealthy individuals who agree to commit a fixed amount of capital to the fund, which may be called over a period of time by the fund managers who identify investment opportunities for the fund.
The fund managers will usually form a separate entity, typically structured as an LLC, to serve as a management company for the fund (management company). The management company, which usually will not own an equity interest in the fund, will act as the fund’s investment advisor and provide other basic operational services to the fund in exchange for an annual management fee, typically 2 percent of assets under management.
A successful fund will have substantial amounts of cash proceeds to distribute between the GP and LPs as investments are liquidated. The manner in which these distributions are made is set forth in the fund’s partnership agreement and is often referred to as the “distribution waterfall.” Pursuant to a typical distribution waterfall, distributions are made to the partners in the following order of priority:
• First, all investors receive a return of their invested capital. This includes any capital invested by the fund managers, either through the GP or directly in the fund as an LP.
• Second, all investors receive a preferred return on their capital investment.
• Third, the GP (the holder of the carried interest) is entitled to a catch-up distribution to make up for the preferred return paid to the investors.
• Finally, of the remaining profits, 20 percent is distributed to the GP as the carried interest and 80 percent is allocated among and paid to the capital investors.
Because the GP is not entitled to its carried interest unless the fund’s investments generate sufficient profit to return all invested capital plus a specified preferred return, at the time the fund is created (and throughout the fund’s early stages) the carried interest has little or no value.4 If the fund is successful, the value of the carried interest could become substantial. The carried interest’s significant appreciation potential makes it an ideal asset to transfer during life using various estate planning techniques.5 However, the economics of a fund and the nature of a fund manager’s various interests therein, require careful navigation of I.R.C. §2701 in order to avoid harsh unintended gift tax consequences.
I.R.C. §2701’s Special Valuation Rules
Generally, I.R.C. §2701 applies any time an individual (transferor) transfers an equity interest in a privately held entity to or in trust for the benefit of a younger generation member of the transferor’s family (referred to as a member of the family)6 if, immediately after such transfer, the transferor or an older generation member of the transferor’s family (applicable family member)7 holds an equity interest in the entity that is classified as an “applicable retained interest.”8
An equity interest will be classified as an applicable retained interest if it confers upon its holder either an “extraordinary payment right,” or in the case of a controlled entity,9 a “distribution right.”10 An extraordinary payment right is any put, call, conversion right, or right to compel liquidation of the entity, the exercise or nonexercise of which could affect the value of the transferred interest.11 An extraordinary payment right does not include any rights that must be exercised at a specific time for a specific amount; a put, call, conversion right, or liquidation right will be an extraordinary payment right only if the holder of such right has discretion over whether such right will be exercised. A distribution right generally includes any right to receive distributions with respect to a retained equity interest.12 However, a distribution right does not include any right to receive distributions with respect to any interest that is junior to or the same as the rights of the transferred interest.13
If I.R.C. §2701 applies, the gift tax value of the transferred interest is determined under the so-called “subtraction method.”14 The subtraction method determines the gift tax value of the transferred interest by subtracting the value of all equity interests in the entity held by the transferor immediately after the transfer from the aggregate value of all equity interests in the entity held by the transferor immediately before the transfer. If the retained interest is classified as an applicable retained interest, its value for purposes of applying the subtraction method is determined by assigning a zero value (zero-value rule) to any extraordinary payment right and any distribution right, unless such distribution right is a “qualified payment right.”15 The result of the zero-value rule is that, for gift tax purposes, the transferor is treated as transferring his entire equity interest in the entity rather than just the equity interest that was actually transferred.
Without proper planning, I.R.C. §2701 will likely be triggered any time a fund manager engages in estate planning and transfers his carried interest to one or more members of the family. A fund manager typically desires to transfer a portion of his carried interest to one or more members of the family and, for both business and gift tax reasons, retain his capital interest in the fund (either through the GP or directly in the fund as an LP). As discussed above, under a typical distribution waterfall, the fund manager’s capital interest in the fund generally will entitle the fund manager to a right to distributions that has preference over the carried interest’s right to distributions (i.e., capital investors are entitled to a return of capital plus a preferred return before the carried interest is distributed). Thus, if the fund manager and applicable family members control the fund immediately before the fund manager transfers the carried interest to members of the family, the retained capital interest will be an applicable retained interest, and I.R.C. §2701 will apply, resulting in a deemed gift by the fund manager.16
Planning Around I.R.C. §2701
With proactive planning, a fund manager can transfer his carried interest to one or more members of the family without running afoul of I.R.C. §2701. The code and the treasury regulations lay out several “safe harbor” exceptions to the application of I.R.C. §2701. What follows is an overview of some of the planning techniques that utilize the various safe harbor exceptions.
• Vertical Slice Exception — The most commonly utilized safe harbor exception is the “vertical slice” exception. Set forth in Treas. Reg. §25.2701-1(c)(4), the vertical slice exception provides that I.R.C. §2701 does not apply to a transfer to the extent that such transfer results in a proportionate reduction of each class of equity interest held by the transferor and all applicable family members in the aggregate immediately before the transfer. In the fund context, the vertical slice exception requires the fund manager to transfer not only the carried interest, but also a proportionate amount of all other equity interests in the fund (e.g., the fund manager’s capital interest in the fund either through the GP or in the fund directly as an LP). It is not entirely clear whether the fund manager’s interest in the management company must be included in the vertical slice. However, most practitioners are of the view that such interest does not constitute an equity interest in the fund, and, therefore, does not need to be included as part of the vertical slice.
A common method to achieve the vertical slice is for the fund manager to form an LLC and transfer all of his or her equity interests in the fund to the LLC. The fund manager would then transfer the desired portion of interest in the LLC to one or more members of the family. Since the LLC would own all of the fund manager’s equity interests in the fund, a transfer of an interest in the LLC would be a transfer of a vertical slice, as all of the fund manager’s equity interests in the fund would be reduced proportionately.
For a fund manager who has significant capital invested in the fund, either through the GP or in the fund directly as an LP, structuring the transfer as a vertical slice can result in a significant gift tax liability (or the use of the fund managers gift tax exemption). A fund manager may be able to limit the gift tax liability resulting from the transfer of a vertical slice by investing most of his capital investment directly in the portfolio companies on a side-by-side basis with the fund rather than through the GP or directly in the fund as an LP. Although the fund manager will likely still invest some of his or her capital investment through the GP or directly in the fund as an LP, this technique has the potential of greatly reducing the gift tax resulting from the transfer of a vertical slice of the fund manager’s equity interests in the fund.17 The planning techniques discussed below, while far less utilized and carrying greater audit risk than the vertical slice, permit the fund manager to transfer his or her carried interest at a lower gift tax cost.
• I.R.C. §2701 Compliant Entities — I.R.C. §2701 also may be avoided through the use of an “I.R.C. §2701 compliant entity.” An I.R.C. §2701 compliant entity, typically an LLC (but can also be a limited partnership) is structured to take advantage of two safe harbor exceptions — the “same class” exception18 and the “qualified payment right” exception.19 With this technique, the fund manager would create an LLC and transfer all of his or her equity interests in the fund to the LLC.20 The LLC would be structured to have two classes of equity interests — preferred interests and common interests. The preferred interests would entitle the holder to a qualified payment right ( i.e., the right to receive a distribution payable on a periodic basis, at least annually, and determined at a fixed rate).21 The common interests would entitle the holder to all future growth in excess of the preferred holder’s qualified payment right.
After the fund manager transfers all of his or her equity interests in the fund to the LLC, he or she would then transfer all or a portion of his or her common interests to one or more members of the family and retain all of the preferred interests. Despite the fund manager retaining a portion of the common interests and all of the preferred interests, the transfer should not trigger I.R.C. §2701. The retained common interests should fall within the same class exception. The same class exception provides that §2701 does not apply if the retained equity interest is of the same class as the transferred equity interest.22 In this case, the fund manager’s retained common interests would be of the same class as the transferred common interests. The retained preferred interests, however, typically would be subject to I.R.C. §2701 because they would confer upon the fund manager a distribution right. However, because the distribution right would be structured as a qualified payment right, the preferred interests would not be subject to the zero-value rule, but instead would be valued at fair market value.23
Although an I.R.C. §2701 compliant entity avoids the zero-value rule, a deemed gift may, nevertheless, occur under general gift tax principles if the coupon rate of the qualified payment right is set at rate below the rate that would be used in an arm’s-length transaction. Furthermore, a special valuation rule, known as the 10 percent minimum value rule, provides that the junior equity interests24 are deemed to have a value equal to at least 10 percent of the total value of the entity’s equity interests.25 Because the common interests of the I.R.C. §2701 compliant entity are the junior equity interests, the transferred common interests would be deemed to have a value at least equal to such interest’s proportionate share of 10 percent of the total value of the entity’s equity interests.
• Trust for the Benefit of Applicable Family Members — As discussed above, I.R.C. §2701 applies only if the fund manager transfers a junior interest to one or more members of the family. The fund manager may be able to avoid I.R.C. §2701 if he or she transfers his or her carried interest to a trust of which only applicable family members or other friendly nonfamily members are discretionary beneficiaries (LPOA beneficiary).26 Because the fund manager would not have made a transfer to a member of the family, I.R.C. §2701 would not be triggered.
The trust would grant to the LPOA beneficiary a broad lifetime and/or testamentary limited power of appointment exercisable in favor of any one or more individuals or entities, other than the LPOA beneficiary, the LPOA beneficiary’s creditors, the LPOA beneficiary’s estate and the creditors of the LPOA beneficiary’s estate (LPOA). This carve out is necessary to prevent the LPOA from being treated as a general power of appointment.27 The LPOA beneficiary could then exercise the LPOA at a later date and direct the assets of the trust to be distributed to a trust for the benefit of one or more members of the family.28 If the plan is carried out to completion, the fund manager will have successfully transferred his or her carried interest to members of the family without triggering I.R.C. §2701.
There is a risk that the IRS would apply the step transaction doctrine to treat the fund manager as transferring the carried interest directly to the trust for the benefit of one or more members of the family. This risk may be mitigated, to some extent, if the fund manager files a gift tax return reporting the gift of the carried interest to the trust for the benefit of the LPOA beneficiaries. This will start the tolling of the three-year statute of limitations with respect to the gift. It would be prudent for the LPOA beneficiary to exercise the LPOA only after the three-year statute has run.
• Parallel Trusts — The parallel trust technique involves the creation of two irrevocable trusts, each for the benefit of members of the family. One of the trusts would be a grantor trust for income tax purposes and would be structured so that transfers to the trust were completed gifts for gift tax purposes (completed gift trust). The other trust would be a nongrantor trust for income tax purposes and would be structured so that transfers to the trust were incomplete gifts for gift tax purposes (incomplete gift trust). The fund manager would transfer his or her carried interest to the completed gift trust and a proportionate amount of his capital interests to the incomplete gift trust.
This technique relies on I.R.C. §2701’s ownership attribution rules and ordering rules set forth in Treas. Reg. §25.270-6 to avoid the application of I.R.C. §2701. Two ownership attribution rules are of particular relevance to the parallel trust technique. The first attribution rule, set forth in Treas. Reg. §25.2701-6(a)(4)(i), provides that a person is considered to hold an equity interest held by a trust to the extent that such person’s beneficial interest in the trust may be satisfied by the equity interest or the income or proceeds therefrom.29 A beneficiary of a trust will generally be attributed ownership of an equity interest held by such trust so long as such beneficiary may receive distributions from such trust.30 The second attribution rule, set forth in Treas. Reg. §25.270-6(a)(4)(ii)(C), provides that an individual is considered to hold an equity interest held by a trust if such individual is treated as the owner of the trust for income tax purposes under I.R.C. §§67-679.
If the ownership attribution rules result in an equity interest being attributed to more than one person, ordering rules determine to whom ownership is attributable for purposes of applying I.R.C. §2701. The ordering rules differ depending on whether the equity interest in question is an applicable retained interest or a subordinate equity interest.31 Ownership of an applicable retained interest ( e.g., a fund manager’s capital interest) is generally attributed in the following order: 1) if the interest is held in a grantor trust, to the individual treated as the holder thereof ( i.e., the grantor); 2) to the transferor; 3) to the transferor’s spouse; or 4) to each applicable family member on a pro rata basis.32 Ownership of a subordinate equity interest ( e.g., a fund manager’s carried interest) is generally attributed in the following order: 1) to the transferee; 2) to each member of the family on a pro rata basis; 3) if the interest in held in a grantor trust, to the individual treated as the holder thereof ( i.e., the grantor); 4) to the transferor; 5) to the transferor’s spouse; or 6) to each applicable family member on a pro rata basis.33
Under the attribution rules, ownership of the carried interest (the subordinate equity interest) held by the completed gift trust will be attributed in two ways: To members of the family ( i.e., the beneficiaries of the complete gift trust) because they will have a right to receive distributions from the trust; and to the fund manager because the completed gift trust is a grantor trust with respect to the fund manager. Under the ordering rules applicable to subordinate equity interests, ownership by members of the family has priority over ownership by a trust’s grantor. As a result, ownership of the carried interest will be attributed to members of the family. Therefore, if the fund manager is deemed to hold a capital interest in the fund after the transfer, I.R.C. §2701 will apply.
Because the incomplete gift trust is structured as a nongrantor trust with respect to the fund manager, the attribution rules will not attribute ownership of the capital interest to the fund manager. Accordingly, the fund manager will not hold an applicable retained interest immediately after the transfer and, therefore, I.R.C. §2701 is not triggered.
• Derivative Contract — A final planning technique to consider is the sale of a derivative (tied to the performance of the fund manager’s carried interest) to an irrevocable grantor trust for the benefit of one or more members of the family. Unlike the other planning techniques discussed above, the use of a derivative contract to transfer the value of the carried interest does not require the actual transfer of the carried interest itself, thereby alleviating the I.R.C. §2701 concerns.
To implement this technique, the fund manager would enter into a derivative contract with an irrevocable grantor trust pursuant to which the fund manager would agree to pay to the trust, at a set future date (usually the first to occur of the fund manager’s death or a fixed date near the end of the fund’s life) (settlement date), an amount of cash equal to the fair market value of the fund manager’s carried interest on the settlement date, plus the amount of any distributions received by the fund manager with respect to the carried interest prior to the settlement date. The contract can be structured so that the fund manager is required to make payment to the trust only after the carried interest has exceeded a certain total return (hurdle amount). The hurdle amount, which is similar to the strike price in a standard option contract, would be set at the fair market value of the carried interest at the time the contract is entered into.
In exchange for the right to receive payment from the fund manager on the settlement date, the trust would pay the fund manager an amount equal to the present fair market value of the trust’s right to receive such future payment. This payment is similar to the option premium in a standard option contact. The value of the trust’s right to future payment under the contract would have to be determined by a professional appraiser, who would take into consideration the hurdle amount or strike price, the volatility of the fund, current interest rates, and the term of the contract. The fund manager would make a cash gift to the trust to enable the trust to purchase its rights under the contract. This gift would require use of some of the fund manager’s lifetime gift tax exemption, or, result in a taxable gift if the fund manager had insufficient lifetime gift tax exemption remaining.
A derivative contract can be an interesting alternative to traditional planning techniques for fund managers, allowing the fund manager to remove the economic value of the carried interest from his taxable estate without falling into the §2701 trap; however, the use of a derivative contract is not without risk and careful consideration should be given as to whether a derivative contract is appropriate for use with any particular fund.
Planning with a fund manager’s carried interest must be carefully undertaken to ensure that the harsh gift tax consequences of I.R.C. §2701 are avoided. As more and more fund managers relocate to Florida, it is becoming increasingly important that estate planners understand I.R.C. §2701 and how to plan around it. The vertical slice is by far the most utilized technique for planning with carried interests. However, estate planners (and their clients) should be aware of the alternative carried interest planning techniques that are available to them.
1 This article focuses on planning opportunities for private equity fund managers. However, for the most part, the same concepts will apply to hedge fund managers.
2 For purposes of this article, any reference to the I.R.C. refers to the Internal Revenue Code of 1986, as amended.
3 The GP’s operating agreement sets forth the manner in which the carried interest is shared among the fund managers.
4 See Bruce A. Geyer, Carried Interest: Reducing the Risk of Audit, Practical Tax Strategies (July 2014) (for a detailed discussion on valuing carried interests).
5 See Ivan Taback & Nathan R. Brown, Estate Planning Ideas for Private Equity Fund Managers, Estate Planning (April 2015) (for a detailed discussion of the various estate planning techniques available for private equity fund managers).
6 I.R.C. §2701(e)(1).
7 I.R.C. §2701(e)(2).
8 I.R.C. §2701(a).
9 A limited partnership (the structure of a typical fund) will be considered a controlled entity if the transferor or an applicable family member holds an interest in the limited partnership “as a general partner.” I.R.C. §2701(b)(2)(B)(ii). The GP of a fund will typically be structured as an LLC and, as a result, a fund manager generally will not hold an interest “as a general partner” in the fund. Rather, the fund manager will hold an interest “in the general partner” of the fund. Most practitioners, however, take the position that a fund is a controlled entity if the fund manager owns any equity interest in the GP.
10 Treas. Reg. §25.2701-2(b)(1).
11 I. R.C. §2701(b)(1)(B); Treas. Reg. §25.2701-2(b)(2). Extraordinary payment rights have no control element because it is the transferor, and not the entity, that holds the extraordinary payment rights, unlike a distribution right, which is held by the entity.
12 I. R.C. §2701(b)(1)(A); Treas. Reg. §25.2701-2(b)(3).
13 I. R.C. §2701(c)(1)(B)(i).
14 Treas. Reg. §25.2701-3.
15 Extraordinary payment rights and distribution rights both attribute value to the retained interest that would be shifted to the transferred subordinate equity interests held by younger generation family members if such rights are not exercised. The zero-value rule is based on the assumption that the holder of the extraordinary payment right or the distribution right will not exercise such right.
16 The conservative approach, and the approach followed by most estate planners, is that a fund manager will be treated as controlling a fund if he holds any equity interest in the fund.
17 The reason that this technique works is because the interest retained by the fund manager in the portfolio companies through the fund manager’s side-by-side investment will not constitute an applicable retained interest (there will be no extraordinary payment right and it is unlikely that the fund manager will control any of the portfolio companies immediately after the transfer of the carried interest) and, therefore, the retained interest is not taken into consideration for purposes of applying I.R.C. §2701. Thus, no portion of the retained interest in the portfolio companies has to be included in the vertical slice. Rather, the I.R.C. §2701 analysis would be restricted to the GP and the fund, where the fund manager’s capital investment would be relatively modest. However, it is possible that the side-by-side investment may be structured in such a way that a portion of such interest would have to be included in the vertical slice.
18 I.R.C. §2701(a)(2)(B). The same class exception provides that I.R.C. §2701 does not apply if the retained equity interest is of the same class as the transferred equity interest.
19 I. R.C. §2701(c); Treas. Reg. §25.2701-2(a)(4). In lieu of the qualified payment right exception, the “mandatory payment right” exception could be utilized. The mandatory payment right exception excludes from the definition of a distribution right, any right to receive a payment required to be made at a specific time for a specific amount. Treas. Reg. §25.2701-2(b)(4)(i). Thus, if the retained preferred interest confers upon the holder a mandatory payment right, I.R.C. §2701 should not apply.
20 A limited partnership could also be used.
21 Treas. Reg. §25.2701-2(b)(6). If the qualified payment right is held by an applicable family member, a special election must be made to treat the payment right as a qualified payment right, even if it otherwise qualifies as such.
Treas. Reg. §25.2701-2(c)(4).
22 I.R.C. §2701(a)(2)(B).
23 If the preferred interest also confers upon its holder one or more extraordinary payment right, the value of all of these interests would be determined by assuming that each extraordinary payment right is exercised in a manner resulting in the lowest total value being determined for all the rights.
Treas. Reg. §25.2701-2(a)(3).
24 I.R.C. §2701(a)(4). For this purpose, junior equity interest means common stock, or in the case of a partnership, any partnership interest under which the rights as to income and capital are junior to the rights of all other classes of equity interests.
25 I.R.C. §2701(a)(4).
26 The fund manager should use caution in selecting the LPOA beneficiary, as it is always possible that they exercise the LPOA in a manner inconsistent with the fund manager intent.
27 A power of appointment will generally be treated as a general power of appointment if such power is exercisable by the powerholder in favor of the powerholder, his creditors, his estate, or the creditors of his estate. I.R.C. §§2041(b)(1), 2514(c).
28 The exercise of the LPOA should not be treated as a transfer subject to I.R.C. §2701; see Treas. Reg. §25.2701-1(b)(3)(iii), nor should it have any gift or estate tax consequences to the LPOA beneficiary. If the LPOA were structured as a general power of appointment, the exercise would be treated as a transfer subject to I.R.C. §2701, and the LPOA beneficiary would be treated as making a taxable gift upon exercise.
29 Treas. Reg. §25.2701-6(a)(4)(i). The determination of whether a person’s beneficial interest in the trust can be satisfied with the equity interest or the income or proceeds therefrom is made assuming the maximum exercise of discretion in favor of the person.
30 Treas. Reg. §25.2701-6(a)(4)(ii)(B).
31 Treas. Reg. §25.2701-3(a)(2)(iii). A subordinate equity interest is an equity interest in an entity as to which an applicable retained interest is a senior equity interest.
32 Treas. Reg. §25.2701-6(a)(5)(i).
33 Treas. Reg. §25.2701-6(a)(5)(ii).
Nathan R. Brown is an attorney in Pillsbury’s Estates, Trusts and Tax Planning Group in Palm Beach . He advises clients on a wide range of tax and estate planning matters, as well as estate and trust administration.
This column is submitted on behalf of the Tax Law Section, James Herbert Barrett, chair, and Michael D. Miller and Benjamin Jablow, editors.