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May 23, 2023
The term “carried interest” originated in the 16th century, when transoceanic ship captains would frequently charge a 20% interest on profits realized from the cargo they carried. Today, “carried interest” refers to a fund manager’s performance bonus on investment returns earned when managing private equity funds, hedge funds and venture capital funds. The typical carried interest performance bonus is 20% of the fund’s investment returns. Carried interest is charged on top of any standard management fees. The standard management fee is 2% on the assets under management. These fees are commonly known as the “2 and 20” fee structure for private fund investments. Fund managers receive a valuable income tax break on carried interest if the investment is held for at least three years. That is because it allows carried interest earnings to be taxed at capital gains rates rather than higher ordinary income tax rates.
Although the income tax benefit afforded carried interest is a popular news topic, valuation issues when transferring shares in carried interest entities for estate tax purposes is not often discussed. Despite this, carried interest rights are often transferred to family members for estate tax planning reasons. A fund manager’s shares in a carried interest entity consists of multiple layers, including an “ownership” portion and carried interest rights. The ownership portion consists of the standard 2% management fee as well as other payment rights (but does not include carried interest rights).
When transferring carried interest, which has high appreciation potential, to family members, the carried interest—and future appreciation thereon—is removed from the transferor’s estate. If transferred early, the carried interest rights usually do not have a high value for gift tax purposes because the entity’s investments have not yet started making large profits. Conversely, the ownership interest consisting of the 2% management fee and other payment rights has immediate value. Historically, that led fund managers to gift carried interest rights at low gift tax values while retaining the ownership rights, which did not have the same growth potential. The value of the retained ownership interest was sometimes further manipulated to produce high valuations (often due to inflated values placed on certain payment rights, such as liquidation rights) while little gift tax value was attributed to the transferred carried interest rights.
To combat perceived abuses when gifting carried interest rights, Congress enacted IRS Section 2701. Section 2701 provides special valuation rules that must be followed when transferring carried interest rights to family members. Under the Section 2701 rules, when carried interest rights are transferred, but ownership interests are retained, the retained ownership interest has the potential to be valued at zero for gift tax purposes. That means the transfer could result in a much higher taxable gift than was intended.
Fortunately, there is a safe harbor to avoid the potentially harsh gift tax consequences that could arise from the Section 2701 valuation rules. The safe harbor is commonly referred to as the “vertical slice” rule. Under the vertical slice rule, when transferring shares of carried interest entities, the transferor must transfer a proportionate amount of each different entity level. If you view the different entity levels as a cake, with the top layer being the ownership rights and the bottom layer being the carried interest rights, a proportionate amount of each layer would be removed when the transferor gifts interests to family members for estate planning purposes.
By requiring proportionate gifts of all entity levels, the vertical slice rule often results in higher amounts of the lifetime gift tax exemption being used, but it avoids the harsh scenario that would result if the retained ownership interest is valued at zero. Therefore, it provides a relatively safe and straightforward valuation method for carried interest entities. This makes the vertical slice safe harbor a popular method among estate planning practitioners when transferring carried interest rights. You might even say it allows the fund manager to “have their cake and eat it too!”
If you have any questions about gifting assets for estate tax planning or other estate planning concepts, please contact our Estate Planning Services group.
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Paul oversees Centralized Estate Services for Cerity Partners and is a Partner based out of Denver, Colorado. He works with Cerity Partners’ advisors to review...
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