Private equity fund managers often own an interest in their funds, which seems ideal for wealth transfer planning. After all, their interest's initial value is often speculative, which would seem to justify a low gift tax valuation. Yet, the value of that interest could appreciate immensely, which would seem to bestow an untaxed windfall on beneficiaries.

Be warned: Fund managers also face special risks when transferring these interests to their descendants. And you can't know how to ameliorate or avoid these risks until you know precisely what they are.

The risk posed by Internal Revenue Code Section 2701 may be the most formidable. But significant risk also may come from the fund's management fee offset arrangement, the vesting of carried interests, and challenges to valuations. (There's also an income tax risk, see “Watch Out,” p. 27.)

LAY O' THE LAND

First, it helps to consider the typical structure of a private equity fund.

Private equity funds are usually created as limited partnerships (LPs).1 (See “Basic Structure,” p. 28.) An LP has two classes of partners: general and limited. The fund's limited partners are its investors. The fund's general partner is typically a business entity created as a limited liability company (LLC).2

The general partner controls the fund. The fund's managers, and usually some of its employees, own units or membership interests in the LLC that is the general partner.

With many funds, the fund's managers form a second LLC to serve as the fund's management company and investment advisor. This management company identifies and negotiates investment transactions on behalf of the fund. In exchange for these services, the fund pays the management company a management fee. Generally, that fee ranges from 1.5 percent to 2.5 percent of the fund's annual value.3 Although the management company is often owned by the same individuals who own the general partner, the management company has no ownership interest in the fund. Instead, the management company's sole relationship with the fund is contractual, via the management agreement.

Managers typically invest their own capital in the fund. Their combined investment usually comprises 1 percent to 5 percent of the fund's capital.4 The capital investment helps attract other investors to the fund, because the money helps them feel that their and the managers' interests are aligned.5

The capital investment may be made through the general partner. It also may be made by the managers through an investment in the fund in exchange for an LP interest. Alternatively, the managers may invest directly in the same companies that make up the fund's portfolio. Often, the managers create a separate entity to hold the separate investments in the portfolio companies. This is sometimes referred to as a “side-by-side” investment vehicle.6

A “carried interest” is normally allocated to the general partner, pursuant to the terms of the fund's LP agreement. The general partner's operating agreement then allocates the carried interest among its owners: the managers and employees. The current market standard for a carried interest, sometimes referred to as a “promoted interest,” is 20 percent of the fund's profits or gains, although managers with strong past performances may charge higher rates.7

Before allocating the carried interest to the general partner, many funds first return to the investors their capital investment. Some funds may even pay the investors a preferred return. Such funds calculate the carried interest only on profits in excess of the specified preferred rate of return (the “hurdle” rate.)8

Other funds may pay the carried interest to the general partner before the capital investment has been recovered by the investors. If the fund earns gains in early years, there will be a corresponding allocation of a portion of those gains to the general partner via the carried interest. In later years, the fund may not have any gains and may even incur losses. When the losses of the later years are netted with the gains of the early years, it's possible that the amount of the carried interest previously allocated to the general partner may be more than the amount allowable under the fund's LP agreement. In this event, the agreement will require the general partner to return the excess carried interest previously allocated to it. This contractual obligation is commonly referred to as a “clawback” provision.9

DEEMED GIFTS

At the early stages of a private equity fund, the fund's potential profit is only an expectation. There's no assurance the fund will succeed, so the value of the carried interest is merely speculative. Also, the allocation of the expected carried interest may be subject to the investors' right to a return of their capital investment in the fund. And the carried interest may be subordinated to the investors' preferred return. A manager should be able to justify a low gift tax value for the carried interest.

In later years, the fund may be extremely successful. As the fund's success increases, the value of the carried interest may grow tremendously. Thus, in theory, carried interests seem ideal for inter vivos estate-planning transfers.

The opportunity for effective estate planning with carried interests comes with notable risks. Without proper planning, these risks can significantly diminish any potential benefit from gifting the carried interest.

As an allocation pursuant to the fund's LP agreement, the carried interest is an economic interest and not itself an interest in a legal entity. Transfers of economic interests are possible, but problematic. Thus, the manager must transfer his legal interest in the general partner (that is to say, LLC units) which includes the underlying economic interests. If the capital is contributed through the general partner, the estate-planning benefit of a gift of an interest in the general partner is diluted, because the capital interest increases the current value of the transferred interest and decreases the potential upside.

If at all possible, the manager would give an interest in the general partner that, pursuant to the terms of its operating agreement, was allocated solely a portion of the carried interest and none of the capital account. The manager thereby would be able to give a portion of his carried interest while retaining his entire capital account. Doing so would help ensure the lowest gift tax value with the highest post-gift appreciation.

However, such a transfer may be subject to IRC Section 2701. This section imposes special valuation rules for gift tax purposes to certain intra-family transfers. If the transfer of the carried interest becomes subject to these valuation rules, the manager may incur unexpected gift tax liability. Furthermore, the special valuation rules of Section 2701 may apply to a gift of an interest in the general partner even if the capital was invested in the fund through a side-by-side entity.

  • Valuation under the subtraction method — A manager may transfer an interest in the general partner that's allocated solely a portion of the carried interest. If the transfer falls under Section 2701, the interest is valued for gift tax purposes using the “subtraction method.”10 Under this method, the value of the manager's retained interest in the general partner is subtracted from the total value of the manager's interest (and those of certain other family members) in the general partner before the transfer.11 The higher the value of the manager's retained interest, the lower the gift tax value of the transferred interest.

    However, if the manager and his family are deemed to have control over the fund, the retained interest will be deemed to have a value of zero. The zero valuation for the retained interest may dramatically increase the deemed value of the transferred interest. In effect, Section 2701 treats the manager as having made a gift not only of the value of the transferred carried interest, but also of the value of all other interests in the general partner that the manager retained. The manager's capital account would be deemed to have been part of the gift along with his carried interest.

    A manager's capital interest in the fund is certainly not an ideal asset for estate-planning transfers — because its value is not speculative. In addition, the capital interest does not have anywhere near the same potential for appreciation that the carried interest does. By adding the value of the manager's retained capital account to the value of the transferred carried interest, Section 2701 increases the value of the gift and, naturally, the amount of any corresponding gift tax.

  • Family member — Note, though, that Section 2701 only applies if the manager makes a gift to a “family member”12 — and family member is narrowly defined. It means the manager's spouse, the lineal descendants of the manager and the manager's spouse, and the spouse of any such descendants.13 It does not include upstream transfers to parents and grandparents and lateral transfers to siblings, nieces and nephews.

    For example, a gift of an interest in a fund's general partner to nieces and nephews is not subject to the deemed gift rule under Section 2701. As a result, a fund manager may give an interest in the general partner that has been allocated solely a portion of the carried interest, to a niece or nephew, and the value of the gift will not be increased by the manager's retained capital account.

  • Control exception — Also, the valuation rules of Section 2701 apply only if, immediately before the transfer, the manager, applicable family members and all descendants of the manager's parents and the manager's spouse's parents in the aggregate, have control of the fund.14 In an LP, “control” means holding an interest in the fund as a general partner.15 However, managers typically own an interest “in” the general partner of the fund, and not “as” a general partner themselves. If the manager owns a controlling interest in the general partner, certainly the manager controls the fund for purposes of Section 2701. If a manager owns a non-controlling interest in the general partner of a fund, there's a risk that the Internal Revenue Service will claim that an individual owning any interest in an entity that is the general partner holds a controlling interest in the fund itself.

    There is a private letter ruling supporting the view that ownership in an entity acting as general partner is not sufficient to give rise to control, provided that the manager does not have a majority ownership or majority voting rights of the general partner.16 But, of course, PLRs cannot be relied upon as precedent.

  • Vertical slice exception — Another exception to Section 2701's deemed gift is if the manager transfers to his beneficiary a proportionate amount of all of his ownership interests in the fund. This is known as the “vertical slice” gift.

A vertical slice of the manager's interest in the fund includes not only the desired portion of the carried interest, but also a proportionate share of every other interest in the fund owned by the manager. The other interests include the manager's interest in the capital, as well as any corresponding obligation to make future capital calls.

In structuring the vertical slice, the manager must consider interests that he may own in a side-by-side investment vehicle. If the side-by-side investment vehicle owns an interest in the general partner, a proportionate share of the manager's interest in the side-by-side investment vehicle also has to be included in the vertical slice. That's why, when setting up the side-by-side entity, it's wise to ensure that it does not own any interest in the general partner.

Combining a gift of the carried interest with a proportionate gift of the capital interest dilutes the opportunity to transfer future appreciation, because the capital interest has less appreciation potential than the carried interest. Furthermore, combining the capital and carried interests in the gift increases the value of the gift for gift tax purposes.

OFFSET

Managers also can risk having to pay gift taxes because of their fund's management fee offset arrangement.

In many funds, the fund income is not a reliable source of cash flow to cover the management fee.17 Proceeds from the investments may not be available for years after the fund's inception. It's common for these funds to permit the manager's capital commitment to be reduced (that is to say, offset) by the amount of management fee payable. And herein lies the problem.

The recipient of gifts of interests in the fund entities may be obligated to make capital contributions: The family member (or trustee) who receives the gift of interest from the manager may be subject to a proportionate obligation to satisfy a capital call. Because the management fee offset arrangement may reduce the family member's obligation to contribute capital, the IRS could find that the arrangement is a series of disguised gifts from the manager to the family member.

Also, the IRS could say the arrangement creates a relationship between the management company and the fund or the general partner that is more than contractual, which may result in the management company becoming subject to the vertical slice rule as well. This may be an undesirable result, because the benefit of transferring the carried interest could be further diluted.

INCOMPLETE GIFT?

A manager's allocation of carried interest via the manager's interest in the general partner may by subject to vesting. “Vesting” refers to a contractual provision that changes the manager's share of the carried interest if the manager ceases to be actively involved in the general partner.18 If a manager gifts an interest in the general partner and the carried interest is subject to a vesting schedule, there's a risk that the gift won't be considered complete for gift tax purposes until the entire carried interest actually vests. At that time, the value of the general partner interest may have appreciated greatly, potentially resulting in a large taxable gift.

The IRS has ruled that a gift of unvested stock options is not complete for gift tax purposes until the completion of services that caused the vesting to occur.19 In its ruling, the IRS stated that an unvested employee stock option has “not acquired the character of enforceable rights susceptible of valuation for federal gift tax purposes.”20

It's possible the IRS will draw an analogy between unvested stock options and unvested general partner interests. If so, a fund manager could face significant gift tax liability, especially if the vesting doesn't occur until the fund fully appreciates.

There are some strategies that may reduce the risk of gift tax from vesting. One is for the manager to make a gift only after the carried interest has vested. However, this solution is not practical for many managers. For gift tax valuation purposes, it's desirable to transfer an interest in the general partner at the inception of the fund, when the value is low. Unfortunately, that may be when very little of the carried interest has vested.

Another approach is to dispute the analogy between unvested stock options and unvested carried interest interests. Note that unvested stock options may have no enforceable rights, but an unvested carried interest may give the manager certain property rights. For example, a manager may be entitled to immediate rights to allocations and distributions as if the carried interest were fully vested. When structuring a new fund, the founders may consider permitting a manager to retain capital account allocations and distributions made prior to resignation, thereby helping to increase the distinction between unvested stock options and unvested carried interests, thereby reducing the risk of higher gift taxes.

Clearly, though, these proposed solutions are not assured.

VALUATION RISK

There's also a risk that the IRS will dispute the gift tax value of the transferred interest in the general partner and may adjust the value on audit.

The IRS can challenge the valuation at any time during the manager's life — or at death, a fact that creates great uncertainty. If the IRS increases the value of the transferred interest, the manager may incur gift tax liability. Worse, interest and penalties may have accumulated for many years on the unpaid gift tax.

Filing a gift tax return starts the statute of limitations running for assessing gift tax. The limitations period is three years after the gift tax return is filed or due.21 But, if the value of the gift omitted from the gift tax return exceeds 25 percent of the total gifts reported in the year in question, the limitations period jumps to six years after the return is filed or due.22 If the statute of limitations has run, the value of the gift is conclusively determined.23 The statute of limitations will not begin to run unless the gift has been adequately disclosed on a gift tax return.24

BEFORE YOU LEAP

The carried interest may in theory be an ideal candidate for estate-planning transfers. Such planning may provide the private equity fund manager the opportunity to effectively transfer wealth to younger generations at relatively low transfer tax cost.

Grantor retained annuity trusts, sales to intentionally defective grantor trusts and other wealth transfer techniques can be utilized in the private equity setting: These techniques may help leverage the potential for significant growth in the gifted carried interest. But because of the complexities in this area, before implementing any estate-planning technique with a carried interest, practitioners must analyze the corresponding risks thoroughly.

Endnotes

  1. James M. Schell, Private Equity Funds: Business Structure and Operations, Law Journal Press, New York, 2007, Section 3.01. For illustrative purposes, the structure discussed in this article is simpler than one typically used by funds. Variations in the fund's structure, while they do not alter the legal principles discussed, do make the application of those principles more complex.
  2. Ibid., Section 4.03.
  3. Ibid., Section 2.05[1].
  4. Ibid., Section 3.02[2].
  5. Ibid.
  6. Ibid., Section 1.01.
  7. Ibid., Section 2.02[1].
  8. Ibid., Section 2.03[2], which states that “fixed rate preferred returns commonly range from 5% to 12%. Currently, a fixed rate of 8% appears to be a frequent starting point.”
  9. Ibid., Section 2.04[2].
  10. Treasury Regulations Section 25.2701 3(b).
  11. Treas. Regs. Section 25.2701 3(b).
  12. Internal Revenue Code Section 2701(a)(1).
  13. Ibid., Section 2701(e)(1).
  14. Ibid., Section 2701(b); Treas. Regs. Section 25.2701-2(b)(5)(i).
  15. IRC Section 2701(b)(2).
  16. Private Letter Ruling 9639054, June 21, 1996.
  17. Schell, supra note 1, Section 2.05[4].
  18. Ibid., Section 4.04[4]
  19. Revenue Ruling 98-21, 1998-18 IRB 7.
  20. Ibid.
  21. IRC Sections 6501(a) and 6501(b)(1).
  22. IRC Section 6501(e)(2).
  23. Ibid., Sections 2001(f) and 2504(c).
  24. Ibid., Section 6501(c)(9).

WATCH OUT

There's also a related income tax risk

On top of transfer tax risks, private equity fund managers also may face a special income tax problem. A full account of that difficulty is beyond the scope of our current discussion, but it's important to note.

Briefly, the Internal Revenue Service should not treat the receipt by a manager of a general partner interest to which solely carried interest has been allocated as a taxable event, if the interest received is in consideration for services provided by the manager.1

This safe harbor is not available if the interest is transferred by the general partner to the manager in anticipation of a subsequent disposition, which is presumed if the interest is disposed of within two years of receipt.2

It's possible, but not certain, the Service will consider an estate-planning transfer of the general partner interest during those two years a “disposition,” which may trigger income tax.
David Jacobson

  1. Revenue Procedure 93-27, 1993-2 C.B. 343; see also Rev. Proc. 2001-43, 2001-2 CB 191 and Notice 2005-43, 2005-24 IRB 1221, May 5, 2005.
  2. Rev. Proc. 93-27, supra note 1.