At the Heckerling Institute on Estate Planning last month, one of my favorite presentations was by my friend, David Handler of Kirkland & Ellis, entitled “Naked Derivatives and Other Exotic Wealth Transfers.” The presentation introduced a broader audience to the private derivatives strategy he’s been utilizing as an alternative to the vertical slice for at least a decade, as summarized in this 2006 article. At Heckerling, he described how the private derivative alternative to the vertical slice strategy can work and offered a host of other client situations in which the strategy may be appealing.
Traditional Vertical Slice
Principals who manage private equity, venture capital and/or hedge funds often desire to transfer the upside potential (namely, the carried interest or performance fee) to lower generations because during the early stages of a fund, the carried interest has little to no value. However, making a direct gift of the carried interest in a fund invites a number of possible concerns including: (1) potential Internal Revenue Code Section 2701 valuation, which would greatly increase the gift tax valuation of the transferred interests by adding the value of the transferor’s applicable retained interests; (2) arguments stemming from Revenue Ruling 98-21 that vesting over time makes the initial gift incomplete; (3) worries that any management fee waivers could result in inadvertent taxable gifts to the donee of the carried interest; (4) investor status limitations requiring that investors must qualify as “accredited investors” and “qualified purchasers”; (5) liquidity available for funding any future capital calls; (6) potential income tax risk if the general partnership interest of a fund is transferred within two years of fund formation resulting in ordinary income at the time of grant; and (7) lack of certainty as to the value being transferred, which could be more than desired if the fund is successful.
Accordingly, implementing such transfers can be quite complicated, and the traditional approach for gifting such interests has been to rely on the safe harbor of Treasury Regulations Section 25.2701-1(c)(4), known as the “vertical slice” to avoid the Section 2701 valuation concerns. The vertical slice approach involves transferring a proportionate share of all interests in the fund (not just the carried interests) held by the principal to an irrevocable grantor trust, sometimes through an intervening family limited partnership or limited liability company. While this approach may solve any perceived Section 2701 risk and tangentially solve other risks, it doesn’t necessarily solve many of the other possible concerns listed above. While practitioners such as N. Todd Angkatavanich and David Stein have published “Going Non-Vertical With Fund Interests”, the use of private derivatives has been hailed as a helpful alternative to the vertical slice by some (such as last year by Ivan Taback and Nathan Brown).
Private Derivatives Contract Alternative
Derivatives are simply financial instruments that give the holder a right to payment from the counterparty to the instrument if a certain event occurs during the term of the contract. Derivatives can be tied to anything: the price or performance of an asset, the weather, or even a family member’s survival for a specified period of time. In that way, private derivatives can transfer wealth based on the financial performance of an asset like a carried interest. As Handler explains, so-called “carry derivatives” can be thought of as a cash settled option on the carried interest that avoids the concerns described above and offers other meaningful benefits. These work best, of course, when the contract is with a grantor trust to avoid income tax consequences.
Example: Sell a private derivative contract to a grantor dynasty trust for a term that isn’t tied to the life of the fund but is deemed to be sufficient to capture as much of the fund’s gains as possible (for example, nine years or the seller’s death if sooner). Set as a hurdle the value the carried interest would need to attain before the trust receives any benefit (for example, $5 million). Set a “split” of the profits (for example, 40 percent to the seller and 60 percent to the trust). Your client can also cap the benefit to the trust (for example, $10 million). If a qualified appraiser determines the contract is worth $150,000, then the trust pays the seller $150,000. On the settlement date in nine years, if the carried interest has distributed $15 million and is valued at $7 million, the seller keeps $12 million and settles with the trust for the $10 million.
Benefits include: (1) the trust doesn’t become a fund partner; (2) there’s a greater certainty regarding the value being transferred and retained; (3) the investment risk is minimized, because less gift tax exemption is used than with a vertical slice; and (4) the damage of valuation risk is minimized, because the derivative contract will be worth less than the carried interest itself.
Risks and considerations include: (1) if the seller leaves the fund and loses the unvested carried interest, he may owe the trust more than is desired or received; (2) the seller may lack liquidity to pay the settlement, and the trust might have to accept alternative payment like a promissory note; (3) fund clawbacks after settlement impact the seller, but not the trust, which is a positive in terms of wealth transfer goals; (4) the death of the seller would require settlement at death instead of at term, resulting in realization of taxable short-term capital gains, assuming the trust is no longer a grantor trust and the risk isn’t otherwise mitigated using dual lives or life insurance; (5) the seller retains full income tax liability on carried interest, which is a positive in terms of wealth transfer goals; (6) direct transfers can shift more wealth if they’re successful even though they waste more exemption when they fail; and (7) there’s a valuation risk on challenge that the carried interest value was inaccurate and/or the contract was mispriced.
Although gift tax reporting isn’t required for these transactions, clients can use a qualified professional appraiser for the valuations and may wish to report such transactions as non-gifts, as is often done with installment sales transactions.
Other Creative Uses
The focus of Handler’s presentation was that the use of this strategy isn’t limited just to fund principals, but can be used for any asset that’s difficult or undesirable to transfer. Some examples include:
- Assets that are non-transferable (due to securities law or contractual restrictions);
- Assets that are difficult to transfer, like race horses or gun collections;
- Low growth assets like T-bills, whose returns are unlikely to beat the relevant applicable federal rate or IRC Section 7520 rates;
- Assets that don’t generate any cash flow like unimproved real estate or tangible personal property;
- Low-basis assets that waste exemption to transfer like stocks, depreciated real estate and collectibles; and
- Speculative buying opportunities, in which the goal is to hedge the downside and avoid actual speculative investing.
Private derivatives are completely customizable and can be combined with other traditional strategies. For example, the success of grantor retained annuity trusts (GRATs) can be significantly amplified by using private stock options rather than transferring the securities themselves.
“Not for the Faint of Heart”
This strategy could be very attractive for the right clients when the values at stake justify the added complexity and transaction costs over more traditional planning strategies. But it certainly isn’t appropriate for everyone.
In addition to the risks and considerations listed above, one overriding concern is that unlike a GRAT, which simply requires the return of all assets to the donor if it fails, if a private derivative contract fails, it results in assets moving backwards, because the contract price is paid at the outset of the transaction.
Handler also mentioned that although he didn’t think it applies to cash settled contracts, there could be IRC Section 2703 concerns raised about private options.
Another potential downside is that private derivatives contracts can be troublesome when outstanding during divorce –valuing the obligation to pay can be costly, and the non-seller spouse can end up with a significant liability if the obligation is allocated equally. There also may be unintended income tax consequences, particularly if the divorce results in shutting off grantor trust status.
What has been your experience with private derivatives? Do your clients use them? Have there been any problems? In what contexts have they been, or do you think they could be, useful? Please share your comments below.
This material is provided for educational purposes only. The author and Gresham Partners, LLC cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute legal, financial, tax or accounting advice. Please consult with qualified professionals for such types of advice.
