Transferring Carried Interests One Vertical Slice at a Time

If you run a private equity firm, you’re probably familiar with the concept of “carried interests.” Carried interests generally refer to a partner’s (or member’s) right to share in the profits of a partnership or other joint venture at a level disproportionately higher than its capital investment. For example, a fund’s general partner may contribute 1% of the fund’s investment capital, but be entitled to receive 20% of its profits.

Carried interests have many different variations and names, including overrides, promotes, performance allocations, incentive fees, and profits interest. Funds also vary in organizational structure—some are limited partnerships, while others may be LLCs. For purposes of this post, we’ll simply focus on carried interests within limited partnerships.

Carried interests are highly dependent upon the success of the investment. As a result, the value of a carried interest is very speculative. If the fund is tremendously successful, the carried interest may result in substantial profit for the manager. On the other hand, if the investment fails to meet expectations, the carried interest may not result in any economic benefit to the manager. For this reason, when we meet with fund managers on estate planning matters, they often assign zero value to the carried interest. Formal valuations of carried interests usually result in similarly low valuations.

The speculative nature of carried interests make them prime assets for advanced estate planning strategies. After all, in estate tax planning, we’re often looking to fund irrevocable trusts with assets that have a low initial gift value and high appreciation potential in order to minimize future estate tax liability.

Unfortunately, the IRS has implemented rules that restrict your ability to transfer only carried interests to trusts or family members at extremely low valuations. Specifically, Section 2701 of the Internal Revenue Code provides that if you gift part of your carried interest to family, but retain an underlying ownership interest in the general partnership (the “GP”) and/or the limited partnership (the “LP”), you are treated as if you made a gift of all of your interests in the fund owned prior to the transfer, despite not actually gifting those GP and/or LP ownership interests to family.

As a result of Section 2701, everything you owned in the fund prior to the transfer is deemed a gift, and you are treated as having retained no interests for gift tax purposes. Careful planning is required to avoid this result, which could generate substantial gift tax liability. Fortunately, the IRS carved out a safe harbor rule within Section 2701.

Enter: The Vertical Slice.

You can avoid the result of Section 2701 by proportionately reducing each class of your ownership interests in the fund. In other words, to avoid Section 2701, you need to gift a “vertical slice” of your various interests.

As an example, let’s say you have a GP interest in a private equity fund valued at $1 million, and an LP interest in the fund valued at $5 million. If you want to gift half of your carried interest in the GP ($500k) to a trust for your spouse and children, you would also need to gift half of your LP interests ($2.5 million) to the trust to avoid Section 2701. This would result in a taxable gift of $3 million. While it’s not a perfect solution, the upside potential of the carried interest may justify using Vertical Slicing to minimize estate tax liability.  

One easy way to utilize Vertical Slicing to avoid Section 2701 is to create an LLC and transfer all of your fund interests into the LLC. From there, you can gift LLC interests into a trust for the benefit of your spouse and children. Since the LLC owns all of your interests in the fund, vertical slicing is achieved more simply. The initial contribution of LLC interests to the trust is valued for gift and estate tax purposes, and the appreciation of the LLC interests after the date of the gift passes outside of the fund manager’s taxable estate. These gifts could be made to an irrevocable gift trust for the benefit of children, a spousal lifetime access trust for the benefit of a spouse and children, or potentially a grantor retained annuity trust. And if gifting the LLC interests is not feasible, it's possible to sell the LLC interests to a trust and receive note payments back for the initial contribution.

In summary, the IRS has restricted the ability of fund managers to transfer only his/her carried interests in a fund. However, the upside potential of carried interest may still justify making gifts to a spouse or children, in trust, by utilizing vertical slicing.