As the financial markets flourish, there continues to be a strong focus on gift and estate planning opportunities available to hedge fund and private equity fund managers. The inherent compensation structure, including the “carried interest,” presents a unique opportunity for advisors to formulate wealth-transfer strategies for the fund manager’s future generations.

The lynchpin of any planning for profits (“carry”) interests is the speculative nature of its future value and the corresponding ability to gift such interests at a lower valuation. Traditionally, at least since the enactment of IRC section 2701, advisors have rarely ventured from what has been considered the tried and true path of “vertical slice” planning, under which the fund manager/donor would make a proportionate gift of both the carry and the underlying limited partnership or “principal” interest. Although not specific to the generational transfer of carried interest holdings, IRC section 2701 creates a complex array of gift valuation rules that give pause to even the most seasoned advisors. Because valuation is often at the heart of gifting transactions specifically advantageous to fund managers, these special valuation rules can make or break a proposed gifting transaction. Failing to heed the intricacies of IRC section 2701 often results in harsh and costly consequences that threaten to ruin otherwise legitimate estate and gift planning.

This discussion explores how the vertical-slice became the “go to” approach in carry planning and proposes potential alternatives and planning opportunities around IRC section 2701, whether or not a carried interest is involved.

What Is Carried Interest?

Hedge fund and private equity fund managers generally receive a profits interest in the fund or funds they manage. This profits interest is referred to as the “carried interest,” or the “carry,” and entitles the fund manager to a portion of the profits earned by the fund. Because the carried interest is dependent upon fund performance, the value of the interest is likely lower in the early years of the fund, due to the speculative nature of the carried interest; the fund manager has not yet had an opportunity to generate significant profits for the fund or its investors. Over time, and as profits increase, the value of the carried interest increases to reflect the increase in fund profits and the earnings history of the fund manager.

Planning for carried interest has become even more important because the newly enacted Tax Cuts and Jobs Act (“TCJA”) may significantly impact certain fund managers, depending how their carried interest was earned and their individual investment profile. Furthermore, tax reform introduced a new concept known as the “applicable partnership interest,” defined as any interest that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business (i.e., a carried interest). The big impact is that what was traditionally taxed as long-term capital gains for income tax purposes may now be taxed as short-term capital gains in the hands of the carried interest holder for lack of meeting a three-year holding period requirement. The result is a material tax increase to certain types of carried interest and an impetus for proactive and tailored planning in advance of future valuation increases.

Transfer Tax Basics

The United States imposes tax on certain transfers of assets, in excess of transfer tax thresholds, from one individual to another: gift tax for those transfers occurring during the life of the transferor and estate tax for those occurring at the transferor’s death. The tax assessed is entirely dependent upon the value of the asset transferred as of the date it is transferred—the date the gift is transferred to the donee (gift tax) or the date the transferor dies (estate tax). Without regard to estates falling below the transfer tax threshold, assets not transferred (and taxed) during life will be taxed in the transferor’s estate. Successful gift and estate tax planning should aim to transfer assets at a time when the asset is least valuable for transfer tax purposes. Assets that have the potential to appreciate should be transferred early and when they presumably have less value. Because the gift tax is levied upon the value of the asset at the time of transfer, appreciation that occurs after transfer is not subject to transfer tax with respect to the original transferor; however, the future potential for appreciation may be taken into consideration in determining the fair market value of the asset.

With these transfer tax basics in mind, engaging in early stage planning for fund managers has the potential to minimize estate and gift taxation while transferring substantial appreciation to, or for the benefit of, future generations. The carried interest is not just a revenue stream but also an asset itself; in addition to providing compensation to the fund manager, it holds value relative to the present value of anticipated future earnings of the fund. When viewed as a separate and distinct asset with value and projected returns, it becomes apparent that carried interest is an asset ripe for wealth transfer planning because the carried interest begins as a relatively low-valued asset with the potential to appreciate, perhaps substantially, based on the performance of the fund manager.

Generally, a tax adviser’s objective should be to transfer the carried interest at a lower value before the fund manager generates significant profits (or develops a proven track record of year-to-year profits). The carried interest will then have a lower transfer tax value and the fund manager will be able to maximize the portion of the carried interest transferred without utilizing all of the donor’s lifetime gift tax exemption or exceeding the amount and incurring gift tax. The share of the carried interest transfer is not only proportional to but can also result in an exponential increase in the share of wealth transferred to or retained for the benefit of future generations. Traditional transfer planning techniques could further impact the transfer of a carried interest—for example, it could be transferred to a multigenerational instrument (a trust) to minimize future gift, estate, or generation-skipping transfer taxes. In addition to moving wealth to future generations early, transferring the carried interest during life will remove the asset’s appreciation from the funder manager’s gross estate, reducing estate taxes upon the fund manager’s death.

IRC Section 2701 Pitfalls

It may be best to start with an example of a historical planning technique that, since October 9, 1990, falls within the purview of IRC section 2701: creation by a senior family member of a partnership with multiple classes of ownership interests. Consider, for example, that the senior family member capitalizes the partnership with cash and an appreciable asset. Initially, the senior family member holds both a preferred ownership interest with a preferred coupon return and a common ownership interest without a preferred coupon but entitled to the appreciation of the contributed assets. Thereafter, the senior family member would gift the common ownership interests to junior family members (while retaining the preferred ownership interest). In doing so, the senior member would retain an asset with a “frozen” value—the present value of the future preferred coupon payments—while transferring the potential growth upside to the junior members.

Certain taxpayers would aggressively inflate the value of certain retained interests (such as liquidation rights) to further lower the value of the transferred interest, and worse, create preferred or senior interests that were largely illusory (i.e., the preferred coupon would never be exercised). In response to this potential for manipulation, whether real or perceived, Congress enacted IRC section 2701 to control certain transfers between family members by providing special valuation rules that apply to the transfer of an interest in a partnership or corporation to a member of the transferor’s family. While IRC section 2701 is not designed to aid in determining whether a gift has occurred, it is imperative in determining the gift’s value. When an individual gifts (or sells) a portion of an asset she owns, the asset converts into two distinct pieces of property: the gifted portion and the retained portion. To combat potential manipulation of value, IRC section 2701 alters the traditional method for valuing a gifted interest in a corporation or a partnership when the gift is to a family member and when the transferor, or a transferor’s applicable family member, retains an “applicable retained interest” in the entity. An applicable retained interest is either an extraordinary payment right (such as a put, call, or conversion rights) or a distribution right (such as a preferred coupon rate).

Valuation under IRC section 2701 is twofold:

• Value the entire interest owned by the transferor (and certain family members) immediately prior to the transfer.
• Subtract the value of the property retained by the taxpayer immediately after transfer.

The special rules of IRC section 2701 apply to the valuation of the retained portion and indirectly affect the value of the deemed gift. At worst, the retained interest could have a zero value because of the special valuation rules; or perhaps only some portion of the retained interest could have a zero value. Typically, a zero valuation results when the senior family member holds and retains a senior interest in an entity while simultaneously transferring a subordinate interest in the same entity to a family member. In the case of a zero valuation of the retained interest, it is possible that the entire interest owned by the transferor (and certain family members) could be deemed to have been gifted. This is the result even if the retained interest demonstrably has value.  However, it is important to note, that even if section 2701 is triggered, there are still other components of the senior family member’s equity interest that will still be ascribed some value under this “subtraction method” of valuation (e.g., liquidation participation rights and non-lapsing conversion rights).

For example, imagine that the senior family member is the manager of a newly formed private equity fund. The fund manager holds a limited partnership ownership interest in the fund, as well as a carried interest that entitles him to a portion of the fund’s profits in excess of a predetermined threshold. If the senior family member were to gift his carried interest to junior family members, while retaining his limited ownership interest in the fund, one would presume that the value of the gifted interest would be low or at least lower, because the carried interest has not yet appreciated.

On the face of the transaction, the retained limited partnership interest by the senior family member should not conjure the illusory rights concern that could arise in the context of a self-created preferred interest; nevertheless, because of the broad language of IRC section 2701 it can also apply to gifts of carry interests. Transfers under IRC section 2701 include not only gifts of ownership interest but also changes to the capital structure of an entity, such as capital contributions, redemptions, and recapitalizations. In the carried interest context, it is not entirely certain what constitutes a “subordinate” or “senior” interest, but many practitioners have concerns that that if a carried interest is subordinate to a limited interest (or the “capital” interest) in a partnership, then IRC section 2701 could present an issue.

In the case of a transfer of carried interest in a hedge fund, the application of IRC section 2701 is less clear, since in such case the carried interest and the limited partnership interest are generally not considered to be neither senior nor subordinate. Rather, they share in different proportions of the profit. Thus, an argument could be made that perhaps the draconian rules should not be applicable in such case, and that the carried interest and the limited partnership interests fall within an exception to the statute for transfers of interests that are “proportionately the same.”  However, there is a paucity of authority as to what exactly this phrase means – therefore, one should approach affirmative planning based upon this interpretation very cautiously.

If IRC section 2701 applies to the transfer of a carried interest, the transferor may be deemed to have made a gift (for gift tax purposes) of not just the carried interest actually transferred, but significantly more of his or her interests in the fund (e.g., general partner interest and limited partner interest, or some component of the limited partnership interest). Because a fund manager often invests a sizeable amount of capital into a fund as a limited partner (either directly or perhaps via her interest in the general partner of the fund), an IRC section 2701 deemed gift could result in practical issues (where the transferred interest is different for tax purposes and legal title). In addition, the deemed gift could cause a significant gift tax liability despite the fact that the principal had not actually transferred her limited partner interest nor intended to do so.

The Vertical Slice Safe Harbor

IRC section 2701 provides a safe harbor exception to the special valuation rules that would otherwise apply to transfers described above. Specifically, Treasury Regulations section 25.2701-1(c)(4) states that the special valuation rules described in IRC section 2701 do not apply to the transfer of an equity interest to a member of the transferor’s family, provided that the transfer results in a proportionate reduction of each class of the equity interest held by the senior family member. If you were to imagine the transferor’s ownership interests stacked in order of seniority, the vertical slice exception would require a carve-out of the stacked interests, much like a slice of cake, that proportionally takes from each section. Simply put, making a vertical slice transfer requires the fund manager who wishes to transfer a portion of her carried interest to family members to proportionately transfer all of her other equity interests in the fund in order to avoid triggering a deemed gift (such transferred interests constituting the vertical slice). Presumably, a vertical slice transfer would reduce every interest in the entity on a pro-rata basis, thereby taking away the opportunity to disproportionately shift wealth to the next generation through the retention of some artificially inflated equity interests and the transfer of an artificially depressed non-equity or profit interest. Instead, the vertical slice ensures that the younger generation and senior generation would share proportionally in the future growth—or decrease in value—of the entity and thus not allow for a shift in value away from the parent to the younger generation by way of the non-exercise of discretionary rights between two or more different classes of equity.

Consider the earlier example where the senior family member fund manager holds both limited partnership interest and a carried interest in the hedge fund he manages. Should the fund manager wish to gift a portion of his interest to junior family members without running afoul of IRC section 2701, he must give a proportionate share of both the limited ownership interest and the carried interest.

Most fund managers would typically desire to give away a larger percentage of the carried interest in their fund, because that is the asset that has the greatest potential for exponential growth; however, because they often own a significant amount of limited partnership interests in a fund, there are inherent limitations to how large a percentage of the carried interests they can give away if using the vertical slice approach.

Enhancing Vertical Slice Planning

For advisors who would rather not venture beyond what has been considered the tried and true path, there still exists some opportunity to maximize the planning potential, with a few additional enhancements.

Consider IRC section 2701 issues

While vertical slice planning is certainly the most popular approach, like any planning technique, it should not be followed or applied without thoroughly vetting the context. If, for example, the fund manager makes a vertical slice transfer of a percentage of some or all of her interests in the fund entities to her children or their trusts but the fund manager’s parent or spouse’s parent, both of whom are “applicable family members,” continue to own an interest in the fund, then the deemed gift tax rules under IRC section 2701 could still be implicated. This is because the transferor’s parent or in-law has retained a limited partnership interest in the fund, which could be the retention of a distribution right and, therefore, an applicable retained interest, subject to the zero-valuation rule.

Using a holding entity

Verticality may be enhanced through the implementation of a holding vehicle, such as a limited partnership or an LLC (aka, the vertical slice holding entity). In this instance, the fund manager/transferor would first contribute all fund interests—both general and limited partnership—to a newly established vertical slice holding entity, which would be structured as a single-class entity to avoid another level of IRC section 2701 scrutiny. These approaches rely on Treasury Regulations section 25.2701-1(c)(3), which states that section 2701 “does not apply if the retained interest is of the same class of equity as the transferred interest or if the retained interest is of a class that is proportional to the class of the transferred interest.” Subsequently, the fund manager would transfer an interest in the vertical slice holding entity to his child or perhaps a trust for the child’s benefit. By placing the ownership of the fund entity interests within a vertical slice holding entity, a gift of a vertical slice may be achieved in a more streamlined fashion: a simple transfer of a percentage ownership interest in the holding entity. Going forward, this would ensure that the same proportional ownership is maintained. Further transfers could be achieved by transferring additional interests in the vertical slice holding entity. These transfers should not require an additional round of approvals, qualifications, or consents at the fund level because what would be transferred are interests in the vertical slice holding entity rather than in the fund entities.

IRC section 2036 implications

The creation of a vertical slice holding entity can be an efficient way to address the IRC section 2701 issue in the context of carried interest transfer planning; however, this also presents unique issues that should be considered under IRC section 2036(a). The IRS has a history of challenging the funding and subsequent transfer of interests in family limited partnerships (FLP) under a number of different theories—the most notable and successful being under IRC section 2036(a)(1) as a transfer with retained interest and to a lesser extent under IRC section 2036(a)(2) as a transfer with retained control. While the typical FLP challenged by the IRS often involves entities formed for much different reasons than a vertical slice holding entity, the creation of an entity with subsequent transfers of interests should nonetheless be examined in this light.

Under IRC section 2036(a), one way to avoid this altogether is to satisfy the “bona fide sale” exception. If the fund manager’s initial capital contribution to the entity is considered a bona fide sale for “adequate and full consideration,” then IRC section 2036 is not applicable. If this exception is satisfied, then, as a technical matter, the retained control issue under IRC section 2036(a)(2), as well as any implied understanding issues under IRC section 2036(a)(1), should not be an issue because the application of IRC section 2036 to the transfer of assets into the entity should be off the table. However, this exception is not simple to satisfy. In practice, it appears that courts’ analyses of whether a decedent’s contribution of assets into a partnership constituted a bona fide sale for adequate and full consideration appears, at least in part, to be intertwined with a determination as to whether an implied understanding existed under IRC section 2036(a)(1). Recent developments in case law related to IRC section 2036 add some pressure to this approach in the current environment. It is critical that the vertical slice holding entity be created in furtherance of a legitimate and significant non-tax purpose.

Non–Vertical Slice Approaches [1]

The vertical slice exception is not the only statutory way to comply with IRC section 2701. Other approaches rely on provisions in the IRC and Treasury Regulations exempting the parental retention of certain mandatory and quantifiable interests. The Treasury Regulations acknowledge that the zero-valuation rule should not apply if a parent has not retained certain types of suspect interests in the transferred entity. For example, the zero-valuation rule does not apply if the parent transfers interests of the same class as those retained.

Qualified payment right holding entity

This approach essentially relies on the creation of some form of a preferred partnership holding vehicle within the statutory confines of IRC section 2701 and its exceptions. Similar to the Vertical slice holding entity approach, the fund manager would establish and fund a new family LLC with all of her interests in the fund. Unlike the vertical slice holding entity, this vehicle (the preferred partnership) would issue two classes of interest: common and preferred.

The preferred interests would have priority over common interests with respect to the payment of a fixed coupon on the holder’s investment and in the event of a bankruptcy. Preferred interests would not, however, participate in the upside growth of the preferred partnership, as all the future appreciation in excess of the preferred coupon inures to the benefit of the common class of partnership interests, which would be transferred (gifted) to the younger generation or trusts for their benefit. The fund manager would continue to hold the preferred interests.

In order to satisfy the statutory exception under IRC section 2701, the preferred interest would be structured as a “qualified payment right,” which means “a right to any periodic dividend on any cumulative preferred stock (or a comparable payment on partnership interest) to the extent such dividend (or comparable payment) is determined at a fixed rate.” Flexibility can be built into the structure, as a qualified payment can be paid up to four years after its required due date and can be paid with a promissory note with a maturity of up to four years.

One provision that may impose some practical limitation to this approach is the minimum value rule, which provides that the value of a junior equity interest can’t be less than its pro rata portion of 10% of the sum of the total value of all equity interests and the total amount of indebtedness owed to the transferor and applicable family members. Because the common interests would be junior equity interests, the minimum value rule would cause the value of the gifted common interests to be at least 10% of the total value of all equity interests in the preferred partnership. Thus, even if the zero-valuation rule didn’t apply, the fund manager may still be treated as making a partial gift in excess of the fair market value of the transferred interests if the retained preferred interest exceeds 90% of the capitalization of the preferred partnership.

Another variation to the above approach would be to structure the holding entity LLC as a reversed preferred entity, in which the fund manager would hold the common interest and the transferee family members would hold the preferred interest. In such cases, the fund manager’s retained common interest shouldn’t trigger IRC section 2701.

Even if the fund manager’s preferred interest is properly structured to avoid the potentially severe aspects of IRC section 2701, there are still deemed gift issues to consider because the foregoing structuring merely ensures that the fund manager’s preferred interest is not valued at “zero” for purposes of determining the fund manager’s gift to younger generation family members. There may still be a partial gift under traditional valuation principals if the fund manager’s retained preferred coupon is less than what it would have been in an arm’s-length situation. For example, if the fund manager’s retained coupon under the partnership agreement is a 5% coupon, but a 7% return would be required in an arm’s-length transaction, then a deemed gift has been made by the parent to the extent of the shortfall—albeit not as potentially dramatic a gift as would occur by violating IRC section 2701.

It is vital to retain a qualified appraiser to prepare a valuation appraisal to determine the preferred coupon required for the fund manager to receive value equal to par value for his capital contribution. The appraiser will typically consider the factors set forth by the IRS in Revenue Ruling 83-120. The starting point under this guidance is to analyze comparable preferred interest returns on high-quality publicly traded securities. Additional factors for consideration include the security of the preferred coupon, the size and stability of the partnership’s earnings, asset coverage, management expertise, business and regulatory environment, and any other relevant facts or features of the preferred partnership. The partnership’s coverage of the preferred coupon (which is the ability to pay the required coupon when due) and of the liquidation preference (which is its ability to pay the liquidation preference upon liquidation of the partnership) will impact the required coupon. A higher percentage of the partnership interests being preferred interests, and correspondingly fewer common interests, puts greater financial pressure on the partnership’s ability to pay the coupon on time; this translates to weaker coverage of the coupon, and thus greater risk—and ultimately a higher required coupon to account for this greater risk. Conversely, a partnership that has a higher percentage of common interests relative to preferred interests would provide stronger coverage, which would result in lower risk and consequently a lower required coupon. A lower coupon may be more desirable from a wealth-transfer standpoint because growth above the lower coupon will shift to the younger generation owning the common interests.

Last, similar to the vertical slice holding entity, the preferred partnership may also invite scrutiny under IRC section 2036. In order for the preferred interest to be respected as equity (rather than debt), the indicia of ownership would likely be of the same nature that could raise a re-inclusion risk under IRC section 2036.

Trust for non-descendants

This approach navigates IRC section 2701 by establishing a trust for the benefit of persons other than a member of the family of the fund manager/transferor—that is, persons who are not the fund manager/transferor, the transferor’s spouse, any lineal descendant of the transferor or the transferor’s spouse, and the spouse of any such lineal descendant.  For instance, the fund manager could create a trust for the benefit of extended family members, such as a class trust for parents, siblings and their children.  Over time, this trust could be used to make sprinkling distributions to provide support to parents for their remaining lifetimes, provide assistance to siblings and/or perhaps provide support to nieces and nephews for educational expenses, such as college education.  In this respect, such a type of trust can provide a means for the fund manager to allow extended family members to share in the fruits of the fund manager’s labor, which is very often consistent with his or her objectives, and, quite honestly, consistent with family dynamics and expectations.

The fund manager would establish an irrevocable trust for the benefit of the fund manager’s parent, or perhaps a sibling or non-family member, and transfer (gift) some or all of their carried interest into such a trust. Under the trust’s terms, the beneficiary would possess a lifetime and/or testamentary limited power of appointment, and the trustee would possess absolute discretion over distributions to the beneficiaries. The power of appointment should be drafted as broadly as possible without creating a general power of appointment.

As long as the power of appointment is structured so that it’s not a general power of appointment, and the exercise of the power is not a taxable gift under chapter 12, its exercise by the beneficiary shouldn’t be considered a transfer that triggers IRC section 2701. Treasury Regulations section 25.2701-1(b)(3)(iii) specifically provides that a “transfer” doesn’t include a transfer resulting from “a shift of rights occurring upon the release, exercise, or lapse of a power of appointment other than a general power of appointment described in IRC Section 2514, except to the extent the release, exercise or lapse would otherwise be a transfer under chapter 12.” Because the beneficiary wouldn’t have a legal entitlement to trust assets due to the absolute discretion given to the trustees, and because the power is a limited rather than general power of appointment, arguably the exercise of that power shouldn’t be considered a taxable gift.  It is important, however, to consider whether or not a chapter 12 gift could occur to the extent that a beneficiary’s exercise of a limited power of appointment if such would reduce the amount of income that he/she has historically enjoyed from the trust.  While such would be a highly facts and circumstances determination, arguably, in the case of a class trust in which the trustee has absolute discretion to distribute or not distribute some, none or all of the trust assets, evenly or unevenly amongst a group of beneficiaries, it would be difficult to effectively argue that an exercise of a limited power of appointment has resulted in a gift by the power holder.

The practical risk with this approach is that the beneficiary has very broad power to appoint or not appoint assets to a broad class of people, and it is very possible that trust assets could be appointed to unanticipated recipients; the fund manager would not have legal power to prevent such an exercise.

Planning Opportunities

Carry planning, if timely and correctly executed, can afford some of the best transfer of wealth at a low taxable gift “cost.” The authors are optimistic that the planning opportunities presented in this article can help achieve this objective.

Joel Friedlander, JD, joined Ernst & Young in September 2018 as a managing director in the private client services practice specifically targeting the wealth and asset management sector. He has dedicated his time to working with some of the world’s wealthiest hedge and private equity fund managers as well as their family offices to provide proactive, thoughtful and complex planning strategies. He has also worked with clients on aircraft acquisitions, professional sports team transactions, various trust and estate planning matters including GRAT planning, CLAT planning, etc. He graduated from Binghamton University in 2005 receiving a BS in accounting, then received a JD from the Maurice A. Deane School of Law at Hofstra University in 2011, and is now admitted to practice law in the State of New York.

Joshua Zimmerman, JD, LLM, is a manager in the private client services group at Ernst & Young, LLP.  He provides sophisticated tax compliance and planning to high-net-worth individuals and their families. Josh started his career in the tax department of a large law firm based in Indianapolis. Josh’s legal practice consisted of drafting sophisticated trust and estate documents, researching various tax issues, and assisting with tax controversy matters. Prior to joining Ernst & Young, Josh was a manager in the trust and estate department of a mid-sized accounting firm in New York City, where he concentrated his practice in trust, estate, and gift planning and compliance for high-net-worth individuals. Additionally, Josh has significant experience in tax controversy matters concerning gift, estate, and income tax related issues. Josh currently advises clients on strategic and effective wealth transfer planning, sophisticated gift and estate compliance matters, and various income tax planning issues.  Josh received a B.B.A in Accounting, B.B.A. in Finance, and a M.B.A. from Texas State University. He received his J.D. from the Maurer School of Law at Indiana University and his LL.M. from Georgetown University. He is licensed to practice law in the state of Indiana. Josh is a member of the Estate Planning Council of New York City.

Naomita Yadav, JD, is a senior manager in the private client services group in the San Francisco office of Ernst & Young. Her experience in estate and gift planning includes working with closely held entities including family limited partnerships, family businesses and real estate investment, and advising clients on wealth transfer planning. She received her undergraduate degree from Yale University and her JD and MBA degrees from the University of Michigan, Ann Arbor.