How Do I Gift My Carried Interest?
After meeting with your personal CFO and financial team, you have determined, as a private equity professional, that gifting carried interest fits within the scope of your long-term financial goals. You have reviewed future cash flows, potential income and estate tax savings, and the amount of estimated growth you are shifting to future generations. The question then becomes, “How do I gift my carry?”
There are two primary strategies used to gift carried interest. The first and more traditional option is known as the Vertical Slice. The second option, which carries a little more complexity with it, is gifting a carry derivative. We’ll briefly dive into both of these strategies and list the Pros and Cons of each. Keep in mind that these options should be reviewed carefully with your wealth manager and estate planning attorney to determine their suitability for your situation, depending on your personal financial goals.
The Vertical Slice Strategy
The Vertical Slice strategy is the simplified version of gifting a proportional amount of both your carried interest and capital interest into an irrevocable trust. As a general partner, you are required to make a specific allocation of both interests to comply with the IRS gift code. This typically happens in the early stages of a fund’s life to take advantage of the potential appreciation associated with it.
- Simple Funding: Although there are multiple factors to consider when executing the vertical slice strategy, the actual funding method is fairly simplistic. The trust has a predetermined allocation of both carried and capital interests. Depending on the fund performance, the capital interest is paid to the trust first, and then any carry that may also apply.
- Shifting Growth: Transferring carry early on can help maximize the wealth-transfer to younger generations. If the partners are confident in the fund’s long-term prospects, getting a specific portion out of an already taxable estate may significantly reduce your future estate tax burden.
- Lack of Control: There’s no crystal ball when deciding how much of your carry to gift in the early stages of a fund. If the fund has tremendous growth over its lifetime, you may unintentionally give away more than you originally intended to your beneficiaries.
- Carried Interest & Capital Interest: Due to IRS code rulings, you are required to gift a proportional allocation of both your capital interest and carried interest to the trust. Therefore, you must have a trust that can make the appropriate capital calls with cash flow issues potentially presenting a challenge.
Rather than gifting your carry directly, you can utilize the derivative option by attaching the economic value of your carried interest (at a discounted rate). Thus, the amount of your gift is determined by the initial valuation, and your beneficiaries benefit from the success of the fund and the carry associated with it.
- Customization: This is perhaps the most attractive feature of the derivative option, as it allows you to be completely dynamic with your gift. Rather than choosing a flat percentage to gift in trust, you can associate hurdle rates, maximum caps on the amount gifted and designate specific amounts of proceeds to divide between yourself and your beneficiaries.
- Use of Exemption: The discounted value of your carry allows you to minimize the amount of your gift tax exemption utilized today. If the fund does not have long-term success or does not meet the hurdle rates you have associated with it, you’ve minimized your cost to just your exemption used.
- Cost: The cost of valuing a general partner’s carry and calculating the appropriate benefit to associate with future earnings can be high. Ideally, multiple partners will want to participate in gifting a portion of their carry as well, allowing the cost to be spread amongst everyone.
- Liquidity: The derivative option is essentially a contract between you and the trust to which the benefits are being gifted. Should the fund experience significant growth, you will owe the trust the predetermined settlement amount at the conclusion of the contract. If liquidity is an issue for you at the time the contract is due, you may have to resort to alternative settlement options.
While these summaries are intended to give you a brief description of both funding strategies, there are many other factors to consider that are not mentioned above. If you’re seriously considering employing one of these gifting methods in your personal life, please reach out to your wealth management team to discuss further.
No representation is being made that any strategy shown will or is likely to achieve results similar to those shown in this presentation. BDF does not provide legal, tax, insurance, social security, or accounting advice. Clients of BDF should obtain their own independent tax, insurance, and legal advice based on their particular circumstances. The information herein is provided solely to educate on a variety of topics, including wealth planning, tax considerations, insurance, estate, gift, and philanthropic planning.
Sean is a Wealth Manager at BDF and a member of the firm's Financial Professionals Practice Group. He enjoys providing solutions to unique financial circumstances and clarity on complex planning needs. Sean has also served on the firm's financial planning committee. Sean earned a Bachelor of Science in Agriculture and Consumer Economics with a concentration in Financial Planning at the University of Illinois.