Gifting of Carried Interest – A Strategy To Save Estate Taxes

March 30, 2021

One of the common pain points for financial professionals (private equity professionals, investment bankers, and asset managers) that we hear is “I pay too much in taxes.” Most professionals typically are talking about income taxes; however, estate taxes often get overlooked. If you are a private equity professional, one of the great tactics unique to your industry to avoid paying taxes is gifting carried interest.

The Power of Gifting

Carried interest or ‘carry’ is the investment gains received by private equity professionals as compensation. Typically, the fund’s underlying success determines the amount of compensation these individuals will receive after certain return requirements have been met. What makes carry so unique and powerful as a method for gifting is the potential growth of that interest outside of a family’s estate. If a professional can shift their interest into an irrevocable trust in the early stages of a fund or deal while utilizing a favorable valuation, the upside of that interest is now captured in a vehicle no longer subject to federal and state estate taxes. This is especially beneficial in reducing a family’s overall estate tax liability and avoiding the possible 40% estate tax rates currently in place on the federal level.

Gifting Now vs. The Future

Gifting carry is also a timely discussion given the current lifetime gifting exemption amounts and potential for those to decrease, either as a part of new tax legislation or the expiration of our current laws in 2025. As of today, each individual has a lifetime gifting exemption amount of $11,700,000 (or $23,400,000 per married couple) to utilize while they’re alive or to pass on to the next generation. Although no definitive numbers have been released, new tax proposals could reduce that figure down as low as $3,500,000 – $5,000,000 per person. If no changes are made, the lifetime exemption will return to its 2017 level of $5,000,00 per person ($10,000,00 per married couple) in 2026. With either of these scenarios ultimately resulting in a reduced lifetime exemption amount, the urgency to shift these carried interest opportunities outside of an estate during the genesis of a fund becomes much more vital. However, before executing this type of estate planning strategy, it is important to make sure that it is suitable for your situation. So, why gift your carry, and when could it make sense?

Aside from receiving carry as part of your compensation, the other components to keep in mind when considering this type of gifting method are:

  • Do you currently or expect to have a taxable estate in the next ten years? If so, could shifting carried interest opportunities greatly reduce the potential estate tax burden?
  • What is your appetite for gifting assets away? Although you might expect to have a taxable estate, you may not be ready to give up control of those assets, regardless of their potential growth.
  • Do you need the cash flow, or would this strategy put stress on your future personal plans?

If you still find yourself in the position to gift your carry after asking yourself these questions, you will want to know the mechanics of taking advantage of this opportunity. While it sounds simple in theory, there are multiple ways to calculate and fund these types of gift trusts. Stay tuned for our next On the Horizon Blog, where we will dive into the different strategies and examine the Pros and Cons of each.

Sean Knoerzer is a Wealth Manager at BDF where he enjoys digging deep into the details of a client’s financial plan. He has spent time serving on the firm’s Financial Planning Committee, which is responsible for educating the BDF team on financial planning topics that help drive the team’s planning processes. He earned a Bachelor of Science in Agriculture and Consumer Economics with a concentration in Financial Planning at the University of Illinois.  Sean is a CERTIFIED FINANCIAL PLANNER™ professional.

Author(s)