Estate Planning for Private Equity Fund Principals

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Bradley M. Van Buren, Esq., Holland & Knight

There has been considerable debate on Capitol Hill over the taxation of a Carried Interest in the context of a Private Equity Fund (“PEF” or the “Fund”). At the same time, there has been public discussion of the role that the private equity industry will have in our economic recovery. In the realm of estate planning, PEF Principals possess unique opportunities to shift the performance of their interest in a PEF to future generations potentially resulting in very significant estate tax savings.

Generally, those individuals who founded and operate a PEF are referred to as the “Principals” of the Fund. More specifically, Principals are those individuals who ultimately posses an interest in the general partner entity of the PEF. A “Carried Interest” is an allocation of future profits distributed to a Principal (via his or her interest in the general partner entity of the PEF). The Carried Interest is generally satisfied after the following distributions:

• a return of capital contribution to all investors;
• a proportionate distribution of aggregate profits equal to the stated investment hurdle rate of the PEF (the “Hurdle Distribution”); and
• a catch-up allocation to the Carried Interest holders to make up for the Hurdle Distribution.

Typically, the PEF Agreement will provide that the profits remaining after these allocations will be distributed 20% to the general partner entity as Carried Interest and the remaining 80% will be divided proportionately among the investors. The cash flow distributions of a PEF are commonly referred to as the “Waterfall Distribution.”

A Carried Interest is currently characterized as capital gain for income tax purposes, which by the nature of the long-term investment strategy of a PEF, permits a Principal to recognize his or her Carried Interest allocation as a long-term capital gain (taxed currently at a 15% federal tax rate). From an income tax perspective, the current debate over how to tax a Carried Interest hinges on two competing arguments:

• Capital Gains Argument: A Carried Interest is an interest in the future realized profits of the PEF, which is comprised of aggregate realized capital gains. Therefore, the character of that income should be maintained as capital gain.

• Ordinary Income Argument: Notwithstanding the capital gains character of the profits generated in a PEF, a Carried Interest received by the Principals has a disproportionate relationship to the capital contributions made by them via the general partner entity (generally a modest 1%-5% of total capital contributed to the Fund). Since the Principals are benefiting from the capital contributions of other investors, the Carried Interest is compensatory in nature. Accordingly, distributions received by a Principal via his or her Carried Interest should be subject to ordinary income rates (potentially also subject to self-employment tax).

Whether the income tax treatment of a Carried Interest will be changed in upcoming legislation is still unclear. If a re-characterization of the tax treatment of a Carried Interest does come to fruition, the specifics associated with the implementation of the change will ultimately determine the level of effect it will have in the estate planning context.

In the meantime, due to the methodology inherent in valuing a Carried Interest, implementing wealth transfer techniques leveraged upon the performance of a Principal’s Carried Interest to shift wealth to future generations remain viable and effective estate planning strategies. In addition to the marketability and minority valuation discounts that are generally afforded a Principal’s interest in a PEF, the uncertainty of the financial future of many investment classes, including private equity, as well as the tax fate of Carried Interests, provide further speculation and potential discounting when valuing a Principal’s Carried Interest for gift tax purposes. That is to say, will the fund portfolio produce a return sufficient to exceed the priority rights stipulated in the Waterfall Distribution under the PEF Agreement? Due to the low current value of the Carried Interest and its potential for significant appreciation, the Carried Interest is an optimal asset to shift wealth to future generations at little or no gift tax cost.

If you would like to read more about the estate planning techniques available to Private Equity Fund Principals, please go to the following link: