Trust Planning for Carried Interest: Strategies for Fund Partners

General partners, or GPs, and others involved in managing a private equity or venture capital fund should consider the important wealth transfer vehicle that carried interest can provide.

In addition to helping meet the often-complex needs of private equity and venture capital funds, carried interest has the potential to represent significant value to fund partners. However, there are some rules to navigate that impact its transfer. Here's what you need to know.

What is carried interest in private equity or venture capital?

Carried interest is a share of the profits earned from a private equity or venture capital fund's investments and is allocated to a fund's GPs as a form of compensation provided to fund managers for their services. The share of the profits is paid once a predetermined minimum rate of return—a hurdle rate—has been achieved.

Potential value

While it can be highly speculative and difficult to value, carried interest has the potential to be worth a tremendous amount. As an example, if a GP is part of a $200 million fund with 2-and-20 structure that achieves a 2.5X return, the carried interest could be worth $10 million. This makes it a great option for advanced estate planning—such as generational transfer and philanthropic planning—but it does come with certain limitations.

Limitations

Section 2701 of the Internal Revenue Code greatly restricts the ability to gift carried interest to family members and still retain the underlying capital interest—or the amount committed by the GP to invest in the fund. This means that if a GP transfers their entire carried interest in the fund to their children, the entire interest—including the underlying capital investment—would be considered a gift.

The value of the vertical slice

It's possible to avoid the limitations of Section 2701 by creating a vertical slice. This is done by proportionately reducing each class of ownership interest in the fund.

For example, let's say your capital commitment is $1 million and your carried interest is 20%. In order to gift half your carried interest, you must also gift half the capital interest—$500,000—at its current value.

Whether the gift is made directly to a trust or to an individual, it must be proportionate. It will also need an independent appraisal. Keep in mind that the recipient will be responsible for capital calls on the gifted portion if the fund requires additional capital.

An easy way to manage the process is to put the fund interests into a family limited partnership, or FLP, or a limited liability company, or LLC. Then you can transfer interests in the new entity. The gifts themselves can be made to either individuals or trusts that move the assets outside the estate. However, you'll need a valuation of the carried interest and capital before gifting to determine the actual value of the gift—which can be costly and time-consuming.

The advantages of carry derivatives

Another advanced estate planning strategy is to use carry derivatives, which may help you avoid the issues created by Section 2701. With a carry derivative, the contract amount determines how much will be paid into the fund at a future date. You can also stipulate a floor or hurdle return rate that must be exceeded before funds are due to the trust account.

Things to consider

While carry derivatives can be an effective estate planning tool, keep in mind the following factors.

• Reviewing the operating agreement of the fund can help you determine which transfers are permissible—if any.
• Borrowing against fund interests may be more challenging.
• Vesting restrictions may have a different treatment by the IRS.
• Management fee wavers in place may be affected.
• Accounting for GP commitments paid after the time of the original gift is important.