Estate planning with carried interests: navigating I.R.C. s. 2701.

• Author: Brown, Nathan R.
• Position: Tax Law

Recently, business development boards throughout Florida have ramped up efforts to lure to Florida private equity firms and hedge funds (1) headquartered throughout the country. With no state or local income tax and no state gift or estate tax, high net worth individuals, such as private equity fund managers (fund managers), can reap significant tax savings by relocating to Florida. The state is already home to over 130 private equity firms and hedge funds, and it appears that the southern migration may just be getting underway. In light of this influx of fund managers to Florida, it is imperative that our estate planners understand the intricacies of I.R.C. [section]2701 (2) to ensure that our fund manager clients do not inadvertently fall prey to its harsh gift tax consequences.

Structure and Economics of a Standard Private Equity Fund

A private equity fund is an investment vehicle, typically structured as a limited partnership, formed by fund managers to invest large pools of capital in various portfolio companies. The general partner (GP) of the fund is typically structured as a limited liability company (LLC). The fund managers are typically the members and managers of the GP and, thus, the fund managers control the fund via their control of the GP. A fund typically allocates and distributes to the GP a percentage of the fund's overall profits (generally 20 percent) in excess of a minimum return in exchange for the services the fund managers provide. (3) The GP's share of profits is commonly referred to as a "carried interest." In addition to providing services to the fund (in exchange for the carried interest), the fund managers also may invest their own capital in the fund, either through the GP or in the fund directly as an LP. The LPs of the fund typically consist of outside investors, such as pension plans, university endowments, insurance companies, and wealthy individuals who agree to commit a fixed amount of capital to the fund, which may be called over a period of time by the fund managers who identify investment opportunities for the fund.

The fund managers will usually form a separate entity, typically structured as an LLC, to serve as a management company for the fund (management company). The management company, which usually will not own an equity interest in the fund, will act as the fund's investment advisor and provide other basic operational services to the fund in exchange for an annual management fee, typically 2 percent of assets under management.

A successful fund will have substantial amounts of cash proceeds to distribute between the GP and LPs as investments are liquidated. The manner in which these distributions are made is set forth in the fund's partnership agreement and is often referred to as the "distribution waterfall." Pursuant to a typical distribution waterfall, distributions are made to the partners in the following order of priority:

* First, all investors receive a return of their invested capital. This includes any capital invested by the fund managers, either through the GP or directly in the fund as an LP.

* Second, all investors receive a preferred return on their capital investment.

* Third, the GP (the holder of the carried interest) is entitled to a catch-up distribution to make up for the preferred return paid to the investors.

* Finally, of the remaining profits, 20 percent is distributed to the GP as the carried interest and 80 percent is allocated among and paid to the capital investors.

Because the GP is not entitled to its carried interest unless the fund's investments generate sufficient profit to return all invested capital plus a specified preferred return, at the time the fund is created (and throughout the fund's early stages) the carried interest has little or no value. (4) If the fund is successful, the value of the carried interest could become substantial. The carried interest's significant appreciation potential makes it an ideal asset to transfer during life using various estate planning techniques. (5) However, the economics of a fund and the nature of a fund manager's various interests therein, require careful navigation of I.R.C. [section]2701 in order to avoid harsh unintended gift tax consequences.

I.R.C. [section]2701's Special Valuation Rules

Generally, I.R.C. [section]2701 applies any time an individual (transferor) transfers an equity interest in a privately held entity to or in trust for the benefit of a younger generation member of the transferor's family (referred to as a member of the family) (6) if, immediately after such transfer, the transferor or an older generation member of the transferor's family (applicable family member) (7) holds an equity interest in the entity that is classified as an "applicable retained interest." (8)

An equity interest will be classified as an applicable retained interest if it confers upon its holder either an "extraordinary payment right," or in the case of a controlled entity, (9) a "distribution right." (10) An extraordinary payment right is any put, call, conversion right, or right to compel liquidation of the entity, the exercise or nonexercise of which could affect the value of the transferred interest. (11) An extraordinary payment right does not include any rights that must be exercised at a specific time for a specific amount; a put, call, conversion right, or liquidation right will be an extraordinary payment right only if the holder of such right has discretion over whether such right will be exercised. A distribution right generally includes any right to receive distributions with respect to a retained equity interest. (12) However, a distribution right does not include any right to receive distributions with respect to any interest that is junior to or the same as the rights of the transferred interest. (13)

If I.R.C. [section]2701 applies, the gift tax value of the transferred interest is determined under the so-called "subtraction method." (14) The subtraction method determines the gift tax value of the transferred interest by subtracting the value of all equity interests in the entity held by the transferor immediately after the transfer from the aggregate value of all equity interests in the entity held by the transferor immediately before the transfer. If the retained interest is classified as an applicable retained interest, its value for purposes of applying the subtraction method is determined by...