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Friday, August 07, 2015

Article Abstract: Estate Planning with Carried Interests & Code §2701


Estate Planning with Carried Interests: Navigating I.R.C. §2701


Nathan R. Brown


The Florida Bar Journal, July/August 2015


Florida Bar

ABSTRACT (Key Points & Discussions)

    • Issue: Fund managers of private equity funds typically obtain a percentage of total profits via general partner interests - a "carried interest." 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. The carried interest’s significant appreciation potential makes it an ideal asset to transfer during life using various estate planning techniques. However, Code §2701 typically applies to increase the value of the transferred asset for gift tax purposes if the managers own any other equity interests in the fund, such as limited partners. The article addresses various planning mechanisms to avoid Code §2701 limitations.
    • VERTICAL SLICE EXCEPTION: Utilizing Treas.Regs. § 25.2701-1(c), the vertical slice exception to §2701 requires the fund manager to transfer not only the carried interest, but also a proportionate amount of all other equity interests in the fund (e.g., the fund manager’s capital interest in the fund either through the GP or in the fund directly as an LP). This is commonly done via a transfer of all interests to an LLC and then a gift of member interests in that LLC.
    • CODE §2701 COMPLIANT ENTITIES: The manager transfers all of his interests to an LLC, which is structured to have common and preferred interests. Transfers of common interests are able to use the "same class" exception, and the retained preferred interests are structured to qualify as "qualified payment rights" under 2701. A deemed gift of 10% of the total equity interest values will still occur, and care must be exercised as to the coupon rate on the qualified payment right.
    • TRUST FOR APPLICABLE FAMILY MEMBERS:  The manager transfers the carried interests to a trust under which applicable family members and other friendly persons are only discretionary beneficiaries without triggering §2701. Transfers to family members later occur through exercise(s) of limited powers of appointment to and among them. Step transaction exposure may exist.
    • PARALLEL TRUSTS. Two irrevocable trusts  are created for the benefit of family members. One would be a completed gift grantor trust which receives the carried interest. One would be an incomplete gift nongrantor trust which received a proportionate amount of other capital interests. §2701 is avoided by the fund manager being treated as not owning the capital interest in the second trust.
    • DERIVATIVE CONTRACT:  A  derivative contract tied to the performance of the carried interest is transferred to an irrevocable grantor trust in exchange for a payment. Since an actual interest of the carried interest does not occur, then §2701 should not apply.


Carried Interests, Code §2701


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