Managers of private equity funds, venture capital firms or hedge funds who own an interest in their fund’s future performance—known as carried interest—have a unique wealth transfer opportunity. But the structural and tax issues can be complex.

With the right advice—and careful planning—you can use carried interest to help transfer your wealth in a tax efficient way.

Carried interest: the fundamentals

Carried interest is the economic interest a manager of an investment fund has in the fund. Most commonly, it is a 20% allocation of the fund’s profits to a manager or General Partner (GP) of the fund. Normally, this is in addition to the 2% management fee. Together, this is commonly referred to as the ‘two and twenty’ fee structure.

A GP will normally have two types of fund ownership: (1) a capital investment in the fund and (2) the carried interest, or a percentage share of the profits.

general partner/investment fund chart
  • Depending on the fund, carry can be earned right away or, more often, after a predetermined minimum rate of return is achieved by the fund.

Strategic gifting using the vertical slice

Because there is uncertainty about a fund’s success or future performance, the initial fair market value of the carried interest will be low (or even very low) compared to its future potential value. For this reason, a popular strategy is to transfer part of the fund manager’s interest to family members, before a sizable increase in value.

  • When considering your gifting strategy, it is important to consider Section 2701 of the tax code, which seeks to prevent manipulating the gift tax value of the transferred carry.
  • A common strategy for avoiding application of Section 2701 is to use the so-called “vertical slice†of all ownership interests. Current federal law provides a safe harbor for fund managers to make a proportional reduction in each type of fund ownership—their capital commitment (or ownership as a GP) in a fund as well as their carried interest (or share of the fund’s profits)—and then transfer these interests as a gift.

Estate planning strategies using the vertical slice

There are a number of effective ways to transfer carried interest using the ‘vertical slice’ strategy for the benefit of the next generations. These can include the following:

  • Outright gifts to children
  • Gifts to a trust, for benefit of children
  • Installment sales to a trust, for benefit of children
  • Grantor retained annuity trust (GRAT)

Tread carefully, avoiding pitfalls

Because of the complexity of using carried interest in tax and estate planning, it is important to work closely with your team of advisors and estate planners to help navigate the complexities of the rules and tax laws surrounding carried interest. A few issues to bear in mind include:

  1. Vesting – carried interest is often subject to a vesting schedule.
  2. Transfer restrictions in the fund agreement
  3. Capital calls

Learn more

To learn more about carried interest and how it may be part of your overall gifting and estate planning, download our publication Planning with carried interest or speak to a ÃÛ¶¹ÊÓƵ Financial Advisor.

Cover of Planning with carried interest report

Neither ÃÛ¶¹ÊÓƵ Financial Services Inc. nor its employees (including its Financial Advisors) provide tax or legal advice. You should consult with your legal counsel and/or your accountant or tax professional regarding the legal or tax implications of a particular suggestion, strategy or investment, including any estate planning strategies, before you invest or implement.

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