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Business owners and fund managers can face challenges when transferring wealth, and private derivatives may help them overcome those challenges. A private derivative can offer a way to transfer wealth based on the financial performance of assets like unvested or non-transferrable shares of company stock or a carried interest in a fund.

Because it doesn’t require the transfer of the asset, a private derivative can be attractive when an asset has the potential to appreciate substantially but a transfer of the asset isn’t feasible or possible.

Addressing common challenges

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A business owner or executive who owns shares of their company’s stock may find transferring the stock is not feasible because:

  • The shares are not vested, so gifting them would likely be ineffective for gift tax purposes
  • There may be contractual obligations that bar their transfer
  • There may be concerns around how the market may view the transfer
  • A transfer may require the consent of other investors

A manager of a private equity, venture capital or hedge fund typically owns a carried interest in their fund, which entitles them to a share of the fund’s profits. Since it may potentially generate significant wealth, carried interest is often an attractive asset to gift, so that any future wealth doesn’t become part of the manager’s estate. However, a gift of carried interest may trigger special valuation rules. While gifting a vertical slice (a proportionate share of their carried interest and ownership or capital interest) can avoid triggering these rules, this may be impractical or undesirable.

In these cases, a private derivative may be a useful strategy. Very simply, this most commonly involves selling the right to some or all of the future appreciation of the stock or carried interest to a grantor trust. The derivative usually is designed so that the sale price equals the fair market value of the future appreciation, so that the transaction isn’t a gift. This strategy generally is successful if the actual appreciation exceeds the anticipated appreciation.

Understanding private derivatives

A private derivative is a contractual arrangement, typically between an individual and an irrevocable trust that’s a grantor trust with respect to the individual. When designed in that fashion, the derivative transaction is ignored for federal income tax purposes.

The contract specifies the purchase price, contract’s term and amount payable to the trust upon the contract’s settlement. The purchase price that the trust pays to the individual equals the current fair market value of the derivative.

The contract defines the amount payable to the trust upon the contract’s settlement, which may:

  • Be equal to the appreciation of the underlying asset, including or excluding the amount of distributions made during the term of the contract
  • Specify a hurdle, so the trust would only receive any appreciation that exceeds the hurdle
  • Split the appreciation between the individual and the trust
  • Cap the amount payable to the trust

The person selling the derivative must settle upon the end of the contract’s term, which should be sufficiently long to allow the underlying asset to appreciate. The trust bears the financial risk of the purchase price exceeding the amount it receives upon the contract’s settlement.

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Learn more

To see how a private derivative strategy may make sense for your situation, please contact a ÃÛ¶¹ÊÓƵ Financial Advisor.

For a more in-depth discussion of private derivatives, see Todd D. Mayo, Using Private Derivatives in Wealth Planning (a publication of the ÃÛ¶¹ÊÓƵ Advanced Planning Group). For a more in-depth discussion of carried interest, see Ann Bjerke, Planning with Carried Interest (a publication of the ÃÛ¶¹ÊÓƵ Advanced Planning Group).

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ÃÛ¶¹ÊÓƵ Financial Services Inc. does not provide legal or tax advice and this does not constitute such advice. ÃÛ¶¹ÊÓƵ strongly recommends that persons obtain appropriate independent legal, tax, and other professional advice.

The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest.

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