Alternative investments in private equity and hedge funds have gained in popularity over the last two decades and have become a regular allocation of many investment portfolios. During this period, significant wealth has been generated and continues to be generated by the fund managers. There are some unique opportunities available to these fund managers and significant estate tax savings can be achieved with careful planning.

The fund managers generally are compensated with an annual management fee equal to 1-2% of the value of the fund. In addition, the fund managers typically receive a “capital interest” and a “carried interest” in the fund. The capital interest represents the money committed to the fund by the fund managers to be invested alongside the amounts committed by the investors in the fund. Generally, the fund managers are required to contribute 1-5% of the fund so as to have some of their own money at risk (“skin in the game”). The capital contributed by the investors and the fund managers is entitled to a preferred return (typically 6-8%). Once the investors receive back their original investment and the preferred return, any remaining profits are typically split 80% to the investors and 20% to the fund managers. This 20% interest to the fund managers is typically referred to as the carried interest. If the fund is unable to return to the investors their original contribution plus the preferred return, the carried interest will have no value. However, if the fund’s performance is successful, the fund managers may enjoy significant appreciation in the value of their carried interest.

Since the investors are entitled to the preferred return, the carried interest may be perceived to have very little value at the start or early years of the fund but can explode in value. This makes planning for carried interests very attractive from an estate planning perspective.

However, any transfer of a carried interest could be subject to the special valuation rules of Section 2701 of the Internal Revenue Code. The application of Section 2701 can result in unexpected deemed gifts and potentially disastrous transfer tax results. If a fund manager transfers his entire carried interest in the fund to his children (or a trust for his children) and Section 2701 applies, the gift is valued under what is known as the “subtraction method,” and the interest retained by the fund manager is valued at zero for gift tax purposes. This means the fund manager may be deemed to have made a gift of his entire interest in the fund (including the capital interest). If the application of Section 2701 is not recognized immediately, the gift tax problem may be compounded by the additional interest and penalties that would be accruing until paid. There are several exceptions to Section 2701 which can be relied upon by the careful planner to avoid the unexpected and potentially disastrous results of Section 2701 while still taking advantage of the opportunity presented by the gifting of carried interests.

For more information, please contact a member of the BakerHostetler Private Wealth team.