When private equity or venture capital fund principals and managing partners look to roll out a new fund, in addition to reconciling general fund formation issues, they should consider the personal-planning opportunities available to each principal.
Potential Tax Savings and Creditor Protection
Personal planning should not be overlooked during the fund formation process. With appropriate structuring, principals may generate considerable tax savings and creditor protection without, in many cases, entirely losing their access to the carried interest performance. This type of personal tax planning is nuanced and complicated, and requires professional advisers who are acutely aware of the structural and tax issues associated with such strategies.
Changes in the Taxation Landscape
As a result of the recently enacted American Taxpayer Relief Act of 2012 (ATRA), the long-term capital gains tax has reset to its pre-2001 rate of 20 percent for taxable income of $450,000 for joint filers and $400,000 for single filers in 2013. Beginning in 2013, the Patient Protection and Affordable Care Act also imposes a Medicare surtax of 3.8 percent on net investment income (e.g., capital gains, including carried interest) for taxable income of $250,000 for joint filers and $200,000 for single filers in 2013. Further, ATRA sustained the applicable exemption amounts for federal estate, gift and generation-skipping transfer (GST) tax at $5 million per person (indexed for inflation) but increased the applicable tax rates to 45 percent from 35 percent. In 2013, the exemption amount for each tax is $5.25 million.
Absent from ATRA is a re-characterization of carried interest that will alter its current capital gain treatment and subject it to ordinary income tax rates — although debate over this issue is likely to continue.
Gift or Sale of a "Vertical Slice"
Optimizing tax savings often involves implementing one or more strategies as part of the fund structuring. Such strategies are focused on the transfer of some or all of a principal's carried interest allocation in a fund to an irrevocable trust for the benefit of the principal's children and further descendants. Having the economic performance of the carried interest inure to the trust, the assets of which will not be subject to estate tax at the principal's death (or in many cases for generations to come), preserves the full return of the carried interest for the principal's family. Under current tax law, it is generally advisable that a principal transfer the same portion of his or her capital interest in the fund (the proportionate amount commonly referred to as a "vertical slice"). Most frequently, this is accomplished by the principal transferring the same proportion of all his or her economic interests in the general partner entity of the fund. The most common methods for the transfer of a vertical slice in a fund are outright gifts and financed sales to irrevocable trusts.
An outright gift of a vertical slice to a principal's irrevocable trust would result in a taxable gift, which would use a portion of the principal's remaining gift tax exemption amount, as well as his or her GST exemption amount if the irrevocable trust is designed to benefit multiple generations.
A financed sale by the principal of a vertical slice in the fund entails a purchase of such interests by the irrevocable trust in exchange for some combination of cash (or other marketable assets) and a promissory note. The note bears interest at the applicable federal rate determined by the Internal Revenue Service (IRS) and is collateralized with the purchased vertical slice. The trust would pay interest annually and principal would be due in a balloon payment at the end of the term, but could be prepaid at any time without penalty.
To effectuate a gift or sale of a vertical slice to the principal's irrevocable trust, he or she would enter into a transfer agreement with the trust or have the trust be an initial signatory to the fund general partner operating agreement (and any other relevant entity operating agreement). Under the terms of the agreement, the principal would assign a portion of his or her carried interest and capital interest(s) to the trust and the trust would agree to meet the obligations associated with such interests (e.g., capital commitment). The economic viability needed by the trust to meet its capital call obligations generally is provided by the principal via additional gifts or loans to the trust. A financed sale would also include the execution of a purchase and sale agreement, security agreement and a promissory note.
An outright gift or sale of a vertical slice will need to be disclosed on a gift tax return to start the gift tax statute of limitations. Once the statute of limitations is initiated, the IRS may only contest the reported value of the transferred vertical slice for a three-year period, generally beginning on the date the return is filed. As part of the gift tax return filing, a qualified appraisal must be attached to substantiate the value purported on the return. Unlike an income tax valuation, which is based on a liquidation value at the time the carried interest is granted and often has no value for a newly created fund, the gift tax valuation methodology takes into consideration projected economic results of the fund, the likelihood of achieving such results and the mechanics of the fund waterfall distribution provision. As a result, the carried interest will always have some value.
Benefitting from Creditor Protection
The transfer of a vertical slice by a principal to his or her irrevocable trust may provide an element of creditor protection for those who are concerned about potential personal liability claims arising from the principal's activities with the fund (e.g., serving as a director on a portfolio company's board). Stated differently, any claim asserted against a principal personally will not likely extend to the assets of his or her trust. In some jurisdictions, such as Delaware, asset protection may be achieved with the use of a self-settled trust (a trust in which the principal is also a discretionary beneficiary). A principal who does not already reside in such a jurisdiction, however, must find a resident of the jurisdiction to serve as trustee of the trust in order to qualify under the laws of that jurisdiction. This type of arrangement creates an additional annual expense if a commercial trustee is needed. However, in other jurisdictions, self-settled trusts will not provide the desired creditor protection. In these jurisdictions, a principal would not be a named beneficiary of the trust, but his or her spouse may be included without jeopardizing the creditor protection status of the trust. In either case, the trust may be designed to provide the desired creditor protection while also maintaining the possibility of accessing the trust principal via the discretion of an independent trustee — yet another desirable component of personal planning that is attractive to many principals.
Charitable Giving with Carried Interest
With the recent increase to the capital gain rate and implementation of the Medicare surtax, charitable giving with carried interest has become an increasingly popular area of interest. In reaction to this trend, many donor-advised funds have become considerably more flexible in accepting carried interest and other alternative investment interests. Should the income taxation of carried interests be re-characterized as ordinary income, this will likely become an even more attractive consideration.