Donating Fund Interests: A “Why Now?” and “How To” Primer

by Coblentz Patch Duffy & Bass

Due to increased valuation of public and private equities, coupled with the upcoming end of the sunset provision that allows hedge fund managers to defer taxation on fees earned offshore,[1] there is an increased interest among hedge fund and private equity managers to donate a portion of their fund interests to charity.  The goal is to allow a manager to avoid ordinary income or capital gains tax and/or to obtain a tax deduction while accomplishing his or her philanthropic goals.  In order to make the most of any such charitable giving plan, managers need to appreciate that the amount of any charitable deduction will vary depending on the character of the donated property and the type of organization that receives the gift.

Hedge fund and private equity fund managers hold bundles of rights, including rights to management fees, a return on invested capital and carried interest distributions, each of which may be treated differently for tax purposes.  In devising a philanthropic strategy, it is important to identify exactly what rights are being donated, whether the donation will be respected as a donation of property and, if so, whether the property would be characterized as ordinary income, short or long-term capital gain property and what type of charity is being targeted.

Assignment of Income vs. Property Donation

In some instances a manager may seek to donate part or all of their management fees to a charity in order to avoid paying ordinary income tax on that income.  However, it is unlikely that this donation would be respected as a donation of property.  When a person directs the payment of earned income to another person or entity, this constitutes an assignment of income that is typically disregarded for Federal income tax purposes.  Under the assignment-of-income doctrine, the transfer would be treated as if the manager received the fee income as compensation for services and later donated cash to charity.  The manager would be allowed to claim the charitable deduction, but it would be subject to certain limits as set forth below.  Consequently, the end result may differ from that which would exist if the manager was able to simply eliminate the fee income from his or her taxable income.

Characterization and Appreciation of Property

When property, such as an equity interest in a fund or stock in portfolio company, is contributed to a charitable organization, the amount of the deduction will depend upon the character of the property contributed and whether it has appreciated or not.  In general, a donation of property other than cash triggers a charitable deduction equal to the property’s fair market value.  However, if property has appreciated in value in excess of its tax basis, the amount of any deduction may be reduced.  In the case of appreciated property that, if sold, would generate income other than long-term capital gains, any deduction related to the donation if such property is reduced by an amount equal to the gain the would be recognized upon the sale of that property.  Essentially this limits the deduction in such instances to the tax basis of the donated property.

Clearly this limit would apply in a situation where a manager donates an interest in a fund or a general partner entity that the manager acquired within the past year as any gain inherent in the donated interest is short-term capital gain.  Furthermore, a reduction would occur if the fund or general partner entity holds any “hot asset” such as appreciated inventory, accounts receivable and depreciation recapture because ownership of such assets trigger ordinary income tax when the interest is disposed of.  However, because private equity funds and hedge funds do not commonly hold hot assets, this later scenario is unlikely.  Consequently, provided the donated equity interest is held for more than one year, this limitation would generally not apply and the amount of the donation of the interest would equal its fair market value.

The same does not hold true if a manager chooses to receive a distribution of portfolio company stock or equity that is, in turn, donated to a charitable organization.  Under such circumstances the character of the donated property as short-term or long-term capital gain property is not dependent upon how long the manager held an interest in the fund, but rather on how long the fund held the stock or equity interest in the portfolio company.  If the property was held for one year or less, as would be the case with most hedge fund assets, the reduced deduction on appreciated assets would apply.  On the other hand, if the fund held the portfolio company stock or equity interest for more than one year, as is typical with most private equity funds, the reduction would generally be inapplicable unless the portfolio company was a partnership or limited liability company that is treated as a partnership for tax purposes.  In that case, it would not be unusual for a portion of the portfolio company’s assets to be hot asset that generate ordinary income tax and that would trigger this limitation.

Types of Charitable Organizations

If the goal is to maximize a charitable deduction, managers also need to understand that not all charities are treated equally.  The amount that can be deducted for charitable contributions to public charities, private operating foundations and certain limited private non-operating foundations of ordinary income property is generally is limited to 50% of the donor’s adjusted gross income; while donations of capital gain property is limited to 30% of adjusted gross income.  A donor can elect to reduce the amount of a donation of capital gain property to the property’s tax basis if they want to apply the 50% adjusted gross income limitation to the donation instead of the 30% limitation.  Deductions of ordinary income property to other types of charitable organizations, such has most private non-operating foundations, are limited to 30% of the donor’s adjusted gross income; while deductions of capital gain property to such organizations is limited to 20% of adjusted gross income.  Consequently, in composing a charitable giving strategy, managers should consider these limitations and consider the various types of public charities, private foundations and donor advised funds available to accomplish their charitable goals.

Charitable Deduction –Substantiation & Appraisal Requirements

In order to receive a charitable deduction, the Internal Revenue Code applies substantiation requirements for donors for charitable contributions.  In donating his or her property, a manager must meet the following substantiation requirements:  (1) obtain a contemporaneous written acknowledgement of the gift, (2) obtain a qualified appraisal prepared by a qualified appraiser, and (3) complete IRS Form 8283 for noncash charitable contributions over $5,000 which accompanies the manager’s tax return.

A qualified appraisal is one prepared by a qualified appraiser in accordance with generally accepted appraisal standards and tax regulations.  The appraisal must contain a description of the property, the valuation effective date (date to which the value opinion applies), the date (or expected date) of the contribution, the fair market value, and any specific limitations or restrictions on the use of the gift.  In addition, the appraisal must include specific information regarding the basis for and methodology used to determine the value.  The qualified appraiser must include its name, address, taxpayer ID number, qualifications, relevant employment information, a statement that it was prepared for income tax purposes and the appraiser’s signature and date of signing.  The appraisal cannot be signed earlier than 60 days before the contribution date or after the due date of the return (including extensions).


Many hedge fund managers may be fearing the tax implications of increased valuations and the impending expiration of the sunset provision that allows for tax deferral of offshore fees.  However, as laid out above, a carefully crafted philanthropic strategy can create a win-win for managers and charitable organizations that prevents anything further from riding off into the sunset without them.


[1] In the past, it was standard practice for hedge fund managers to fund offshore deferred compensation plans with fees generated from offshore investment funds in order to avoid U.S. income tax on those fees.  However, under Section 457A of the Code, beginning January 1, 2009, such deferred compensation is includable in gross income unless it is subject to a substantial risk of forfeiture.  That said, Code Section 457A provided for a sunset provision for services performed before January 1, 2009.  This sunset provision was structured so that all such deferred compensation must be repatriated on or before December 31, 2017. For many hedge fund managers, this will cause a dramatically higher income in 2017. This required repatriation by the end of 2017 is the element that is driving the present planning for many in the hedge fund community.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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