Estate Planning with Carried Interests

Lonnie Whitehead, CFP? SVP, Senior Wealth Planning Strategist Comerica Wealth Management

Explore the nature of carried interests, its unique characteristics and strategies to maximize its value while minimizing potential estate tax impact.

Key Takeaways:

• Carried interests align the incentives of managers and investors.

• Strategic use of irrevocable trusts to hold carried interest can be a tax efficient planning tool.

• The complexity of valuing carried interests requires partnering with experts.

What is a Carried Interest?

A carried interest, also known as a promote or performance allocation, is a common arrangement in investment structures, such as private equity, venture capital and real estate partnerships. It represents a share of the profits or gains generated by the investment allocated to the investment manager or general partner (GP) as compensation for their services. Carried interests are often subject to vesting schedules and performance benchmarks to align the interests of the GP with those of the limited partners (LPs).?

• Carried Interests, or “Promotes”, require managers to achieve stated performance hurdles before receiving any profits.
• Due to their illiquidity, carried interests can be difficult to value.
• Carried interests have unique taxation that requires careful consideration.?

Challenges

Valuation

Carried interests are typically illiquid and lack an easily identified market value, making valuation a challenge. For example, at the start of an investment, carried interests may have minimal value since the required performance hurdles have not been met.

To gift caried interests , it’s necessary to hire an experienced appraiser to establish a fair market value (FMV). This is used to determine the value of the gift being made.

Taxation

The Tax Cuts and Jobs Act (TCJA) enacted in 2017 introduced a three-year holding period requirement to qualify for long-term capital gains treatment. Failure to meet this holding period may result in higher tax rates on the allocated gains. Consult with an experienced professional to identify and minimize the tax impacts for your situation.

Depending on your specific goals, there are several irrevocable trust strategies to consider.

Transfer Vehicles

Irrevocable Trust

A key strategy to reduce taxes is to transfer ownership of your carried interest to an irrevocable trust. The uncertainty around whether a carried interest will realize a liquidity event drastically depresses the stated value, creating an opportunity to shift significant appreciation out of your estate.

Two common irrevocable trusts used with this strategy are the Spousal Limited Access Trust (SLAT) and a Dynasty Trust.

A SLAT involves creating an irrevocable trust for the benefit of your spouse. This is a popular strategy for clients who want to use their available gift and estate tax exemption but are not comfortable with losing complete access to the underlying assets.

A Dynasty Trust is an attractive option for individuals looking to transfer carried interests to future generations while minimizing estate taxes. A unique benefit of a Dynasty Trust is the ability of the trust to continue for multiple generations without the trust assets being subject to estate taxes. This strategy preserves wealth within the family and provides ongoing financial support for future descendants.

Depending on your specific goals, there are several irrevocable trust strategies to consider.

Grantor Retained Annuity Trust (GRAT)

A GRAT is a useful tool for transferring carried interests while minimizing gift tax consequences. The grantor transfers the interests into an irrevocable trust while retaining an annuity payment for a predetermined term. At the end of the term, any appreciation above the annuity payments passes to the trust's beneficiaries, typically family members, with potential estate tax savings. For this strategy to be effective, the overall appreciation of the asset must exceed the §7520 “hurdle” rate. This rate is determined by the IRS each month and must be used in the annuity payment calculation for a GRAT established in that month. As such, the success of this strategy is reduced in high interest rate environments.

Charitable Remainder Trust (CRT) For individuals with philanthropic inclinations, a CRT can be an effective strategy. By transferring the carried interests to a CRT, you can receive an income stream for a specified period or for your life expectancy. The remaining assets at the end of the payout then pass to a charitable organization of your choosing. This approach provides potential income tax deductions and reduces estate tax liability while supporting a worthy cause.

Planning with carried interest is complicated. Consult with an experienced professional to maximize your financial benefits.

Conclusion

Estate planning strategies can help you preserve and maximize the value of carried interest while minimizing gift and estate tax implications. The right transfer technique may reduce taxes, protect your assets and ensure the seamless transfer of wealth to future generations. Planning with carried interest is complicated. The professionals at Comerica Wealth Management can help tailor strategies to your individual circumstances and goals. Contact us today or your Comerica Relationship Manager.

NOTE: IMPORTANT INFORMATION

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, N.A. and Comerica Insurance Services, Inc. and its affiliated insurance agencies. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

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