Transferring Profits Interests: Wealth Transfer Strategies for Professional Investors

One impactful wealth transfer tool for professional investors is the ability to transfer (gift, sale, or exchange) the profits interest from the fund(s) they manage. Depending on the type of fund, this could be called profits interest, promotes, performance allocations, incentive fees, or carried interest. Regardless of the name, it all refers to the profit a fund manager receives in addition to the return on their direct investment in the fund and their share of the management fees. 

Although fees vary from one fund to another, the most classic example is with private equity, where the fund managers will charge “2 and 20”.  The 2% refers to the management fee of the fund that general partners (GPs) receive for day-to-day costs, and the 20% is an incentive-based fee that the GPs will receive based on the performance of the fund (in private equity this is known as the carried interest).

If a 1% capital contribution by a GP entitles them to an allocation for 20% of profits, there is significant growth potential in this asset. Because carried interest is not realized until a later time and is dependent on the future performance of the fund, it becomes a highly effective way to transfer wealth before the value has been realized, allowing the partner to use little of their lifetime and/or GST exemption, so future growth is realized outside the partner’s taxable estate. 

Considerations & Pitfalls

As effective as this strategy may be, there are several considerations and some pitfalls within the IRC that could penalize professional investors attempting to cherry-pick segments of their fund interest to move the fastest growing assets outside their estate. The relevant code is Section 2701, specifically, the zero-valuation rule.

Section 2701

Originally enacted to prevent exploitation of disproportionate wealth transfers in family businesses, Section 2701 also applies to fund managers when dealing with gifts of their carried or profits interest. 

Section 2701 is not used to evaluate if a gift has been made, but rather to assess the value of the gift. In practice, if a gift of a business or fund interest is made from a senior family member to junior family members, and it is determined that the transferor’s remaining equity has a “retained interest” (which allows the family member extraordinary payment or distribution rights), then the value of the gifted interest is assumed to be zero. This essentially means that for gift tax liability purposes, the transferor will have made a gift valued as their entire interest (both the gifted AND retained portions); a significantly more costly way to transfer wealth outside of their estate. 

Vertical Slice Technique

Although there are other ways to avoid the zero-valuation rule, such as a derivative contract, the simplest and most common safe-harbor technique for fund managers is to gift a “vertical slice” of their interests in the fund. This would include the profits interest, the common (or LP) interest, and their share of management fees in equal proportions. This will result in the gift being more expensive because there is typically a greater value to the LP interest and management fee interest, but the gift tax liability (if challenged) will be less than if the transferor was penalized by the zero-valuation rule. 

How to Transfer a Profits Interest in Practice

In determining the best structure, key items to consider are:

• Valuation & Valuation Risks

  • A valuation of the interests is required in all cases, and some structures have self-correcting provisions if the value is disputed, while others do not and may carry higher risk if challenged.

• Income Tax Considerations

  • Other tax rules indicate that the transferor will be subject to income taxes on the profits interests for some time after the initial transfer. Therefore, a common approach is to transfer the interest to an intentionally defective grantor trust (often GST exempt). This allows the manager to continue to pay income tax on behalf of the trust, making these tax payments efficient gifts for estate tax purposes and allowing the assets to grow free of both estate and income tax for future generations.

• Cash Flow & Liquidity Needs

  • Since the transferred share will be subject to the same vesting provisions as if the fund manager continued to hold it, it is crucial to ensure that the transferee can meet future capital commitments.
  • The transferor needs to consider how much of the interest to retain to cover the income taxes on 100% of the interest, even though they will no longer received 100% of the cash flow when the profits are realized.

• Trust Planning

  • Given the future value is unknown and can vary greatly, it is important to use flexible trusts as the ultimate transferee. The professional investor may also want to include the flexibility to add additional beneficiaries, such as extended family or charity, if the trust becomes larger than expected.

Considering the above, a few strategies that can be used are:

• LLC

  • A fund manager can create an LLC and transfer all fund interest into the LLC and gift a portion of the LLC interest to another beneficiary. This transfer is valued for gift and estate tax purposes, and any appreciation of the LLC interests transferred after the gift date ideally passes to the beneficiaries outside of the fund manager’s taxable estate. The LLC's terms and current tax regulations may offer additional valuation discounts due to factors such as lack of marketability and control.

• Gift

  • A fund manager could also gift their proportional fund interest directly. An appraisal of the fund interest will be required for gift tax purposes, and this strategy will use gift tax exemption and GST exemption (if applied). One major consideration is funding capital commitments if the beneficiary or trust lacks sufficient assets to cover the capital requirements. In such cases, additional gifts would need to be made to the transferee.

• Sale

  • A fund manager could sell their interests in the fund to the transferee in exchange for cash or equivalent assets. The advantage is that if the transferee already has other assets, the transferor's gift tax exemption wouldn't need to be utilized.

• Loan

  • To get around the prefunding issue of a sale, an alternative would be for a fund manager to transfer interests in exchange for a combination of cash and a promissory note that will mature after carried interest realizations have occurred.

Conclusion

As we approach the sunset of the Tax Cuts and Jobs Act's (TCJA) estate exemption at the end of 2025, professional investors looking to take advantage of the current high lifetime and GST exemptions should consider transferring a portion of their fund interests to minimize estate taxes. However, it is crucial to discuss this with an attorney and advisors to make sure all risks are understood.

At Lake Street, we act as our clients’ financial architect and general contractor, coordinating the implementation of advanced estate and tax planning strategies. If you would like to discuss whether this strategy would work for you, please don't hesitate to reach out to speak with one of our advisors.

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