Transfer Planning with Interests in Private Equity and Hedge Funds

July 16, 2012

Authored by: Stacie J. Rottenstreich and Karin Barkhorn

Much has been written about the potentially unique opportunities available to people to make gifts before year-end (for example, see our prior posts here and here). If Congress does not act, the increased $5,120,000 gift tax exemption will decrease dramatically. However, if you are the owner of an interest in a private equity or hedge fund, planning to gift part or all your interest in such fund requires particular care and attention.

Private equity funds are usually created as limited partnerships with two classes of owners. The limited partners are the investors in the fund, while the general partner is typically a business entity created as a limited liability company (“LLC”). A carried interest is normally held in and allocated to the LLC/general partner. A carried interest is the right to receive some of the profits of the fund. The initial value of a carried interest is speculative, as it is not certain how profitable the fund will ultimately be. Thus, gifting such an interest is often very attractive. It is imperative to get an appraisal of such interest by an experienced appraiser. Generally, the gift tax cost of the transfer should be relatively low, due to the low value attributed to the interest, but there is often significant potential appreciation inherent in the carried interest.

Congress was concerned that an individual would transfer the appreciation in an asset to the next generation at a low gift tax value, while controlling the asset. The Internal Revenue Code was drafted with many provisions to prevent this type of abuse. Section 2701 of the Internal Revenue Code imposes a gift tax liability equal to the value of all interests in a fund, those transferred, as well as those retained, if an individual transfers a carried interest (held in the fund’s LLC/general partner) while still retaining an interest in the same entity, even if it is of a different class. Thus, it is very risky for someone to transfer a carried interest, the potential appreciation, in the fund, while retaining the interest as an investor.

Exceptions to the general prohibitive rules are built into the Internal Revenue Code. One such exception is the “vertical slice” rule. A vertical slice is a proportionate amount of all interests owned in a fund. Broadly stated, a parent who wishes to transfer an interest in a fund to his or her children should transfer the same percentage of his of her carried interest as of his or her limited partnership interest.

Once an investor transfers a vertical slice of his or her interest in a fund, a wide arsenal of sophisticated transfer planning tools may be available. Transfer can be made to an intermediary vehicle such as a Family Limited Partnership or Family Limited Liability Company. He of she could then sell or gift outright or to a trust some or all of his or her interest in the intermediary entity.

There are many complex rules relating to the transfer of an interest in a private equity fund. But with proper planning and guidance, one might be able to transfer such an interest before year’s end at a relatively low transfer tax cost.