Gifts and sales of carried interests have gained popularity as a method for intergenerational wealth transfer due to the low valuations supportable in the early stages of an investment fund. It is important to be aware of certain hazards and best practices related to transfers of these interests.
A carried interest (sometimes referred to as a profits interest) is typically granted to the sponsor/manager of private equity, hedge, venture or similar funds and entitles the holder to a percentage of the fund’s profits. While it may be structured in a variety of ways, holders commonly receive 20 percent of profits after the capital investors receive a return of their capital and, sometimes, an interest-like return. The sponsor/manager also might invest capital alongside the other investors and thereby receive a capital interest in the fund.
The sponsor/manager may grant a portion of the carried interest to key employees. Under current income tax law (Rev. Proc. 93-27), the employee generally recognizes no income upon grant if nothing would be distributed to the employee assuming a hypothetical liquidation of the fund at that time (because the investors have the right to capital return before anything is distributed to the carried interest owners).
However, if the carried interest is transferred to a member of the holder’s family, the amount of the transfer for gift tax purposes equals the fair market value of the interest transferred.
The two most commonly considered and employed methods for valuing a carried interest are the option pricing and discounted cash flow (DCF) methods, both of which have been accepted by IRS.
Although the option pricing model is less understood, it is ultimately easier to employ. At its most basic level, a call option is the right, but not the obligation, to buy an asset for a predetermined price at a future date. Call options have value to the extent that the value of the underlying asset is expected to exceed that predetermined strike price. Similarly, a carried interest has value to the extent that the fund is expected to realize gains from its investments.
However, there are key differences between basic call options and carried interests that need to be considered in estimating the value of the carried interest being transferred. For example, if management fees are due to the entity or interest being valued, the transfer may include an economic right that may need to be considered separately. Other potential factors that could impact the valuation include any preferential returns to be paid, management fees waived in exchange for deemed capital contributions, and the possible dilution from the acceptance of new general partners, among others. It is critical to ensure that the valuation reflects not only the legal structure and conditions in place as of the valuation date, but the expectations for those conditions over the life of the fund.
Many of the same assumptions utilized in the option pricing model are incorporated into the DCF method. An added complexity, however, is that the timing and amount of investment proceeds expected for the fund are explicitly forecasted and, as a result, need to be estimated. In addition, while the DCF method is relatively straightforward, it involves the appraiser making a number of subjective assumptions, which can have a significant impact on the valuation of the carried interest.
Finally, valuation discounts for lack of control and marketability are considered and generally applied in the valuation of a carried interest. Often these can be material given the long holding period of the interest, the lack of regular cash flows, and the volatility associated with the interest.
The value of a carried interest is typically higher (i) in more mature funds, since the fund’s investments have had significant opportunity to appreciate in value, and (ii) for interests that receive management fees or other economic benefits.
Artificial Valuation Rules
Sec. 2701 provides special valuation rules that may apply to gifts or sales of carried interests to family members. If this very complex provision applies, the valuation might be increased artificially by the value of any capital interest retained by the senior generation. The result could be a substantial, unexpected taxable gift. One may avoid Sec. 2701 by transferring a vertical slice of each interest (i.e., both a carried and capital interest). For example, transferring 25 percent of a capital interest along with 25 percent of a carried interest avoids the potential application of this artificial rule and its unexpected gift tax. You should speak with your tax advisor to determine whether this provision might apply.
Some carried interest owners may be subject to vesting provisions, such as required continued employment. Transferring unvested carried interests raises additional issues. If the recipient is an employee, it may be appropriate to make an election under Sec. 83(b) to recognize the value of the interest at date of grant, which typically is zero, as compensation income. Otherwise, the employee will recognize the value as of the vesting date as compensation income, which could be substantial.
If an unvested carried interest is transferred to a family member, IRS may argue that the transfer is incomplete for gift tax purposes. The transfer would become complete at the vesting date. If this view were to prevail, the appreciation in the value of the carried interest between the transfer and the vesting dates would be subject to gift tax, unraveling the wealth transfer plan.
IRS concerns about carried interest valuations often revolve around the underlying assumptions used. It is important that the assumptions be well-supported and documented in any valuation. One of the most significant assumptions is the underlying value of the investments. Often, pricing information for the fund’s investments is not readily available and valuations of the investments are needed. Significant, rapid and realized increases in value of the underlying investments would be cause for IRS concern. Additionally, adjustments for lack of control and marketability without demonstrated support for the degree of the adjustment, and an analysis of the underlying factors requiring such an adjustment, are often areas of IRS focus.
Numerous complexities associated with successful transfers of carried interests require careful planning and consideration of complex tax rules, valuation assumptions and IRS audit review processes.
Published December 19, 2014.