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OpEd: Estate Planning with Hedge Fund Performance Allocations (part two) Wealth Transfer Options

New York (HedgeCo.net) – By hedge fund specialist law firm Holland & Knight partner Bradley M. Van Buren.

Continued from part one – Under current tax law, for gift and estate tax purposes, each individual has the ability to give away $5,000,000 during his or her lifetime (the “Lifetime Exemption”) or upon his or her death (“Estate Tax Exemption”) without incurring any federal gift tax or estate tax. The use of an individual’s Lifetime Exemption will also reduce his or her available Estate Tax Exemption at death. In addition to the Lifetime Exemption, an individual currently can make gifts of up to $13,000 per person per year without incurring any gift tax. Thus, a married couple can make annual gifts totaling $26,000 to each of their children or trusts for the benefit of their children, for instance, free of gift tax and without using any of their respective Lifetime Exemptions. There is no similar allowance for transfers at death.

Each individual is also entitled to a $5,000,000 exemption against the generation-skipping transfer (“GST”) tax, which can be used during his or her lifetime (although a gift tax would be due if the transfer exceeded such individual’s remaining Lifetime Exemption), at his or her death, or a combination thereof. A GST tax would result on certain transfers to grandchildren and future generations.

Lifetime gifting, or wealth-transferring as it is referred to in this article, focuses on the efficient use of an individual’s Lifetime Exemption to ensure that the assets ultimately subject to estate tax at the individual’s death are minimized. To optimize the use of the Lifetime Exemption, an individual should focus on transferring assets that have significant potential for appreciation, such as a Performance Allocation.1

1/ For purposes of the Wealth Transfer Techniques for Performance Allocations section of this article and unless stated otherwise, references to “Performance Allocation” means a Manager’s ownership interest in the GP LLC, which includes a proportionate amount investment capital in the GP LLC and the Performance Allocation itself (the “carry” portion), and a proportionate amount of all other equity interests in the fund, such as direct interests in a Feeder Fund.

Gift to an Irrevocable Trust

The simplest method for transferring a Manager’s Performance Allocation is to transfer it to an irrevocable trust for the benefit of his or her children and further descendants. The trust may include certain administrative provisions to cause the creator of the trust, the “Donor”, to be treated as the owner of the trust for federal and state income tax purposes (commonly referred to as a “grantor trust” or “intentionally defective irrevocable trust”). Such provisions should not, however, cause the Donor to be treated as the owner of the trust for transfer tax purposes. Under this structure, all income taxes (including capital gains) generated by the gifted Performance Allocation will continue to be payable by the Donor without such tax payments being deemed additional gifts to the trust by the Donor. As a result, the Performance Allocation and its economic performance is permitted to grow outside the Donor’s taxable estate unfettered by income taxes, while the Donor’s payment of income tax on these items further reduces his or her taxable estate for estate tax purposes.

The Manager may want to consider gifting his or her Performance Allocation to an irrevocable trust established in a jurisdiction that allows the trust to remain in existence in perpetuity.2 Such a trust is commonly referred to as a “Dynasty Trust.” The choice of an appropriate jurisdiction may also provide the Manager a layer of asset protection and, if the trust is structured as a non-grantor trust (i.e., the trust is a separate income tax payer), state income tax savings.

2/For example, Delaware, New Hampshire, Alaska and South Dakota.

Sale to an Intentionally Defective Irrevocable Trust

Another wealth transfer option that a Manager should consider is the sale of all or a portion of his or her Performance Allocation to an Intentionally Defective Irrevocable Trust (“IDIT”). An IDIT is another name for a grantor trust, which, as described above, includes certain administrative provisions to cause the Donor to be treated as the owner of the trust for federal and state income tax purposes, but not for transfer tax purposes.

In the HF context, the Manager would sell all or a portion of his or her Performance Allocation to an IDIT created by him or her in exchange for a down payment (typically 10% of the purchase price) and a promissory note (“Note”) for the balance from the IDIT in an arm’s length transaction. A sale of the Performance Allocation to the IDIT should not be recognized as a sale for income tax purposes (that is, there is no taxable gain) because the Manager, as the Donor, and the IDIT, which is structured as a grantor trust, are treated as the same entity. However, the transaction is effective for transfer tax purposes and, assuming the sale is for true fair market value, the value of the Performance Allocation sold to the IDIT will not be includible in the Manager’s estate at his or her death. To ensure that the sale reflects the true fair market value of the Performance Allocation, it is imperative that a professional appraiser be retained to provide a comprehensive valuation report.

The Note may be structured with interest-only payments during the term and a balloon payment at maturity. The interest rate of the Note is based on the applicable federal rate in effect on the date of sale and is paid either from the income earned by the IDIT or trust principal. An “estate freeze” is created by exchanging an appreciating asset (the Performance Allocation) for a non-appreciating asset (the Note) that earns modest interest. Since the IDIT is structured as a grantor trust, no income needs to be recognized as interest payments are made to the Manager.

If the Manager does not have an existing and funded IDIT to engage in the sale transaction, a new trust will need to be created. The Manager will need to contribute either cash, cash equivalents or some of the Performance Allocation to the trust to serve as “seed capital”. The amount of this gift should be enough to provide the trust capital equal to at least 5% – 10% of the value of the net assets of the trust following the fulfillment of a 10% down payment to help establish the Trust as an economically viable entity capable of repaying the note. The gift may be sheltered from gift tax by structuring the trust to take advantage of the $13,000 per beneficiary annual gift tax exclusion, as well as utilizing the Manager’s (and possibly the Manager’s spouse’s) Lifetime Exemption and, if applicable, GST tax exemption.
If the Note is fully paid during the Manager’s lifetime, the Performance Allocation, along with all post-sale appreciation and associated distributions, remains in trust for the Manager’s children (and/or grandchildren) free of any transfer taxes. If the Manager does not survive the term of the Note, only the remaining Note balance is includible in his or her estate for estate tax purposes.

Grantor Retained Annuity Trust

A Grantor Retained Annuity Trust (“GRAT”) is an irrevocable trust funded with a single contribution of assets. The terms of the GRAT require annuity payments to the creator of the trust, the “Grantor”, over a term of years equal to the full value of the assets contributed, plus interest at an IRS determined rate (commonly referred to as a “Zeroed-out GRAT”). Since the Grantor is entitled to receive back the full value of what was contributed to the trust, plus the IRS assumed rate of return, the use of a Zeroed-out GRAT results in the Grantor using a nominal amount of the his or her Lifetime Exemption. The required annuity payments may be made in cash or in kind. Any assets remaining at the end of the annuity term are distributed to the Grantor’s children or a trust for their benefit.

The objective of a GRAT is to shift future appreciation on the assets contributed to the GRAT to others at a minimal gift tax cost. For this strategy to be successful, the Grantor must survive the term of years and the assets transferred to the GRAT must appreciate at a rate greater than the IRS assumed rate of return. The difference between the actual rate of return on the investment and the IRS assumed rate of return will pass, gift tax free, to the beneficiaries at the end of the GRAT term. If the Grantor dies before the expiration of the GRAT term, the trust assets will be includible in the Grantor’s estate, and the advantages of the GRAT strategy will be lost. This risk typically favors use of a relatively short annuity period to counter-balance any mortality risk.

If there is adverse investment performance and the rate of return on the assets in the GRAT is lower than the IRS hurdle rate, the Grantor will receive back all of the assets contributed to the GRAT via the annuity payments, and nothing will be left for the benefit of the remainder beneficiaries. However, the Grantor will not have wasted an appreciable amount of his or her Lifetime Exemption. Comparing the potential upside versus the minimal gift tax exposure highlights a key tax benefit of the GRAT – when it works, the results are excellent, and when it does not work, the loss is negligible. Based on this characteristic, a GRAT is traditionally viewed as an excellent vehicle to hold a highly volatile investment, such as a Performance Allocation, that has the potential for significant appreciation. However, it is important to note that a GRAT is not generally viewed as an appropriate technique to engage in generation-skipping transfers.

Unlike a carried interest in the private equity fund context, which can present unique obstacles for a GRAT considering its general lack of cash flow for potentially an extended period of time and associated capital commitments, a Performance Allocation of a HF may be well suited for this technique. Generally, a HF provides monthly valuations. Since the valuation is readily available, a GRAT can satisfy its annuity obligations in typically one or more of the following ways: in-kind distributions of interests owned directly in the Feeder Funds (e.g., limited partner interests of the U.S. Fund), Withdrawals and/or distributions associated with the Performance Allocation. If the Manager would like additional means to satisfy the annuity obligations, he or she may also contribute cash to the GRAT upon its creation. Of course, the inclusion of too much cash in the GRAT, which by its nature is a low appreciating asset class, may affect the overall performance of the GRAT.

Family Limited Partnerships and Family Limited Liability Companies

It is commonly recommended that the Manager first contribute his or her Performance Allocation to a Family Limited Partnership (FLP) or Family Limited Liability Company (FLLC) and then gift the limited partner interests or non-managing member interests, as the case may be, to a grantor trust or GRAT, or sell it to an IDIT. This tiered structure is recommended for several reasons.

First, since the transfer of the Performance Allocation includes the Manager’s ownership interest in the GP LLC and thus, in some cases, management rights, the use of an FLP or FLLC to own the GP LLC interest prevents those management rights from being disbursed among various trust entities or individuals.

Second, as the owner of the Performance Allocation, the FLP or FLLC will receive any cash distributions made by the HF in conjunction with the Performance Allocation. Accordingly, the general partner of the FLP or managing member of the FLLC will determine if and when those cash flows are distributed to its limited partners or non-managing members. The possibility of “bottle-necking” cash flows at the FLP or FLLC level may subject the Performance Allocation to a second tier of valuation discounts for gift tax purposes.

Third, it may serve a useful administrative purpose by allowing the trust to transfer limited partner interests or non-managing member interests to satisfy its payment obligations without fund involvement (e.g., to satisfy a GRAT annuity obligation).

Otherwise, HF interests may need to be distributed by the trust, which will likely require the involvement and consent of the fund, including the execution of fund transfer documents. Finally, the FLP or FLLC may provide a more elaborate and flexible platform for implementing a more expansive long-term investment strategy. That is, the FLP Agreement or FLLC Operating Agreement could contemplate and include the necessary terms to permit an organized pursuit of other investment opportunities with the cash flow realized from the Performance Allocation. Such a platform may also provide a mechanism to educate future generations by incorporating roles for those family members selected to partake in the investment decision and implementation process.

Preferred Partnerships

A Preferred Partnership (“PP”) is generally a variation of the FLP concept that entails a bifurcation of limited partnership equity interests, resulting in the creation of preferred and common limited partnership interests. The preferred interest is structured to comply with Section 2701 of the Internal Revenue (explained below), while permitting the Manager to transfer a portion of his or her Performance Allocation and retain his or her investment capital with a predetermined return on such capital. Since the preferred interest retained by the Manager takes a priority return (often in the form of a cumulative preferred profits interest), the fair market value of the common interests will inherently be discounted to reflect its subordinate economic return. The steps involved in this wealth transfer strategy are as follows:

First, the Manager forms a PP and contributes some of all of his or her Performance Allocation to it. As with the other wealth-transfer techniques previously discussed, the Manager should contribute a proportionate amount of all of his or her equity rights in the fund to the PP to safely comply with current tax law (See Vertical Slice discussion below).

Second, the preferred interest of the PP will have the capital investment of the Manager’s fund contribution to the PP allocated to it with an 8% cumulative profits preferred return, for example (Note that this return can be adjusted and is intended to be an acceptable market rate that will need to be substantiated by a professional appraiser).  Structuring the preferred interest as a profits interest will result in the Manager realizing income for income tax purposes consistent with the character of the income earned by the PP. The preferred distributions are commonly based on net cash flow or a net asset value, which may differ from the allocations of income to the preferred for income tax purposes.

The portion of value associated specifically with the Performance Allocation (i.e., the “carry” portion) is therefore allocated to the common interests. It is important to note that the “minimum value rule” will require that such common interests are allocated at least 10% of the total value of all interests in the PP.

Third, the Manager gifts the common interests in the PP to a trust for the benefit of his or children and further descendants, which is structured as a grantor trust.  Due to the 8% cumulative profits preferred return owed to the preferred interest holder (the Manager) and the inherent lack of marketability and control associated with the common interests, the value of such common interests may be significantly discounted for gift tax purposes.

As a result of this strategy, the Manager will have retained his or her investment capital with a cumulative 8% return associated with such capital and thus isolated the transfer to his capital performance in excess of that return, plus the Performance Allocation portion (the “carry” portion).

The PP strategy is often desired by those Managers who would like to retain a meaningful return on his or her capital investment, while also isolating the performance of his or her Performance Allocation (carry) portion for transfer to future generations.

Cash-Settled Option

Another planning technique to consider for transferring the economic performance of a Performance Allocation (generally limited to only the Manager’s “carry” portion) may be the sale of a Cash-Settled Option (“CSO”) to a grantor trust for the benefit of the Manager’s children and/or grandchildren. Unlike the outright gift of a fund ownership interest, the CSO technique does not require the actual transfer of any fund interest. Accordingly, concerns about vesting and control, as described herein, and SEC qualification as an Accredited Investor and Qualified Purchaser are arguably not issues that need to be resolved to implement this strategy.

Generally, the CSO strategy consists of the creation and subsequent sale to an IDIT (grantor trust) of a CSO with respect to some or all of the economic performance generated by a Manager’s Performance Allocation. The CSO strike price is generally set at the current value of the fund interest (as determined by a third party appraisal). The CSO is a modified “European-style” option: exercisable upon the earlier of the expiration date or the Manager’s death. In order to determine the value of the CSO, a professional appraiser will need to calculate the current fair market value of the Performance Allocation, and thereafter determine the option premium, taking into account the strike price, the volatility of the performance of the fund interest, current interest rates and the term of the option contract. The IDIT will purchase the CSO from the Manager for the option premium. The funding for the payment of the option premium is provided by the Manager as a gift to the trust purchasing the option, or by using the existing assets of the acquiring trust.

When the trust exercises the CSO, the Manager will be required to pay the trust an amount of cash equal to the value of the fund ownership interest at such time (as determined by a third party appraiser), plus all prior distributions received on account of the fund ownership interest, less the amount of the strike price. If the value of the fund interest and prior distributions are worth less than the strike price (that is, the fund is not successful), the CSO will expire unexercised and the Principal retains the option premium paid by the acquiring trust. If no strike price is required by the contract, the trust would exercise its CSO recovering its option premium and any performance in excess of the premium would inure to the acquiring trust.

If the Principal dies before the term of the CSO expires, the CSO is deemed to be exercised by the trust if doing so would yield a profit to the trust. The amount due under the CSO contract would be a liability of the Principal’s estate that should be deductible for estate tax purposes. Thus, the pre-death distributions and appreciation are transferred to the trust.

Section 2701 of the Internal Revenue Code

Section 2701 of the Internal Revenue Code is focused on the valuation of a gift to descendants of the transferor3of a “junior” interest, while retaining a “senior” interest that is not a “qualified payment” (e.g., a cumulative preferred profits interest — See Preferred Partnerships above), in an entity in which the transferor (or his family members) has “control” over such entity. If Section 2701 were to apply, the value of the gift would be equal to the transferor’s entire interest in the entity, which is the aggregate value of all interests owned by the transferor at the time of the transfer – an extremely harsh gift tax result for the transferor. An exception to the application of Section 2701 is commonly referred to as the “Vertical Slice” approach. To comply with this exception, the transferor must include in the transfer a proportionate amount of each equity class in the entity held by the transferor (and applicable family members) immediately preceding such transfer.

It is unclear whether the intent of Section 2701 is to be apply to interests in the investment fund context, such as carried interests. However, due to the potential draconian gift tax result should it apply, the Vertical Slice approach has remained the conventional wisdom when planning with carried interests. Further, assuming Section 2701 does apply to carried interests, central to this analysis is whether the Manager has “control” of the hedge fund. In the context of a limited partnership, Section 2701 assumes that a Manager (or any member(s) of the Manager’s family) holding an interest as a general partner would constitute control for the purpose of applying the statute.

In the traditional HF structure, a Manager will have an interest in an entity that that owns the general partner interest of the fund (i.e., the GP LLC). Therefore, assuming the Manager (and the Manager’s family) does not possess an interest of 50% or more in the GP LLC, arguably control should not be deemed to occur. However, currently the only authority to support this conclusion is Private Letter Ruling 9639054, which does not directly address a carried interest transfer and is only binding on the particular facts included in the submitting taxpayer’s request.

Moreover, if a Manager would like to proceed with a transfer of something less than a Vertical Slice of his or her equity interests, he or she should understand the potential gift tax consequences associated with such transfer under Section 2701. In addition, if the Vertical Slice approach is not employed, consideration should also be given to the potential assignment of income issue that could result.


Revenue Ruling 98-21, which addressed the gifting of non-statutory stock options, concluded that the gratuitous transfer to a family member of a non-statutory stock option is not a completed gift for gift tax purposes until the later of  the transfer, or the time when the transferee’s right to exercise the option is no longer conditioned on the performance of services by the transferor. Under many HF structures, the Manager’s interest in the Performance Allocation may vest in accordance with a schedule stipulated in the GP LLC Operating Agreement. Therefore, the IRS could argue that the Manager’s transfer of his unvested Performance Allocation does not constitute a completed gift until that portion of the interest is fully vested.

To refute this argument, a distinctions must be drawn between non-statutory stock options and Performance Allocations. Unlike the decision reached in Revenue Ruling 98-21, which focused on the unenforceable rights associated with unvested non-statutory stock options, the interest in the GP LLC immediately confers legal rights to its owner (the Manager and/or any trust or other entity that receives the interest as the result of a transfer), including the right to receive current distributions from the GP LLC. Therefore, those rights are immediately “vested”, although subject to diminution should the Manager withdraw from the GP LLC. However, in the case of the withdrawal of a Manager from the GP LLC, he or she may be required to return to the GP LLC any distributions he or she received from the unvested potion of his or her interest. Arguably, this requirement may conflict with the enforceable rights position and thus provide a basis to apply the Revenue Ruling 98-21 incomplete gift conclusion to an unvested portion of a carried interest.

Other than the enforceable rights argument above, there may be other ways to minimize the potential incomplete gift result. For instance, one alternative is to have the Manager transfer only his or her vested interest in the GP LLC. Another possible solution is to have the GP LLC Operating Agreement require that a withdrawing Manager must reimburse the GP LLC for any prior distributions allocable to his or her unvested interests from the Manager’s right to receive future distributions on his or her vested interests.


The use of Profits Allocation for lifetime gifting can produce extraordinarily successful results in shifting wealth to future generations. The availability of valuation discounts, resulting from the difficulty in raising capital and retaining investors when the potential for investor withdrawals is looming, make these assets prime for transfer. In order to engage in wealth-transfer techniques with Performance Allocations, the Manager and his or her advisors must have a significant understanding of the fund structure and tax issues associated with each transfer technique. In addition, it is important to consider whether the transferee individual or trust fully meets the Accredited Investor and Qualified Purchaser definitions, which is beyond the scope of this article.

— The author would like to thank his partners, David Scott Sloan, Private Wealth Service; Chair Estate Planning and Scott R. MacLeod, for their valuable input in the preparation of this article.

Editing by Alex Akesson
For HedgeCo.net
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