Private equity firms and hedge funds are moving to Florida to take advantage of tax savings. Fund managers control and invest in these funds to make profits. They get a share of the profits (called a “carried interest”) in exchange for their services. Other investors, like pension plans and wealthy individuals, also invest in these funds. It’s important for estate planners to understand tax laws to help fund managers avoid gift tax consequences. The fund managers set up a management company to run the fund and get paid a fee. When the fund makes money, it goes to the investors first, then the fund managers. If the fund does well, the fund managers can make a lot of money. They have to be careful about taxes when transferring their share of the profits. I.R.C. §2701 applies when someone gives a part of their business to a family member, but still keeps some control over it. This control might include the right to get special payments or to decide when the business will be closed. If this rule applies, the value of the gift is calculated by subtracting the value of the control the person keeps from the total value of the business. If the control is considered significant, it’s given a value of zero, which means the person is treated as giving away the whole business, not just a part of it. If a fund manager wants to give part of their business to family members without triggering gift taxes, they need to plan carefully. Without proper planning, a tax rule called I.R.C. §2701 could require the manager to pay gift taxes. But with some proactive planning, there are ways to avoid this. The tax code has some exceptions that allow gifts to family members without triggering taxes. By using these exceptions, a fund manager can transfer part of their business to family members without having to pay extra taxes. The “vertical slice” exception is a rule that allows a fund manager to transfer a portion of their ownership in a fund to family members without having to pay additional taxes. This means the fund manager can share some of their ownership with family members without being penalized by the IRS. This can be done by transferring the ownership to a separate LLC and then giving a portion of that ownership to family members. For a fund manager who wants to transfer part of their ownership in the fund, they can do it in a way that minimizes gift taxes. One way is to invest most of their money directly in the companies the fund invests in, rather than putting it all in the fund. Another option is to create a special type of LLC and transfer their ownership in the fund to that LLC. The LLC would have two types of ownership shares, with one type getting regular payments and the other getting any extra profits. This can help the fund manager avoid paying high gift taxes when transferring their ownership in the fund. The fund manager can transfer some of their ownership in the fund to a family LLC, and then give some of that ownership to family members. They can still keep some ownership for themselves without having to pay extra taxes. If they set up the ownership transfer in a specific way, they can avoid triggering certain tax rules. They can also transfer their ownership to a trust that is only for family members or other friendly people, and avoid the tax rules. The trust can give the LPOA beneficiary the power to give the trust’s assets to other people or organizations. This is to avoid the trust being treated as a general power of appointment. The LPOA beneficiary can use this power to give the trust’s assets to family members later on. But there’s a risk that the IRS could see this as the fund manager giving the assets directly to the family trust. To lower this risk, the fund manager can report the gift to the family trust and start the clock on a three-year waiting period for the IRS to challenge the gift. Another option is to create two trusts – one for completed gifts and one for incomplete gifts – and transfer assets to each accordingly. This technique uses certain tax rules to avoid a specific tax law. It involves attributing ownership of a trust to certain individuals in order to avoid the tax law. This is done by following specific rules set by the IRS. The ownership rules determine who is considered the owner of a share of a company if it is owned by more than one person. The rules are different depending on the type of ownership. For the share of ownership that is more important, like a manager’s share, it is first attributed to the person who set up the trust, then to the person who gave it, then to their spouse, and then to family members. For a less important share, like a manager’s carried interest, it is first attributed to the person who received it, then to family members, then to the person who set up the trust, then to the person who gave it, then to their spouse, and then to family members. If the person who set up the trust is also a family member, their ownership is considered first. So, if a manager has given away an important share, they will still be considered the owner. But if they gave away a less important share, they won’t be considered the owner if the trust is set up in a specific way. A derivative contract is a way for a fund manager to transfer the value of their carried interest to a trust for their family without actually giving up the interest itself. The fund manager and the trust enter into a contract where the fund manager agrees to pay the trust the value of their carried interest at a future date. In return, the trust pays the fund manager an amount equal to the value of this future payment. This allows the fund manager to transfer the value of the interest to the trust without giving it away completely. This article talks about how fund managers can plan for their assets when they pass them on to heirs. It mentions a rule in the tax code that can cause problems for fund managers when passing on their assets. The article suggests using a derivative contract as a way to avoid the tax rule, but also warns that there are risks involved. It says that estate planners need to be aware of different planning techniques for fund managers. This is important, especially as more fund managers move to Florida. Overall, the article is about helping fund managers plan for their assets in a way that avoids problems with the tax code. If the fund manager owns any part of the fund, it will be considered a controlled entity, even if they don’t own the whole thing. This is because they have some control over what happens with the fund’s money. This technique works because the fund manager’s investment in the portfolio companies doesn’t count as a retained interest for tax purposes. There are exceptions to the rules that may apply, such as if the retained equity interest is the same as the transferred equity interest. Also, if the fund manager has a right to receive a specific payment at a specific time, the tax law may not apply. It’s also possible to use a limited partnership for this purpose. If the fund manager’s family members are involved, there are special rules that apply. If the preferred interest includes any special payment rights, the value of the interests is calculated based on the lowest possible value. Nathan R. Brown is a lawyer who helps people with their taxes and estate planning in Palm Beach. He works with clients on how to plan their estates and handle trusts and taxes. This information comes from the Tax Law Section.
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Source: https://www.floridabar.org/the-florida-bar-journal/estate-planning-with-carried-interests-navigating-i-r-c-2701/
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