Wealth transfer for fund managers in a post-tax reform world

Tax reform finally is here. And as taxpayers and their advisors digest the provisions of the recent legislation, they continue to enjoy economic recovery even as the Federal Reserve contemplates future interest-rate increases. Together, these conditions have led to what is perhaps the perfect environment for fund managers to visit, or revisit, the broader topic of wealth transfer.

Regarding the impact on funds, two key income tax aspects are the new carried interest provision and the new 20 percent deduction available to certain pass-through entities. These new rules also could affect the decisions a fund manager might make regarding the manager’s wealth transfer intentions. In addition, the legislation contains important provisions bearing directly on estate and gift taxation.

Traditional wealth transfer planning for fund managers

The primary economic incentive for a fund manager is the carried interest. Typically, the fund manager is not entitled to any profits associated with the carried interest until the underlying investments generate enough profit to return all invested capital plus a specified preferred return. As such, initially, the carried interest has nominal or no value. If the fund is successful, as one would expect in a robust economy, the carried interest could have tremendous value in the future.

The unique economics represented by the carried interest mean that fund managers have incentive to use lifetime gifting, particularly leveraged gifting opportunities such as grantor retained annuity trusts (GRATs) and installment sales to irrevocable grantor trusts. Low-interest-rate environments enhance these techniques. For example, in a GRAT, any appreciation in the carried interest over a specified rate – the 7520 rate – could pass tax-free to the beneficiaries. The 7520 rate is derived from prevailing interest rates, so as interest rates rise, the efficacy of a GRAT is diminished.

While the economics make the carried interest an ideal asset for certain techniques, they also subject it to complex provisions governing valuation. Referred to as the “vertical slice rule,” these valuation provisions have far-reaching consequences involving things such as a fund manager’s capital invested in the fund, management fee conversions, vesting and clawbacks. One must exercise great care to make sure the overall gift is properly structured to avoid the pitfalls presented by these issues.

Carried interest

Beginning in 2018, a fund manager generally will recognize long-term capital gain on the carried interest only to the extent the gain is derived from the sale of certain assets held for more than three years. If an asset is held less than three years, the gain would be short-term capital gain taxed at the applicable ordinary income tax rate. The transfer (direct or indirect) of a carried interest to a related party also results in short-term gain to the fund manager under the new law.  As a result, a manager would recognize short-term capital gain on the gift of a carried interest to the extent such carried interest was attributable to assets held less than three years.

Would contribution to a GRAT of the carried interest be considered a transfer for this purpose? The answer seemingly should be no. Transactions between the grantor (ie, fund manager) and a GRAT are ignored for income tax purposes. Unfortunately, the new legislation is sparse on details, so the Treasury department and the IRS will have to provide extensive regulatory and administrative guidance. If applicable guidance were to specify that a contribution to a split-interest vehicle such as a GRAT was a transfer for these purposes, the fund manager would incur any resulting short-term capital gain as the GRAT is a grantor trust.

Assuming the contribution to a GRAT was not a transfer, the GRAT itself could be used as an effective carried interest planning tool. In a case where the overall design of the carried interest was back-loaded, there would be a greater likelihood that the carried interest would be funded only with gain from the disposition of assets held more than three years. As long as the fund maintains an appropriate level of risk, conceivably one could design the carried interest to comply with the necessary income tax rules, at which point the GRAT would become an ideal holding vehicle for the carried interest.

Some taxpayers have explored the use of derivatives to avoid the complexity of the aforementioned vertical slice rule (along with other risks associated with a GRAT). Suppose a fund manager entered into a derivative contract with an irrevocable grantor trust. Could the contract be drafted in a manner such that the hurdle amount was tied to the three-year holding period? Assuming it could, the fund manager would need to fund the trust with additional cash necessary for the premium payment on the contract.

Pass-through deduction

The recently enacted legislation also creates a new 20 percent deduction – subject to a sunset period that ends in 2025 – attributable to an individual’s (or trust’s) share of qualified business income from a pass-through entity (ie, partnerships, limited liability companies, S corporations, and sole proprietorships). The deduction is found in a complexly worded new Section 199A of the Internal Revenue Code. Because of myriad qualifications and phase-out rules, the deduction usually is not available for an investment fund or its manager.

A lot of speculation exists about aggregation and disaggregation to obtain this deduction. In some instances specific assets (and aspects) of the overall fund structure, if segregated, may qualify under some of the phase-out rules. Again, assuming a fund manager can appropriately segregate these assets from the fund itself, he or she could place the assets in a trust that could avail itself of the new deduction. This technique would have the added benefit of removing the vertical slice rule from consideration.

Estate and gift tax reform

Finally, the new legislation essentially doubles the existing transfer tax exclusions. That is, the lifetime exclusion on estates and gifts has increased from $5.6 million (2017) to about $11.2 million (as adjusted for inflation). Thus, a fund manager could gift as much as $11.2 million of value before incurring a gift tax liability under the new law, but the rules have been enacted with planned change. These increases revert to their 2017 levels in 2026, if Congress does not act sooner. 

Nonetheless, a fund manager should not overlook the importance of this increase in lifetime exclusions. Often, the fund manager will contribute his or her own money into a fund, as evidenced by a capital account. Because of the new legislation, the fund manager might consider gifting more of any such capital account. Because the carried interest generally has little to no value, a violation of the vertical slice rule in such an instance would not be as costly as the gift of the carried interest itself.

Fund managers always have enjoyed unique opportunities to engage in wealth planning. The new tax reform legislation may have created increased incentive to do so. Certainly, coupled with an environ

ment marked by robust economic growth and potentially increasing interest rates, the legislation is an important reminder for fund managers not to overlook this important aspect of their planning. 

This article was sponsored by Crowe Howarth and first appeared in the May issue of pfm.