estate planning and carried interest: estate tax reduction...

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Estate Planning and Carried Interest:

Estate Tax Reduction Strategies for

Private Equity and Hedge Fund Founders Strategies for Wealth Transfer and Asset Protection to Avoid Adverse Tax Consequences

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, AUGUST 1, 2017

Presenting a live 90-minute webinar with interactive Q&A

Marissa Dungey, Partner, Withers Bergman, Greenwich, Conn.

Kevin Matz, Partner, Stroock & Stroock & Lavan, New York

Cristine M. Sapers, Partner, Loeb & Loeb, New York

Shishir Khetan, Managing Director, Stout Risius Ross, Houston

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Estate Planning and Carried Interest

Shishir Khetan

Stout Risius Ross

[email protected]

Private Equity is a Major Source of Capital

U.S. Private Equity Capital Raised

Source: Pitchbook.com

$184

$272

$181

$121

$71 $88

$110

$201 $195 $200

$180

269

311

262

161

158

189 202

294

318

283 252

0

50

100

150

200

250

300

350

$0

$50

$100

$150

$200

$250

$300

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Capital raised ($B) # of funds closed

6

Typical Private Equity Fund Structure

Private Equity Fund

Portfolio

Companies

Fund General Partner

Carried

interest

distributions

Capital

interest

Limited

Partners

Capital

interest –

Preferred

return

Management Company

Management

fees

General Partner of the

Fund GP

Non-economic GP interest

Limited Partners (typically the

senior team members of the PE firm)

Carried

interest

distributions

Capital

interest

7

Distribution “Waterfall”

First – Limited partners return of invested capital

Followed by – Limited partners return of management fees & expenses

Followed by – Limited partners preferred return

Followed by – General partner catch up distributions of carried interest

Followed by – pro rata distributions to general partner and limited partners

8

Carried Interest Distributions

There are typically two styles of waterfalls:

European-style: Carried interest distributions are paid once

limited partners have received a return of 100% of their

contributed capital and a preferred return on that total amount of

contributed capital

American-style: Carried interest distributions are paid as

individual investments are sold by the fund

Protection clauses:

Clawbacks

Escrows

9

Estate Planning with Carried Interests Strafford Webinar – August 1, 2017

Section 2701, Rev. Rul. 98-21 and Certain

Deemed Gift Issues (Kevin Matz’s portion)

Kevin Matz, Esq., CPA, LL.M.

(Taxation) Stroock & Stroock & Lavan LLP New York, New York

(212) 806-6076

[email protected]

Overview of Chapter 14 of the

Internal Revenue Code

• The general rule of valuation for estate and gift tax

purposes is “fair market value.” • Fair market value is defined as “the price at which . . . property would change hands

between a willing buyer and a willing seller, neither being under any compulsion to

buy or to sell, and both having reasonable knowledge of relevant facts.”

• Fair market value may not be determined by a forced sale price, nor by the sale price

of the item in a market other than that in which the item is most commonly sold to the

public.

• The location of the item must be taken into account whenever appropriate.

• Note that Revenue Ruling 83-120 outlines the primary guidelines established by the

Internal Revenue Service for valuing preferred interests in closely-held entities.

11



• Chapter 14 of the Internal Revenue Code (IRC §§ 2701-2704) was enacted to

combat so-called “estate freezes” -- manipulative valuation techniques used in

connection with transfers of partial interests in property where the transferor

retained an interest in that property.

• Prior to the enactment of Chapter 14, when a transferor transferred a residual

interest in property and retained the income interest in the property, the

transferred interest was valued for gift tax purposes by taking the value of the

entire property and subtracting the present value of the retained interest.

• Through the use of various techniques, the transferor would overvalue the transferor’s

retained interest which would produce an undervaluation of the transferred interest.

12



• Chapter 14 provides valuation rules to combat specific instances of

valuation abuses.

• Under Chapter 14, the valuation of a transferred interest (residual

interest) is generally determined by the subtraction method of

valuation.

• First, the value of the retained interest is determined; then, this value is

subtracted from the value of the entity (corporation, partnership or trust).

• In many cases, the value of the retained interest under the special valuation

rules is zero, resulting in a taxable gift of the entire property.

13



• CORPORATION OR PARTNERSHIP EXAMPLE:

• FACTS: A is the sole shareholder of a corporation with a value of $10 MLN

and recapitalizes it to have both preferred and common stock. A transfers

the common stock to his children, retaining the preferred stock. The

preferred stock does not require the payment of annual dividends, including

on a cumulative basis.

• RESULT: Because the preferred stock does not provide for “qualified

payments,” unless certain other exceptions apply, the preferred stock that A

retains will be ascribed a zero value for Federal gift tax purposes and

therefore A will be deemed to have made a $10 MLN gift

14



• Chapter 14 contains four sections: • Section 2701 provides rules for determining the value for gift tax

purposes of certain interests in corporations and partnerships that are

transferred to members of the transferor’s family.

• Section 2702 addresses the valuation of retained interests held through

trusts or arrangements that are in the nature of trusts.

• Section 2703 disregards certain options, restrictions and agreements

(including certain buy-sell agreements) for valuing certain interests in

business and other property.

• Section 2704 treats the lapse of certain voting and liquidation rights as

transfers and disregards certain restrictions on liquidation.

15



• It is important to consider when Chapter 14 will not apply. Chapter 14 does not apply to the

following entities or transactions:

• Publicly-traded securities;

• Employment contracts;

• Leases;

• Debt, except as it may affect the value of a transferred residual interest (e.g., common stock);

• Transfers of interests in partnerships or corporations that are not controlled by the transferor or the

transferor’s family, unless it involves certain liquidation, put, call or conversion rights;

• Direct transfers of interests in corporations or partnerships if the transferor retains only stock or partnership interests

of the same class as those transferred;

• Direct transfers of interests in corporations or partnerships if the transferor retains only stock or partnership interests

that differ from the transferred interest with respect to nonlapsing voting rights (in a corporation) or as to management

and liability (in a partnership);

• Irrevocable life insurance trusts; and

• Private annuities, installment sales and self-canceling installment notes.

16

Section 2701 – Transfers of Certain

Interests in Corporations or Partnerships

• Section 2701 applies special valuation rules to determine the value for

gift tax purposes of certain interests in corporations and partnerships

that are transferred to members of the transferor’s family.

• Under Section 2701, a “subtraction method” is employed to value the

transferred junior equity interest (e.g., common stock in a corporation),

which is arrived at by subtracting the value of all family-held senior

equity interests (e.g., preferred stock in a corporation) from the value of

all family-held interests in the entity as determined immediately before

the transfer.

17



• Significantly, for purposes of this computation, an “applicable retained interest” (which

may consist of either an “extraordinary payment right” or a distribution right in a

controlled entity other than a “qualified payment right”) is generally valued at zero for

gift tax purposes.

• Section 2701 also requires the value of the common equity to be at least 10% of the

total value of all entity interests, plus total debt owed by the entity to family members

(i.e., the “10% minimum value rule”).

• The upshot of this is that it could produce an unpleasant “gift tax surprise”

whereby the full value of the family-held interests in an entity may be subject to

gift tax without any offset to reflect the value of retained senior equity interests.

This gift tax surprise could also occur upon an arm’s length sale to a family

member for full and adequate consideration.

18



• Even if it is ultimately determined not to apply, Section 2701 is always of concern in

estate planning for carried interests because the carried interest represents a

“junior” class of equity, as it entitles the holder to a portion of residual investment

gains.

• In contrast, the following classes of equity that are typically held, directly or indirectly,

by the fund manager would be considered “senior” to the carried interest because

they are preferred as to distributions or allocations:

1. The fund manager’s interest in any co-investment or subscription capital

2. The fund manager’s interest in any partnership allocation in lieu of management fees

3. The fund manager’s interest attributable to the general partner’s catch-up allocations on any

hurdle return before the carried interest becomes entitled to distributions (other than “tax

distributions”)

19



• The special valuation rules only apply if one of the following rights (referred to as

an “applicable retained interest”) is retained by the transferor or “applicable

family members” immediately after the transaction:

• A liquidation, put, call or conversion right (which are referred to as “extraordinary payment

rights” in the regulations); and

• A distribution right, but only if the transferor and applicable members of the transferor’s

family control the corporation or partnership (referred to as a “controlled entity” in the

regulations).

• An “applicable family member” is the transferor’s spouse, an ancestor of the

transferor or the transferor’s spouse, or the spouse of any such ancestor.

Applicable family members are in the same generation as or above the

generation of the transferor.

20



• Importantly, a “controlled entity” is a corporation or partnership

controlled immediately before the transfer by the transferor,

applicable family members, and any lineal descendants of the

parents of the transferor or the transferor’s spouse.

• In the case of a corporation, control means holding at least 50% of the total

voting power or total fair market value of the equity interests in the

corporation.

• In the case of a partnership (including a limited partnership), control means

holding at least 50% of either the capital interests or the profits interests in

the partnership.

21



• In addition, per IRC section 2701(b)(2)(B)(ii), “in the case of a limited

partnership, [control also means] the holding of any interest as a general

partner.”

• This is to be distinguished from merely holding an interest in a general partner.

• This critical distinction is illustrated by Private Letter Ruling 9639054, in which

the IRS determined that a controlled entity did not exist for purposes of Section

2701 where a corporation, that served as the sole general partner of a limited

partnership, was 37% owned by family members upon applying the attribution

rules under the Section 2701 regulations.

22



• The “as a general partner” language of Section

2701(b)(2)(B)(ii) is also quoted on page 12 of the preamble to

the proposed regulations under Sections 2704 and 2701 that

were issued by Treasury in 2016, in this context, in connection

with clarifying the determination of control of an LLC or other

entity or arrangement that is not a corporation, partnership or

limited partnership including through “the ability to cause the

full or partial liquidation of the entity or arrangement.”

23



• Attribution rules can cause an individual to be treated

as holding an equity interest where the interest is held

indirectly through a corporation, partnership, estate, trust

or other entity.

• If an individual holds an equity interest in more than one

capacity, the interest is treated as held in the manner that

attributes the largest total ownership of the equity interest

to the individual.

24



• As mentioned above, Section 2701 can also be triggered if the

transferor or applicable family members retain an “extraordinary

payment right.”

• An extraordinary payment right is any put, call, or conversion right,

any right to compel liquidation, or any similar right, the exercise or

non-exercise of which affects the value of the transferred interest.

• A call right includes any warrant, option, or other right to acquire one or

more equity interests.

• These rights confer upon the transferor discretion over whether to receive

the payments or otherwise benefit from these rights.

25



• In contrast, certain rights are not considered extraordinary payment

rights and therefore will not be valued at zero under Section 2701.

• Specifically, mandatory payment rights, liquidation participation rights (unless the

transferor, members of the transferor’s family, or applicable family members

have the ability to compel liquidation), rights to guaranteed payments of a fixed

amount under IRC § 707(c), and non-lapsing conversion rights are valued under

normal valuation rules because they are not considered extraordinary payments.

• These rights effectively give the transferor no discretion over whether to receive

the payments or otherwise benefit from these rights, and therefore the policy

reason for applying Section 2701 to these rights ( i.e., to prevent a disguised gift)

does not exist.

26

Section 2701 cont’d -- Safe Harbors to Protect

Against the Application of Section 2701

• There are safe harbors set forth in the Section 2701 regulations that may be

employed to protect against the risk of a Section 2701 gift tax surprise.

• Chief among these safe harbor techniques is the so-called “vertical slice”

exception.

• Under this exception, Section 2701 will not apply where there is a transfer of equity interests

to the extent the transfer proportionately reduces each class of equity interest held by the

individual and all applicable family members in the aggregate immediately before the

transfer.

• For example, Section 2701 would not apply if the fund manager of a private equity fund owns

50% of each class of equity in the general partner and other affiliated entities, and transfers a

portion of each class of equity thereby reducing each interest held by the fund manager and

any applicable family members in the aggregate by 10%.

27



• Finally, the application of Section 2701 is by no means a death knell as far as

estate planning is concerned.

• First, certain of the cumulative preferred interests that are retained by the transferor or

applicable family members may constitute “qualified payments” -- which are given value

for purposes of Section 2701, although a 10% “minimum value rule” would then apply

for determining the value of the transferred junior equity interests.

• Under the 10% minimum value rule, a junior equity interest in a corporation or partnership

shall in no event be valued at an amount less than the value which would be determined if

the total value of all of the junior equity interests in the entity were equal to 10 percent of the

sum of (i) the total value of all of the equity interests in such entity, plus (ii) the total amount

of indebtedness of such entity to the transferor (or an applicable family member).

28



• In addition, even if a preferred interest does not meet the definition of

a qualified payment because it is not cumulative, the fund manager

may elect to treat it for federal gift tax purposes as though it were a

qualified payment.

• Further, particularly in the early stages of a fund, the value of the

applicable retained interests (to which Section 2701 would potentially

ascribe a zero value) may be sufficiently low so that the amount of

the deemed transfer attributable to these interests would be

manageable (i.e., within lifetime gift tax exemption limits).

29

Revenue Ruling 98-21 and Risk of Incomplete Gifts

on Transfers of Unvested Interests in the General

Partner

• In contrast to the carried interests that are held by the fund’s general partner, a

fund manager’s interest in the general partner will often be subject to a vesting

schedule.

• Commentators have noted the risk that the IRS may argue that a transfer of a

fund manager’s unvested interest in the fund’s general partner to a trust

established for descendants does not constitute a completed gift for federal gift

tax purposes.

• The concern here is that the gift may not become complete for federal gift

tax purposes until the interest transferred becomes fully vested. At that

point the gift tax value of the interest transferred may have significantly

increased, thereby exposing the fund manager to substantial gift tax exposure.

31



Partner

• The basis for this concern is Revenue Ruling 98-21, which

addressed the gratuitous transfer of nonstatutory stock options.

• In that Ruling, the IRS concluded that the transfer to a family

member, for no consideration, of a nonstatutory stock option is not a

completed gift for federal gift tax purposes until the later of (i) the

transfer or (ii) the time when the donee’s right to exercise the option

is no longer conditioned on the performance of services by the

transferor.

32



Partner

• There are significant reasons why the IRS’s analysis in the context of unvested

compensatory stock options should not apply to gifts or other transfers of

unvested partnership or membership interests in the fund’s general partner.

• Importantly, there can be little doubt that a fund manager who holds an interest

in the entity that is the fund’s general partner holds a substantial property

interest.

• Even prior to vesting, he or she will be entitled to allocations and distributions

from the fund’s general partner, and may be able to exercise certain voting and

management rights under the entity’s governing instruments.

33



Partner

• Nevertheless, until the IRS confirms by ruling that the reasoning of

Rev. Rul. 98-21 does not apply to a transfer of unvested equity

interests in the fund’s general partner, it may be appropriate

depending upon the circumstances to prioritize the interests to be

transferred for estate planning purposes so that the fully vested

interests are transferred first, followed by a transfer of the unvested

interests that will be first in line to vest.

• By structuring the transaction in this manner, the risk (if any) posed

by an IRS extension of Rev. Rul. 98-21 can be minimized.

34

Potential Deemed Gift Issues on Waiver of

Management Fees

• Depending upon how the fund is structured, gift tax exposure could

also result from the fund manager’s waiver of its management fees

where the fund manager has transferred its subscription interest to

a trust established for the benefit of family members.

• By way of background, in order to convert ordinary income to capital

gains, it is relatively common for the fund manager to waive its

management fee in exchange for receiving a priority allocation in the

fund’s distribution waterfall.

35

Potential Deemed Gift Issues on Waiver of

Management Fees

• If the fund manager were to receive an offset against subsequent

capital contributions on its subscription interest in exchange for its

management fee waiver after having previously transferred the

subscription interest to a family trust, the IRS could contend that the

fee waiver constitutes a disguised gift by the fund manager to the

trust beneficiaries.

• It may be possible to mitigate the gift tax consequences of the IRS’s

position to some extent by including Crummey powers of withdrawal

in the trust instrument.

36

Estate Planning and Carried Interest

Marissa Dungey

Withers Bergman

[email protected]

Cristine M. Sapers

Loeb & Loeb

[email protected]

New York l New Haven l Greenwich l Los Angeles l Rancho Santa Fe l San Diego l San Francisco

London l Geneva l Zurich l Milan l Padua l Dubai l Hong Kong l Singapore l Tokyo l Sydney l British Virgin Islands

“Vertical Slice” Exception

• Sometimes called the “vertical slice rule,” the phrase refers to an

exception to Section 2701 that applies when the retained interest is

proportionately the same as the transferred interest, without regard to

non-lapsing differences in voting power (or for a partnership, non-

lapsing differences with respect to management and limitations on

liability)

• Broadly requires a parent who wishes to transfer a percentage of his

carried interest to his children (or a trust for their benefit) to also

transfer a proportional interest of his LP interest (e.g., 25% carry +

25% LP interest)

• Drawback: the LP interest is generally worth much more than the

carried interest so the parent’s gifting power may be too limited by the

LP interest

38



What is included in a “Vertical Slice”?

• A proportionate reduction of each class of equity interest

held by the individual and all applicable family members

• Equity interests:

• Management company?

• Essential to closely review the structure

• Attribution rules apply so that proportionality is determined

after taking into account interests held by applicable family

members, and may not result in a proportionate reduction of

the transferor’s interest

39



Example of a Vertical Slice

• Transferor owns 100% of the GP carried

interest worth $1 million and 10%

interest in the LP worth $10 million (other

90% is held by third party investors)

• Transfer of 20% of the GP requires

proportionate transfer of 2% of the LP

interest (i.e. 20% of Transferor’s 10% LP

interest) to qualify for vertical slice

exception

• Value of GP transferred is $200K, value

of LP transferred is $2M Fund

LP

GP LLC

Carried

interest

Transferor

100%

10%

LP

Other

investors

90%

LP

40



Use of Family Limited Partnerships and LLCs

• Transferor contributes fund interests to a FLP or FLLC in exchange for a limited

partner/non-managing member interest in the FLP/FLLC, then gives or sells the

FLP/FLLC interest to a trust

• FLLCs are simpler (no need for separate LLC to serve as GP), but FLPs are

preferable to ensure income tax treaty benefits if the fund will invest in certain

non-U.S. jurisdictions

• Non-tax reasons for using a FLP or FLLC

• Transferor or other trusted person (spouse, sibling, friend) can manage

investments at the FLP/FLLC level

• BUT transferor should not control distributions

• Extra layer of creditor protection

• Fund management may prefer the interest in the fund GP to be owned by an entity

controlled by one of its partners than by a third-party trustee

41



FLPs and FLLCs: Discounts

• For gift tax valuation purposes, interests in fund entities are discounted for

lack of marketability and lack of control

• Are additional discounts at the FLP/FLLC level appropriate?

• From an economic perspective, the interest of an owner of a FLP/FLLC is different

from the interest the FLP/FLLC has in the fund GP.

• FLP/FLLC receives current distributions from the fund GP, while the owner of the

FLP/FLLC receives cash flow only when the GP/MM of the FLP/FLLC chooses to

make distributions. A third-party buyer would not pay the same amount for a non-

controlling interest in a FLP/FLLC as for a direct interest in the fund GP.

• Some court cases support multi-tier discounts. See, e.g., Kerr (Tax Ct. 1999),

Gow (Tax Ct. 2000), Estate of Murphy (U.S. Dist. Ct. 2009).

• But see Astleford (Tax Ct. 2008), suggesting that a second-level discount is

inappropriate if the lower-tier entity is the sole or major asset of the upper-tier

entity.

42



FLPs and FLLCs: Structuring to Avoid Estate

Tax Risks

• To avoid risk of estate tax inclusion under Section 2036, the

transferor should not control distributions or allocations of

profits/losses or have the power to consent to transfers of LP/non-

managing member interests

• E.g., special managing member of FLLC controls distributions, allocations, etc.

• Transferor as managing member controls investments, executes

agreements on behalf of FLLC

• Transferor can remove and replace special managing member subject to

“related and subordinate” restriction

• Or FLLC has a single managing member and hires transferor as investment

manager

43



FLPs and FLLCs: Structuring to Avoid Estate

Tax Risks Cont.

• In light of the Tax Court’s recent decision in Powell,

148 T.C. No. 18 (May 28, 2017), transferor should not

have ability to participate in decisions regarding

dissolution of the FLP/FLLC • Decedent in Powell was a limited partner of a family limited partnership

to which she had contributed assets before her death.

• As limited partner, she could agree with the other partners to dissolve

the partnership, which would re-vest assets in the decedent. She could

then designate who would enjoy the property and its income. The court

held this was sufficient to include the FLP assets in her estate under

section 2036(a)(2).

44



Transfer Tax Landscape in 2017

• Federal estate, gift and generation-skipping transfer

(GST) tax exemption amount of $5,490,000 per person

• Federal tax rate above exemption amount is 40%

• Potential for Legislative Changes

• Past Administration’s proposals included changes to Grantor Retained

Annuity Trusts (GRATs) and valuation of closely held interests

• Current Administration’s proposals include repeal of the estate tax

• Interest rates are still relatively low

• Section 7520 rate for August is 2.4%

• Mid-term AFR for August is 1.95%

• State transfer taxes

45



GRATs

• A GRAT is a trust into which a grantor transfers property and takes

back a fixed-term annuity

• The value of the annuity is calculated using the IRS’s § 7520 rate

(currently 2.4% for August 2017)

• The difference in value between the transferred property and the value of the annuity is a gift; if these amounts are equal then the gift

is zero (“Zeroed-Out GRAT”)

• Annuity cannot be paid with promissory note

• Annuity can increase up to 20% each year

• Enables gift-tax free transfer of future appreciation above 7520 rate

• Must outlive GRAT term to escape estate tax

• Not GST-exempt

46



GRATs in Carried Interest Planning

• Term

• Consider expected cash flow from fund

• Longer-term GRAT instead of a 2-year GRAT:

• Greater likelihood that cash flow from fund will support annuity payments

• Increased risk of mortality

• Less complexity and costs of administration

• Avoid repeated “transfers” with Series GRATs

• Funding

• Cannot add property to a GRAT so need to deal with cash needs for

capital contributions upfront

• Lower risk with valuation because GRATs allow for adjustment

of the annuity if the value of contributed property is later

determined to be higher or lower

• Good for matured funds with substantial value with more upside

potential and predictable cash flow

47



GRAT Illustration

Grantor

Transfer to GRAT

of fund interests (2701 compliant)

Annuity payment equal to

value of transfer plus interest factor (pay in cash)

GRAT

Remainder

Trust f/b/o Children

Remainder at end

of GRAT term

48



Gifts and Sales for Carried Interest

Planning

• Good for transfers of interests at fund inception, where cash

flows from fund will not support GRAT annuity payments in early

years

• Client with substantial lifetime gift exemption available may use

exemption for gifts of discounted fund interests

• Client who has trust with substantial resources thanks to prior

planning can sell fund interest to trust for 100% cash

• Installment sale permits larger transfer with smaller gift (or use

of less existing trust resources) compared to gift or sale without

a debt component

• Can allocate GST tax exemption (unlike GRAT)

49



Installment Sale

• Transferor gives trust cash equal to 20% of appraised value of

FLLC interest to be sold • Or sells interest to existing trust with “old and cold” money to avoid new taxable

gift

• Sells FLLC interest to grantor trust for appraised value

• Down payment of 10% of sale price

• 9-year installment note for balance, bearing interest @ mid-term

AFR • Pre-payable without penalty, secured by pledge of purchased FLLC interest

• For private equity funds, note payments can be interest-only in early years to accommodate expected cash flow from sale of portfolio companies (usually deferred until years 5-10)

• Transferor reports gift of cash in the case of a new trust

• Recommend reporting sale to start statute of limitations

51



Installment Sale Illustration

Transferor Grantor trust

for family

FLLC

Sale of 100% FLLC Non-Managing

Member interest to trust

Purchase price (down payment + note)

Fund GP and/or GP of GP

Contribution of

“vertical slice” of fund entities

“Seed money” gift

(20% of sale price)

52



Managing Valuation Risk

• If IRS increases valuation of fund and/or FLLC interest,

there will be a current taxable gift of the excess value

• Preserve some gift and GST exemption as a cushion

for increase in value upon audit

• Use a formula clause or purchase price adjustment to

avoid a taxable gift

53



Formula and Adjustment Clauses

• Formula allocation clause • McCord (5th Cir. 2006), Hendrix (Tax Ct. 2011), Petter (Tax Ct. 2009; 9th Cir. 2011),

Christiansen (Tax Ct. 2008; 8th Cir. 2009)

• Portion of interest transferred in excess of $_____ as determined for gift tax purposes is

allocated to non-taxable transferee (charity, marital trust)

• Upon increase in valuation on audit, portions owned by trust/non-taxable transferee are

adjusted

• Adjustments to ownership of entity on audit can result in need to amend income tax

returns (unless grantor trust), true-up distributions, etc.

• Defined value transfer clause • Wandry (Tax Ct. 2012)

• Transfer of so much of the interest as has a value of $_____ as determined for gift tax

purposes

• Upon increase in valuation on audit, portions owned by transferor/trust are adjusted (but

argument is that trust was never entitled to receive the excess amount)

• Adjustments to ownership of entity on final determination can result in need to amend

income tax returns (unless grantor trust), true-up distributions, etc.

• IRS non-acquiescence: agents may not have authority to settle

54



Formula and Adjustment Clauses Cont.

• Purchase price adjustment • King (10th Cir. 1976)

• Sale of interest for a price equal to its fair market value

• Price paid at closing based on estimated value, adjusted when

appraisal is finalized and/or value is finally determined by IRS or

court

• Upon increase in valuation on audit, trust pays transferor additional

purchase price (in cash or cash + note)

• As with formula allocation and defined value approach, no portion

of interest is returned to transferor (unlike Proctor)

• Unlike formula allocation and defined value approach, percentage

interest retained by family trust is unchanged on audit; no need to

undo distributions or amend returns

• This approach has been accepted on audit

55

Appraisals

Fair market value of a carried interest can be determined

using the Discounted Cash Flow Method under the Income

Approach.

Requires projected cash flows to the carried interest, which

are discounted at a rate of return required on investments with

a similar risk profile.

Calculated value may need to be discounted for lack of control

and lack of marketability characteristics.

56

Appraisals

Key valuation assumptions:

Final size of the fund

Schedule of capital contributions

Holding period for each tranche of investments

Multiple of invested capital (“MOI”) of each tranche of

investments

Monte Carlo simulation to determine statistically derived

MOI and holding period for each tranche of investments Consideration of existing market conditions, which may be

different than during the sponsor’s earlier funds

57

Appraisals

Investment 1 Investment 2 Investments 3, 4, 5…

Projected Capital Called

Projected Management Fees

Projected sale

proceeds

Holding period

Investment size

Return of LP Capital

Return of LP Fees

LP Preferred Return

Catch-up to GP

Split of Remaining

Proceeds

Projected sale

proceeds

Holding period

Investment size


Return of LP Fees

LP Preferred Return

Catch-up to GP

Split of Remaining

Proceeds

Projected sale

proceeds

Holding period

Investment size


Return of LP Fees

LP Preferred Return

Catch-up to GP

Split of Remaining

Proceeds

58

Appraisals

Carried interest distributions




Life of the Fund

Adjustment for Clawback, Holdbacks, or Other Provisions

Present Value

Discount for Lack of Control

Discount for Lack of Marketability

Fair Market Value

X 10,000 MONTE CARLO ITERATIONS

Present

Value

59

Appraisals Carried Interest Discount Rate Model

1 Partners Preferred Rate of Return 8.0%

2 Assumed Baseline Gross Return on Investments 17.5%

3 Average Holding Period 5.0 Years

4 Carried Interest % 20.0%

Notes Cash Flow LP %

LP Cash

Flow

5 Preferred Return Cash Flow [a] 1.4693$ 100.0% 1.4693$

6 Carried Interest Catch-Up Cash Flow 0.1173 0.0% 0

7 Residual Cash Flow 0.6530 80.0% 0.5224

8 Total Return 2.2397$ 1.9918$

9 Required Return of Partners [b] 14.8%

10 Partners Portion of Total Cash Flow 88.9%

11 Carried Interest Rate of Return [c] 39.4%

12 Carried Interest Portion of Total Cash Flow 11.1%

13 Weighted Average Rate of Return [d] 17.5%

14 Sensitivity Analysis Gross ROR CI ROR

12.5% 33.8%

15.0% 36.6%

17.5% 39.4%

20.0% 42.2%

22.5% 45.1%

[a]

[b]

[c] Return required for the result to be equivalent to the concluded gross return of 17.5%.

[d] Equal to the weighted sum of the required rates of return of the limited partners and the general

partner.

Based on the assumed gross returns and term assumuming capitalzation of $1

Equal to the following formula such that the projected return to the limited partners equals $1.00

as of the Valuation Date: = [Total LP Cash Flow] ^ (1/Investment Term) - 1

60



Alternative Planning Ideas

• Derivative • Partner gives or sells derivative contract that tracks economic return of fund GP’s

carried interest to trust

• Contract entitles trust to receive at settlement date (e.g., earlier of 8 th anniversary of fund or partner’s death) payment equal to (1) ___% of carry distributions made

as of that date, plus (2) present value of ___% of carry distributions expected to be made after that date less a hurdle amount

• Because a partnership interest in the fund GP has not been transferred, section 2701 should not apply

• Important to differentiate partner’s economic rights in carry and trust’s rights under

derivative contract to avoid IRS argument that partner has transferred actual carry and

violated section 2701

• Risk that IRS will treat amount paid to trust at settlement as a gift to the extent it exceeds purchase price for derivative under section 2703

• This analysis is probably incorrect

• Possible double-taxation of carry if partner dies during the term of the contract (once when received by the partner and again when settlement amount is paid to

trust at partner’s death, when trust is no longer a grantor trust)

• Risk can be mitigated by adding one or more interim settlement dates

61



Alternative Planning Ideas Cont.

• Upstream Gifting Trust • Beneficiaries consist of only applicable family members other

than spouse (i.e. no “members of the transferor’s family”) such

as parents and siblings

• Under Treas. Reg. Section 25.2701-1(b)(3)(iii), a shift of

interests from the exercise of a limited power of appointment is

not a transfer for purposes of Section 2701 so long as it’s not

otherwise a transfer for purposes of Chapter 12

• Works with a CLAT, GRAT or basic Irrevocable Trust

• See:

• Todd Angkatavanich and David Stein, “Going Non-Vertical with

Fund Interests”, Trusts & Estates Magazine, Nov. 2010;

• Todd Angkatavanich, Christine Quigley and Marissa Dungey,

“Rising Tide Carry CLAT,” Trusts & Estates Magazine, Sept. 2016.

62



Alternative Planning Ideas Cont.

• 2701-compliant preferred partnership • Contribute all assets to holding company and divide Hold Co’s

interests into preferred and non-preferred

• Preferred have priority to income and liquidation rights, but

appreciation is capped at coupon that is qualified payment right

• Non-preferred (“common”) interests are subordinate to income

and liquidation rights of the preferred interests, but capture upside

above coupon

• Freezes the growth in value of the preferred partnership

interest to shift growth to the common interests

• Coupon valued pursuant to Rev. Rul. 83-120

• Needs to equal par to avoid potential deemed gift

• Technique is good in situation where AFR is inappropriate (e.g. with Marital Trust or planning with GST Exempt and Non-

Exempt Trusts)

63



Speaker Biography

Marissa Dungey, Esq., Withers Bergman LLP Marissa Dungey is a partner at Withers Bergman, LLP, based in the firm’s Greenwich, Connecticut

office. Her practice focuses on transfer tax planning, estate planning and trust structuring for

wealthy individuals and their families. Marissa works with individuals and their advisors to develop

and implement sophisticated planning strategies designed to minimize gift, estate and generation-

skipping transfer taxes with trust planning optimized to achieve the individual's tax and non-tax

goals, including creditor protection, charitable giving and income tax efficiency. Marissa regularly

advises on planning with complex assets including interests in hedge funds, private equity funds

and family businesses. She also advises on estate and trust administration matters, including

adapting existing trusts to improve their tax efficiency and utility. She also frequently speaks to

national audiences on a breadth of topics within wealth planning, including transfer taxes, income

taxation of trusts, planning with fund interests, family business planning and the gift and estate tax

implications of Chapter 14 relevant to business interests.

Marissa earned her B.A. degree, cum laude, from New York University and her J.D. degree, magna

cum laude, from Boston College Law School. Ms. Dungey is admitted to practice in Connecticut and

New York. She is a member of the Connecticut Bar Association, Greenwich Bar Association, New

York State Bar Association and American Bar Association. She serves on the Executive Committee

of the Estates & Probate Section of the CBA and the Vice-Chair of the Committee on the Non-Tax Issues Affecting the Planning and Administration of Trusts and Estates for the Real

Property, Trust and Estate Law Section (RPTE) of the ABA. Ms. Dungey was named as a Trusts & Estates Fellow for RPTE in 2014 and is currently an ACTEC Young Leader in RPTE.

64



Speaker Biography

Cristine M. Sapers, Esq., Loeb & Loeb LLP

Cristine Sapers is a partner at Loeb & Loeb, LLP, based in the firm’s New York office. Cristine

focuses her practice on sophisticated estate and tax planning for high-net worth individuals, preparation of wills and trusts and the administration of large trusts and estates. Her area of specialty is working with hedge fund managers and principals of private equity firms on estate

planning transfers of interests in their investment funds, including their carried interests. Other clients include executives of public companies, owners of closely held businesses and

individuals with inherited wealth. Ms. Sapers has substantial experience handling IRS gift and estate tax audits and negotiating and resolving trust and estate disputes. She also counsels donors on charitable giving and advises private foundations and public charities on tax law,

nonprofit corporation law and other matters.

Cristine earned her B.A. degree, from Harvard University and her J.D. degree from Columbia Law School. Ms. Dungey is admitted to practice in Connecticut and New York. She is a member of the New York State Bar Association of the Professional Advisory Council of the

Central Park Conservancy.

65

Kevin Matz concentrates on domestic and international estate and tax planning, estate administration

and related litigation. Mr. Matz’s practice primarily involves advising high net worth individuals with respect to wealth transfer planning; will and trust drafting; gift, estate, income and generation-skipping transfer tax planning and tax return preparation; charitable gift planning; probate proceedings and

estate administration; and associated litigation as well as corporate counseling.

Mr. Matz has also advised clients on entity and succession planning, including the use of family limited partnerships, the use of grantor retained annuity trusts, transfers to irrevocable trusts involving complex valuation issues, qualified personal residence trusts, irrevocable life insurance trusts, and the

use of charitable remainder trusts, charitable lead trusts and private foundations to further both family planning and philanthropic objectives.

Mr. Matz is a Fellow of the American College of Trust and Estate Counsel ("ACTEC"), and has written and spoken extensively about the use of family limited partnerships and various other leveraged

transfer techniques, as well as on estate planning strategies for groups ranging from private equity fund managers to professional athletes. He has been frequently cited in the professional literature,

including at the Heckerling Institute on Estate Planning, for his innovative solutions and analysis. Mr. Matz is also a certified public accountant.

66

Speaker Biography Kevin Matz, Partner, Stroock & Stroock & Lavan LLP New York

67

Speaker Biography Shishir Khetan, Managing Director, Stout Risius Ross, LLC, Houston

Shishir Khetan is a Managing Director in the Valuation Advisory group. He has extensive global

experience in corporate finance, valuations and strategic planning. He has advised clients ranging

from Fortune 500 companies to medium and small privately held companies, private equity and

investment funds, family offices, and accounting, legal and tax advisors.

Shishir has over two decades of financial advisory experience covering many industries, resulting in a

comprehensive understanding of valuation concepts, capital markets, financial and economic

analyses.

Prior to joining Stout, Shishir was a Senior Managing Director of HFBE where he performed financial

advisory and valuation services.

estate planning and carried interest: estate tax reduction...

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