Private equity, venture capital and hedge fund estate-planning pitfalls.
Trusts and estates attorneys who work with clients who run private equity (PE), venture capital (VC) and hedge funds regularly rely on the “vertical slice” exception to Internal Revenue Code Section 2701 to transfer interests in those funds to their descendants. It’s widely accepted by practitioners in this space that if a general partner (GP) transfers an equal proportion of each class of his equity in a fund, the draconian valuation methodology of IRC Section 2701 won’t be imposed. Achieving verticality, however, is more easily said than done.
Reason for Enactment
Section 2701 was enacted in 1990 to prevent what was perceived to be an abuse of the gift tax system, specifically preferred stock recapitalizations. Before 1990, a member of a senior generation of a family could recapitalize common stock in a corporation controlled by the family into common and preferred shares, exchanging the old common stock for preferred stock and common stock. The senior generation would gift the common stock to a lower generation and retain the preferred stock. Typically, the preferred stock would have noncumulative dividend rights and a fixed liquidation preference that represented a significant portion, if not all, of the value of the corporation, and the common stock had little value at the time of transfer. Because the dividend rights were noncumulative, the family could freeze the value of the preferred stock for estate tax purposes by not paying dividends, with earnings and appreciation accruing to the lower generation common stockholders.
Section 2701 was enacted to prevent this transfer of value, and it casts a wide net. It’s a gift tax valuation rule that applies to family-controlled corporations and partnerships with more than one class of equity interests. For purposes of Section 2701, in the case of a corporation, “control” means holding at least 50 percent of the total voting power or total fair market value of the stock.1 In the case of a partnership, “control” means holding at least 50 percent of either the capital interest or the profits interest. Further, in the case of a limited partnership, control means holding any equity interest as a GP.2
Carried vs. Capital Interests
Generally, if a senior generation family member transfers a junior, or subordinate, equity interest (for example, common stock) to a lower generation family member while retaining a senior equity interest (for example, preferred stock), the retained senior interest is deemed to have no value under Section 2701, resulting in the junior interest having a higher value for gift tax purposes, unless the retained senior interest satisfies certain requirements.3 The Tax Code and regulations use “junior” and “subordinate” interchangeably: A junior equity interest is defined as one in which “the rights as to income and capital…are junior to the rights of all other classes of equity interests.”4“Subordinate equity interest” is defined as “an equity interest in the entity as to which an applicable retained interest is a senior equity interest.”5“Senior equity interest” is defined as “an equity interest in the entity that carries a right to distributions of income or capital that is preferred as to the rights of the transferred interest.”6
A typical PE, VC or hedge fund is structured as a limited partnership (the “LP fund”), and a principal of the fund owns interests in the GP (which itself is typically an LLC or a limited partnership). The outside investors contribute capital to the LP fund, and the principals own their carry and invest in the LP fund through the GP entity, although they could also invest in the LP fund directly. As the principals are owners of the GP entity, the LP fund is a “controlled” partnership as to each principal for purposes of Section 2701.7 Through the GP, the principal makes a capital commitment to the fund for which he receives a capital interest (similar to the interest received by outside investors in the LP fund) and a so-called “carried interest,”8 which entitles the fund principals to 20 percent of the profits realized by the LP fund after the investors (holders of capital interests) receive back their capital plus a preferred return on their investment (typically 8 percent). Therefore, the capital interests are senior to the carried interests, at least until the investors have received their preferred return, and thereafter, the capital and carried interests are pari passu, sharing profits 80:20.
When Section 2701 is Invoked
The vast majority of practitioners in this space agree that Section 2701 is invoked when the principal of a fund transfers his carried interest to his children while retaining his capital interest. Such transfers are usually made at an early stage of the fund, when the carried interest has very little value and remains junior/subordinate to the capital interest. Because fund principals often invest large amounts of capital in a fund, if Section 2701 applies, a large taxable gift could result because the value of the carried interest transferred would include a proportionate share of the value of the capital interest retained. To avoid this result, the fund principal could comply with the vertical slice exception under Section 2701: Section 2701 doesn’t apply if the fund principal transfers a proportionate amount of all his equity interests in the fund; for example, by transferring 20 percent of his carried interest and capital interest in the fund to his children.9 Specifically, Treasury Regulations Section 25.2701-1(c)(4) provides:
Section 2701 does not apply to a transfer by an individual to a member of the individual’s family of equity interests to the extent the transfer by that individual results in a proportionate reduction of each class of equity interest held by the individual and all applicable family members in the aggregate immediately before the transfer.[10] Thus, for example, Section 2701 does not apply if P owns 50 percent of each class of equity interest in a corporation and transfers a portion of each class to P’s child in a manner that reduces each interest held by P and any applicable family members, in the aggregate, by 10 percent even if the transfer does not proportionately reduce P’s interest in each class. See §25.2701-6 regarding indirect holding of interests. (Emphasis added.)
Issues to Consider
The obstacles an estate practitioner must navigate when transferring a vertical slice are both practical and technical, touching on securities laws and gift and income tax laws. Below are issues to consider when implementing a vertical slice transfer:
1. Attribution rules. Do the attribution rules make achieving verticality impossible? Section 2701 looks at which “applicable family members” own interests in the fund before and after the transfer to determine whether a disproportionate transfer was made to younger generations. The term “applicable family member” is defined as the transferor’s spouse, an ancestor of the transferor or the transferor’s spouse and the spouse of any such ancestor.11
The vertical slice rule of Treas. Regs. Section 25.2701-1(c)(4), quoted above, refers to indirect holdings of interests under the attribution rules of Treas. Regs. Section 25.2701-6. Therefore, when determining the family’s reduction in each class of equity, the attribution rules are applied to determine which family members hold what interests and whether the vertical slice rule applies. That is, the attribution rules are applied to determine whether the transfer resulted in a proportionate reduction of each class of equity interest held by the transferor and all applicable family members in the aggregate, even if the transferor doesn’t transfer a vertical slice of what he owns.
Example. Assume that a fund principal owns 20 percent of the carried interest and 40 percent of the capital interest in a fund through the GP and that his father owns 30 percent of the capital interest directly in the fund, but no carried interest. To transfer a vertical slice comprised of 50 percent of the fund principal’s carried interest to a trust of which his descendants are the beneficiaries, the fund principal must transfer 50 percent of his carried interest and
87.5 percent of his capital interest, which is 50 percent of his and his father’s aggregated capital interests.
The attribution rules also address the following points:
Regarding trusts:“A person is considered to hold an equity interest held by or for an estate or trust to the extent the person’s beneficial interest therein may be satisfied by the equity interest held by the estate or trust, or the income or proceeds thereof, assuming the maximum exercise of discretion in favor of the person … However, any person who may receive distributions from a trust is considered to hold an equity interest held by the trust if the distributions may be made from current or accumulated income from or the proceeds...”12
Regarding grantor trusts: An individual is treated as holding an equity interest held by or for a trust if the individual is considered an owner of the trust under the grantor trust rules.13
Tie-breakers: Treas. Regs. Section 25.2701-6(a)(5) contains tie-breaker rules when the attribution rules treat more than one person as holding equity interests. In the case of applicable retained interests (generally, the senior equity interests) attributed to more than one of the transferor and applicable family members (that is, ancestors of the transferor and his spouse and spouses of such ancestors), they’re treated as held: (1) first, by the grantor if owned by a grantor trust; (2) second, by the transferor; (3) third, by the transferor’s spouse; and (4) last, by the applicable family members on a pro rata basis.14
In the case of subordinate/junior equity interests attributed to the transferor, applicable family members and members of the transferor’s family (which includes the transferor’s spouse, descendants and their spouses), they’re treated as held (1) first, by the transferee; (2) second, by each member of the transferee’s family pro rata; (3) third, by the grantor if held in a grantor trust; (4) fourth, by the transferor’s spouse; and (5) last, by each applicable family member on a pro rata basis.15
On its face, it appears that if a fund principal transfers all of his carried and capital interests in a vertical slice to a grantor trust for his spouse and children, under the attribution rules, the interests would be deemed held by the spouse and children as beneficiaries of the trust and by the transferor/grantor. Under the tie-breaker rules, (1) because the senior/capital interest would be deemed held by the grantor and the grantor’s spouse (both applicable family members), it would be deemed to be held by the grantor; and (2) the junior/carried interests would be deemed held by the spouse and children as beneficiaries of the trust. Therefore, despite the apparent transfer of a vertical slice, the transferor is treated as having retained the capital interest and only transferred the carried interest—possibly negating the vertical slice!
If the same transfer were made to a non-grantor trust solely for the children, all of the transferred carried and capital interests would be deemed held by the children, falling under the vertical slice rule.
Can this be? The vertical slice rule says on its face that “Section 2701 does not apply to a transfer...to the extent the transfer…results in a proportionate reduction of each class of equity interest…,” which should end the inquiry, and the attribution rules shouldn’t then be applied to negate what appears to be a vertical slice transfer. Otherwise, despite falling within the vertical slice exception to Section 2701, a gift to a grantor trust could trigger Section 2701. However, this interpretation is uncertain. It could be that a vertical slice transfer doesn’t foreclose the attribution rules, and the vertical slice rule is applied after using the attribution rules to determine who’s deemed to hold equity interests after the transfer.
2. Management fees. The GP charges and collects a management fee from the LP fund, typically 2 percent of the assets under management or capital called. This fee is used by the GP to pay expenses, salaries and overhead, and net fee income is paid to the fund principals as owners of the GP. In some cases, some or all of this fee is paid to a separate management company owned by the fund principals, which serves the same functions. Consideration should be given as to whether a proportionate share of the fund principal’s management fee income should be included in a vertical slice, particularly if the fee is paid to the GP and there’s no separate management company. The GP is almost always a partnership or limited liability company (LLC), and the allocations of income on account of the capital interest, carried interest and management fee would all be reported on the same K-1s issued to the fund principals. These are all items of partnership income, and there’s no separate 1099 for a principal’s share of net management fee income. The vast majority of estate planners take the position that inclusion of the fee income isn’t required as part of the vertical slice, likening it to compensation for services and not an economic stake in the fund investments.
If the fee income were included as part of the vertical slice, it would greatly impact the economics of the transaction. Because the fee income has significant value, it would commensurately increase the value of the vertical slice. Practically, a fund principal is unlikely to want to transfer any part of his net fee income, as that’s his only regular source of income from the fund.
3. Management fee waivers. Funds are sometimes structured to allow the fund principals to waive part of what they would otherwise receive as their share of net management fees and set aside such amount to cover part of their capital commitments as they come due. These “management fee waivers” are also known as “synthetic capital” or “deemed contributions.” By waiving management fees, the fund principal gives up current income (which is taxed currently at ordinary income tax rates) and converts that dollar amount into a profits interest (which is taxed in the future as capital gain, if realized). The fund principal will only benefit from, and be able to apply, waived management fees to capital calls to the extent the fund has profits. If the fund isn’t profitable, the principal will have given up fees and will need to pay his capital calls out of pocket. Fees are either waived on an annual basis, or the full amount is waived at the outset of a fund.
Care must be taken so that management fee waivers don’t upset verticality. For example, if a fund principal waives $100 of management fees to be applied to capital calls, he, in effect, converts $100 of his capital interest/commitment into an interest that shares in net profits of the fund (a waiver profits interest). Unlike the carried interest, the waiver profits interest isn’t subject to an 8 percent preferred return and shares in all profits alongside the capital interest, making it senior to a carried interest but junior to the capital interest (which first receives its capital back). Accordingly, the principal would have three classes of interests, listed from senior to junior: capital interest, waiver profits interest and carried interest. The vertical slice rule would require a fund principal to transfer a proportionate share of that waiver profits interest, because it’s senior to his carried interest.
If the fees are waived at the outset of the fund, it’s easy to transfer a proportionate share of the waiver profits interest, and the value of that interest can be determined. But, if fees are waived annually, the vertical slice transfer made in a prior year is no longer proportionate. The principal’s capital interest would be reduced and waiver profits interest increased each time fees are waived. It could be structured so that the principal’s and his trust’s relative interests are converted proportionately, or the principal could hold all of his fund interests in a family partnership or LLC and transfer a piece of that entity so that if fee waivers convert capital interests into waiver profits interests, proportionality (verticality) is maintained. In either case, if the trust has an unfunded capital interest that’s converted into a “funded” waiver profits interest due to the principal waiving a fee each year, the trust will have received something of value that would be a gift, if not offset by the trust issuing a note to the principal.
4. Unvested interests. A fund principal’s carried interest is typically subject to a vesting schedule with only a portion vesting immediately and the balance vesting over a period of years. In some funds, carried interest is allocated to fund principals for each investment at the time it’s made, rather than to the fund as a whole, with that carry vesting over time.
The Internal Revenue Service has taken the position that a transfer of unvested stock options isn’t a completed gift for gift tax purposes until vesting occurs.16 If a portion of the vertical slice consists of unvested carried interest, the IRS could, by analogy, take the position that the portion of the vertical slice comprised of such interest wasn’t effectively gifted. This would upend the proportionality of the vertical slice. In this case, because a greater proportion of the senior interest would have been transferred, Section 2701 shouldn’t be triggered. However, when the carry does vest, not only would it likely be more valuable than when originally transferred (resulting in a larger gift) but also Section 2701 would apply at that time, because only the junior/subordinate carried interest would have been gifted at that time without a proportionate share of the capital interest.
Of course, unvested stock options are distinguishable from unvested carried interest. The holder of unvested stock options isn’t an owner of the stock, can’t vote the stock and won’t receive any dividends. The holder of unvested carried interest (that is, an owner of the fund GP), on the other hand, is an owner with rights associated therewith, such as voting rights and the right to financial information, and may have a right to receive distributions subject to forfeiture if he leaves the fund before the carried interest is fully vested.
5. Funding future capital calls. The trust holding the vertical slice will need to fund its share of capital calls. The trust can satisfy capital calls via management fees waived by the transferor, additional gifts to the trust by the transferor, loans to the trust by the transferor or a third party, deploying existing trust assets or by some combination thereof. As will be explained below, some of these options will impact the trust’s qualification as an accredited investor (AI) or qualified purchaser (QP) and may trigger gifts.
6. Securities laws. Funds usually seek to qualify for an exemption from registration under the Securities Act of 1933 (the 1933 Act) and the Investment Company Act of 1940 (the 1940 Act). The exemption that funds most commonly rely on allows investments only by AIs as defined in the 1933 Act and QPs as defined in the 1940 Act. If a vertical slice is transferred, it’s of the utmost importance to the fund that the transferee satisfy an exemption from these acts, or qualify as an AI or a QP.
A transfer of a fund interest by gift or intra-family sale generally won’t trigger registration under the 1933 Act, because gifts don’t fall within the definition of a “sale” under the 1933 Act, and there’s an exemption for sales by persons who aren’t selling a security on behalf of an issuer, such as an investment bank. However, if the transferee assumes the transferor’s capital commitment to the fund, the transferee must qualify as an AI when it makes such additional contributions, even if the trust will use cash previously received as a gift from the transferor to do so.
To qualify as an AI, the transferee must: (1) have a net worth in excess of $5 million; and (2) be a “sophisticated person” or if a trust, have a sophisticated person directing the trust’s purchase of securities. To meet the sophisticated person test, the fund must reasonably believe the transferee (including a trustee) has “such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks” of the (trust’s) investment in the fund. Also, if the transferee is a trust, it must not have been formed for the specific purpose of acquiring interests in the fund.
To avoid the need for the trust to qualify as an AI, the transferor could agree with the fund and the trust that the transferor will pay all capital calls on the trust’s behalf, so that the trust isn’t assuming the obligation to pay them. Such payments would be treated as taxable gifts from the transferor to the trust.
Generally, a gift of a fund interest won’t trigger registration under the 1940 Act unless the transferee is obligated to fund future capital calls using assets other than those received as a gift and earmarked for such purpose. If the transferee is so obligated or if the vertical slice is sold rather than gifted, the transferee must qualify as a QP by meeting at least one of four requirements: (1) the transferee must have at least $5 million of investments and, if a company, partnership or trust, be owned legally or beneficially by related parties; (2) the transferee or the person authorized to make investment decisions with respect to a transferee trust, and the transferor or person who’s contributed assets to the trust, must be QPs; (3) the transferee must own or manage, for its own account or the accounts of other QPs, in the aggregate, at least $25 million in investments; or (4) the transferor and person who makes all of the decisions with respect to the transferee’s investments, in the case of a trust, must be “knowledgeable employees,” which generally includes executive officers, directors, trustees, general partners, advisory board members or persons serving in a similar capacity at the fund.
Note that it’s far easier to qualify as a QP than an AI, because to qualify as a QP, the transferee only needs to meet one of the four requirements, while to qualify as an AI, the transferee must meet each of the three requirements.
7. Size of transfer. Interests in PE, VC and hedge funds—and carried interests in particular—have a high appreciation potential, which is what makes them attractive to use to transfer wealth. Clients are sometimes
concerned about transferring “too much” value to the transferee or not keeping enough for themselves. At best, a fund principal can attempt to predict the future value of the vertical slice and adjust the size of the slice accordingly. When transferring to a trust, clients can address this concern by making the transferor’s spouse a beneficiary of the trust so that assets can be distributed to the spouse, who may be willing to share them with the transferor.
8. Income tax issues. Income tax issues need to be carefully navigated, particularly when the transferring a vertical slice to an entity other than the grantor trust.
Generally, the issuance of carried interest to a fund principal in consideration of services to be provided, whether such interest is vested or unvested, won’t trigger taxable income, even without an IRC Section 83(b) election.17 However, if the carried interest is disposed of within two years of receipt, it could trigger taxable income, unless a Section 83(b) election is made,18 as there’s a legal assumption that it was issued in anticipation of a subsequent disposition. Because a gift or sale to a grantor trust isn’t considered to be a disposition for income tax purposes,19 this should only apply to a transfer made to a person or entity other than a grantor trust. Further, a “disposition” under the IRC doesn’t have to be taxable. For purposes of IRC Section 897 (part of the Foreign Investment in Real Property Tax Act), a “disposition” means a disposition for any purpose of the IRC, which includes gifts.20 Accordingly, it’s advisable to make a Section 83(b) election even though it may not seem to be required.
Further, recent legislation under IRC Section 1061 may cause gain on the sale (and possibly a gift) of carried interests within three years of receipt, treated as short-term capital gains as opposed to the usual holding period of more than one year for long-term capital gains treatment. The sale of a vertical slice including carried interest to a grantor trust shouldn’t be treated as a sale under this section because, again, it isn’t considered a sale for income tax purposes.
Avoid Unforeseen Gift Tax Liability
When transferring PE, hedge and VC fund interests, relying on the vertical slice exception to Section 2701 is fraught with complexity and uncertainty. It’s vital to carefully navigate the considerations discussed above or risk causing an unforeseen gift tax liability for your client and even malpractice.21
Endnotes
1. Internal Revenue Code Section 2701(b)(2)(A) and Treasury Regulations Section 25.2701-2(b)(5)(ii).
2. IRC Section 2701(b)(2)(B) and Treas. Regs. Section 25.2701-2(b)(5)(iii).
3. IRC Section 2701(a)(3).
4. IRC Section 2704(a)(4)(B)(i).
5. Treas. Regs. Section 25.2701-3(a)(2)(iii).
6. Treas. Regs. Section 25.2701-3(a)(2)(ii).
7. See also Treas. Regs. Section 25.2701-6 attribution rules, treating each principal as holding the actual general partnership (GP) interests through his ownership of the GP entity.
8. Carried interest, or “carry,” is sometime referred to as a “promote” or “incentive” interest.
9. If the principal also invests capital directly in the limited partnership fund as a limited partner (and not just through the GP entity), those capital interests must be taken into account when transferring a vertical slice.
10. Treas. Regs. Section 25.2701-1(c)(4).
11. IRC Section 2701(e)(2).
12. Treas. Regs. Section 25.2701-6(a)(4)(i).
13. Treas. Regs. Section 25.2701-6(a)(4)(ii)(C).
14. Treas. Regs. Section 25.2701-6(a)(5)(i).
15. Treas. Regs. Section 25.2701-6(a)(5)(ii).
16. Revenue Ruling 98-21.
17. Revenue Procedure 93-27 (as clarified by Rev. Proc. 2001-43).
18. Rev. Proc. 93-27.
19. Rev. Rul. 85-13.
20. Treas. Regs. Section 1.897-1(g).
21. See David A. Handler, Anna Salek and Angelo F. Tiesi, “Carry Derivatives: Using Your Carried Interest in Your Estate Plan,” Venture Capital Review, Issue 31 (2015).