How carried interest transfers work in estate planning

Family equity valuation starts with the whole ownership picture

Special family equity valuation rules apply when an individual transfers corporate or partnership equity to family and, immediately afterward, the transferor or an applicable family member holds an applicable retained interest.

The subtraction method determines the gift by subtracting the value of family held applicable retained interests and other equity not transferred from the aggregate value of family held equity. A transfer for full consideration can still fall within these rules.

Different tests use different family groups

• The recipient family group includes the transferor’s spouse, lineal descendants of either spouse, and spouses of those descendants.
• The applicable family group for retained interests includes the transferor’s spouse, ancestors of either spouse, and spouses of those ancestors.
• Control is tested immediately before transfer using the transferor, applicable family members, and lineal descendants of either spouse’s parents.

Legal adoption counts the same as a blood relationship. Partnership control means holding at least 50% of capital or profits, or any general partner equity interest in a limited partnership.

Rights to fixed amount guaranteed payments under §707(c) are disregarded in the partnership control test.

Identify the actual retained rights

An extraordinary payment right receives zero value under these rules. It includes a put, call, conversion, compulsory liquidation, or similar right whose exercise or nonexercise affects the transferred interest’s value.

A distribution right in a controlled entity also receives zero value unless it is a qualified payment right.

Qualified payments include cumulative preferred dividends at a fixed rate, or other cumulative distributions at a fixed rate or fixed amount, payable at least annually. A distribution right covered by a qualified payment election also qualifies.

When a qualified payment right is combined with extraordinary payment rights, valuation assumes exercise of those extraordinary rights in the manner producing the lowest total value for all the rights.

That valuation uses consistent assumptions and considers the entity’s net worth, prospective earning power, and other relevant factors.

Distribution rights exclude rights attached to interests in the same class as, or a class subordinate to, the transferred interest. They also exclude extraordinary payment rights and the separately excluded categories below.

Mandatory payment rights, liquidation participation rights, fixed amount §707(c) guaranteed payment rights, and nonlapsing conversion rights are neither extraordinary payment rights nor distribution rights.

Test the proposed vertical slice across all applicable holdings

The proportionate transfer exception applies only to the extent the transfer proportionately reduces each equity class held, in the aggregate, by the transferor and all applicable family members immediately before transfer.

Testing only the manager’s holdings can miss other applicable family holdings. Ask your advisers to compare every class before and after the proposed transfer.

Check the separate market and class exceptions

Readily available quotations on an established securities market for the transferred interests remove the special family equity valuation rules. Such quotations for retained interests remove the retained interest valuation rules for those interests.

The same class or proportional class exception requires identical or proportional rights, subject to permitted nonlapsing differences. Permitted differences include voting rights and, for partnerships, management rights and limitations on liability.

Nonlapsing provisions needed to comply with partnership allocation requirements qualify as permitted differences. Rights lapsing under federal or state law are treated as nonlapsing unless Treasury specifies otherwise.

The partnership same class exception fails if the transferor or applicable family members can alter the recipient’s liability. These valuation exceptions do not establish contractual permission to transfer.

An agreement price does not automatically establish estate tax value

For transfer tax valuation, an option or agreement to acquire or use property below fair market value, or a restriction on sale or use, is disregarded unless all three requirements are met:

• It is a bona fide business arrangement.
• It is not a device to transfer property to the decedent’s family for less than full and adequate consideration in money or money’s worth.
• Its terms are comparable to similar arrangements entered into at arm’s length.

Bring any agreement price and transfer restriction to the valuation discussion rather than assuming the price controls.

Income tax treatment requires a separate review

An applicable partnership interest generally requires a connection to substantial services by the owner, a passthrough taxpayer, or a related person in an applicable trade or business. Regulatory exceptions must also be checked.

That business regularly, continuously, and substantially combines raising or returning capital with investing in, disposing of, identifying, or developing specified assets.

Specified assets include securities, commodities, rental or investment real estate, cash or cash equivalents, related options or derivatives, and partnership interests to the extent of their proportionate holdings of those assets.

The statutory service rule excludes an employee of another entity conducting a business outside that category when the employee provides services only to that other entity.

A partnership interest can include a financial instrument or contract whose value depends wholly or partly on partnership distributions, assets, or operations. The service connection and exceptions remain part of the test.

For a taxpayer holding one or more applicable partnership interests at any time during the taxable year, the statute requires this comparison:

1. Determine net long term capital gain with respect to those interests for the taxable year.
2. Recompute that gain under the statutory capital gain definitions, substituting three years for one year.
3. Treat any excess of the first amount over the second as short term capital gain, notwithstanding §83 or a §83(b) election.

A qualifying capital interest is excluded when capital participation is commensurate with capital contributed at receipt or with the interest’s value taxed under §83 at receipt or vesting.

The carry’s holding period alone does not resolve the treatment of each allocation.

The outright gift example has specific limits

The final regulation on related person transfers defines a transfer for that provision as a sale or exchange in which the owner recognizes gain.

Its example involves an individual who performed services in an applicable trade or business, held the interest for ten years, and gave the entire interest to a daughter with no associated debt.

That gift produces no gain under the related person transfer provision, but the interest remains an applicable partnership interest in the daughter’s hands. The example does not automatically resolve transfers involving debt or trusts.

Retained benefits can bring transferred property into the estate

Transferred property is included in the gross estate when the transferor retains possession, enjoyment, income rights, or power, alone or with another person, to designate who possesses or enjoys it, for a period described below.

The retained period must be for life, unascertainable without reference to death, or one that does not actually end before death. A bona fide sale for adequate and full consideration in money or money’s worth is excepted.

Ask your advisers to identify the rights you would keep, including rights described outside the assignment document.

Distribution rights, management, and contributions are separate questions

In Minnesota, for example, transferring an LLC transferable interest gives the recipient transferred distribution rights without itself giving management rights, subject to §322C.0504, and other states differ.

Under this Minnesota rule, the company need not recognize the recipient’s rights until it has notice of the transfer. A transfer violating an operating agreement restriction is ineffective as to a person who knew of that restriction at transfer.

In Minnesota, for example, death, disability, or inability to perform personally does not excuse an LLC contribution obligation, and other states differ.

At the company’s option, an unmade required contribution becomes a monetary obligation of the person or estate equal to the value of the unperformed part.

Under the Minnesota transfer rule, the transferor retains member rights other than transferred distribution rights and retains member duties and obligations, subject to §322C.0602(4)(ii).

A recipient becoming a member assumes the member’s obligations under §322C.0403 and §322C.0406, subdivision 3, known to the recipient when admitted.

Gather the contribution commitment, transfer restrictions, company notice, and any proposed release for review. This LLC example does not establish the rules for every fund entity.

Two related terms

An investor’s perspective on the economics of carry

This speaker describes the return they seek alongside an owner operator. Use that perspective to frame a discussion about the economic role of the interest you are considering transferring.

"we do believe the owner operator deserves the GP and deserves the biggest return so we're looking to get our return with carried interest somewhere in between we do bring a lot of value we do know how to own and operate we can help tremendously when it comes to that"

Common questions