By Alex Smith, Partner and Managing Director; and Sarah Simon, Wealth Strategist and Wealth Advisor with Cresset
Carried interest represents a powerful financial planning tool for private equity partners. With the Biden administration now in office and the likelihood of new tax legislation on the horizon, private equity partners should consider planning with their share of future profits, whether that be new fund interest at discounted valuations or seasoned positions with embedded gains. Plus, with the possibility of a significantly lower estate tax exemption, carried interest is one of the more compelling assets to gift early, given its growth potential and propensity for discounted valuations during new fund formation.
Of course, it’s prudent to plan in advance. The following are five strategies to help you make the most of this powerful asset:
1. Donor-Advised Funds Capable of Holding Appreciated Private Assets
A donor-advised fund (DAF) is essentially a charitable investment account that exists for the sole purpose of supporting the causes you care about. When you contribute cash, securities, or other assets to a DAF, you are generally eligible to take an immediate tax deduction. Those funds can then be invested for tax-free growth and distributed to charitable causes in the coming years.
Private equity partners who have carried interest that has appreciated significantly may want to consider gifting a portion of their carry to a DAF in exchange for a charitable deduction at its fair market value. Alternatively, partners can retain the interest and make cash donations in high-income tax years to offset gains. Both types of contributions can reduce your tax bill while providing your family with a way to support the causes that are important to you.
2. SLATs
Spousal Lifetime Access Trusts (SLATs) are a flexible and relatively inexpensive estate planning tool for married couples wishing to shelter assets from future tax liability. With this strategy, assets are moved into a trust and out of the grantor spouse’s name and taxable estate. The trust’s assets may be accessed by the beneficiary spouse (and other designated beneficiaries) if needed while also sheltering them from creditors.
By funding a SLAT with newly granted carried interest, private equity partners can take an asset that may have a relatively low valuation and remove it from their taxable estate, where its potential growth can be sheltered from future estate tax.
3. NING Trusts
A Nevada (or Delaware) Incomplete-Gift Non-Grantor Trust, or NING (or DING) Trust is an estate planning tool used to eliminate state income tax liability while also providing asset protection. These trusts are particularly effective for individuals with significant income or capital gains who reside in high-income-tax-rate jurisdictions. For private equity partners, carried interest can be an ideal asset to contribute to a NING.
By transferring assets to a NING Trust, the grantor (i.e., creator of the trust) also transfers the income tax liability of the assets to the trust. After the transfer, the grantor is no longer responsible for the income tax generated by those assets. In addition, because Nevada does not impose an income tax, assets in a NING Trust should avoid state income tax altogether.
4. Dynasty Trusts
A dynasty trust is a trust that holds assets for multiple generations without the requirement to terminate on a set date. When drafted properly, a dynasty trust can allow for generational wealth transfer with minimal exposure to the federal estate tax, federal gift tax, and the generation-skipping tax (GST).
As such, private equity partners can explore funding a dynasty trust with carried interest that is expected to appreciate significantly. In addition, private equity partners who live in high-state-income-tax jurisdictions may want to consider setting up a dynasty trust in a state like Nevada or South Dakota to take advantage of the strong asset protection laws, as well as the absence of state income tax.
5. PPLI
Private Placement Life Insurance (PPLI) provides a tax-free insurance wrapper with generally greater access and choice in investment strategy than retail life insurance. More specifically, PPLI is a type of Variable Universal Life (VUL) insurance that allows investments contained within the policy to grow with the income and capital gains taxes deferred. Ultimately, those deferred gains can be received income-tax free at the passing of the insured in the form of a death benefit. For private equity partners, PPLI can be funded with cash distributions from carried interest as a way to invest those proceeds in a tax-efficient manner.
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