The Valuation of Carried Interest and How it Can Impact Gift Tax Exposure
Carried interests in investment funds can have significant effects on valuation and estate planning strategies due to their performance-based contingent nature and due to nuances of the tax code.
Explore how carried interest works and how it can impact valuation and estate planning with the following insights.
How Does Carried Interest Work?
Membership in the general partner of an investment fund typically includes two components: a capital interest in the underlying fund and a carried interest.
The carried interest, or carry, represents the general partner’s share of profits, which are paid only after investors have received a certain return.
The payout to the general partner is contingent on the fund’s returns exceeding a specific hurdle rate. The payout structure is asymmetric, similar to an option. If the fund performs worse than the hurdle, the carried interest would have no value.
Conversely, if the fund is very successful, the carry can be worth a substantial amount.
Because the carry is based on performance, the fund’s underlying investments have a significant impact on the valuation result:
- Private equity funds typically invest in established businesses with more predictable cash flows and returns.
- Real estate funds can have recurring income and less potential upside.
- Hedge funds tend to have more complex investment strategies and shorter holding periods, combined with the possibility of investor redemptions.
- Venture capital funds are usually highly speculative, where many of the investments fail, but a few may experience very large gains.
A planning strategy involving a proportional share of all equity interests—a vertical slice—was developed to avoid Section 2701, which addresses the gift-tax value of transferred equity interests in family-controlled, privately held businesses or partnerships. The rule is intended to prevent manipulation of asset values for gift and estate tax purposes during intra-family transfers.
Why Does the Fund’s Life Cycle Matter?
The stage of the fund’s life cycle is another key factor.
Early Stage
In the initial stages of the fund’s formation, the uncertainty of return is at its highest and the value of the carry is highly speculative and typically low, whereas the value of the carry can increase substantially if the fund succeeds. This difference in value over time allows individuals to transfer significant value to beneficiaries and meaningfully reduce gift and estate tax exposure while preserving most of their gift and estate tax exemption for other assets.
The carried interest component would be at its lowest value due to the high degree of uncertainty, as the capital needs to be obtained, invested, and the investments need to perform. Because at inception or any time prior to the Fund’s capital calls, the limited partner component—the capital component—of the interest would typically have zero dollar value, combined with the carried interest at this stage would result in a very low value for the total vertical slice that is gifted.
Mid-Life: Holding Period
During this period the fund has invested most of the committed capital, but significant uncertainty remains as to when and if gains will materialize.
Appraisers have significant latitude in valuing carried interests for gift tax purposes as long as it is:
- Based on current facts and circumstances
- Supported by a qualified appraisal
- Grounded in reasonable and defensible assumptions
The selected valuation method depends on the factors mentioned above and can include a Monte Carlo, or option pricing model, scenario-based models, or more traditional discounted cash flow models.
Late Stage: Harvesting Period
At this stage the fund is in the process of exiting investment and the profits are more predictable. The appraiser will have more concrete data on which to base their forecasts, such as the current net asset value (NAV) and unrealized gains. Because more is known in terms of investment returns and liquation timelines at this stage, appraisers have less latitude in the valuation.
However, there are still means to address the client's needs and circumstances.
A Monte Carlo simulation is used to model the probability of different outcomes in a process that can’t easily be predicted due to the intervention of random variables. It’s a technique used to understand the impact of risk and uncertainty.
We’re Here to Help
To learn more about carried interest, its valuation, and how to leverage it in estate planning, contact your firm professional.