Planning Helps PE Pros Save on Taxes

Personal planning for members of a fund can provide significant tax savings and creditor protection

As private equity or venture capital fund principals and managing partners look to roll out a new fund, in addition to reconciling general fund formation issues, they should consider the personal-planning opportunities available to each principal.

Personal planning should not be overlooked during the fund formation process. With appropriate structuring, principals may generate considerable tax savings and creditor protection without, in many cases, entirely losing their access to the carried interest performance. This type of personal tax planning is nuanced and complicated, and requires professional advisers who are acutely aware of the structural and tax issues associated with such strategies.

As a result of the recently enacted American Taxpayer Relief Act of 2012 (ATRA), the long-term capital gains tax has reset to its pre-2001 rate of 20 percent for taxable income of $450,000 for joint filers and $400,000 for single filers in 2013. Beginning in 2013, the Patient Protection and Affordable Care Act also imposes a Medicare surtax of 3.8 percent on net investment income (e.g., capital gain, including carried interests) for taxable income of $250,000 for joint filers and $200,000 for single filers in 2013. Further, ATRA sustained the applicable exemption amounts for federal estate, gift and generation-skipping transfer (GST) tax at $5 million per person (indexed for inflation) but increased the applicable tax rates to 45 percent from 35 percent. In 2013, the exemption amount for each tax is $5.25 million. What is absent from ATRA is a re-characterization of carried interest that will alter its current capital gain treatment and subject it to ordinary income tax rates - although debate over this issue is likely to continue.

Optimizing tax savings often involves implmenting one or more strategies as part of the fund structuring. Such strategies are focused on the transfer of some or all of a principal's carried interest allocation in a fund to an irrevocable trust for the benefit of the principal's children and further descendants. Having the economic performance of the carried interest inure to the trust, the assets of which will not be subject to estate tax at the principal's death (or in many cases for generations to come), preserves the full return of the carried interest for the principal's family. Under current tax law, it is generally advisable that a principal transfer the same portion of his or her capital interest in the fund (the proportionate amount commonly referred to as a "vertical slice"). Most frequently, this is accomplished by the principal transferring the same proportion of all his or her economic interests in the general partner entity of the fund. The most common methods for the transfer of a vertical slice in a fund are outright gifts and financed sales to irrevocable trusts.