30 January 2009

Economic Turmoil Creates Unprecedented Planning Opportunities for Principals of Investment Funds


David A. Stein
Partner | US

Within the storm clouds of volatility and economic uncertainty dominating our global financial climate lies an unexpected silver lining: a tremendous opportunity for US principals of investment funds (including US citizens abroad) to implement tax-efficient wealth transfer strategies.

Under current law, an individual may make tax-free gifts of up to $1,000,000 during his or her lifetime. At death, an individual can pass up to $3,500,000, less any lifetime gifts, tax free. Transfers beyond these limits are taxed at a rate of 45%, plus any state taxes. While these exemptions are ample for many people, individuals with more significant levels of net worth must structure their estate plans very carefully if they wish to avoid significant exposure to US estate tax. For those with significant illiquid assets, the issues are magnified as assets may need to be sold within 9 months of death to fund an estate tax bill.

Key Planning Elements are Aligned

While many, if not most, people view the current economic turmoil as a cause for hunkering down and not making any substantial moves, the savviest individuals are capitalizing on an unusual alignment of key planning factors. Each of these elements independently would normally create planning opportunities, but taken together, they make a truly compelling case that this is perhaps the ideal time to pursue a wealth transfer plan. These key factors are:

- Low Valuations. Many assets – particularly those related to the financial services sector – are (hopefully) at or near lows.

- High Volatility. Extremely high levels of market volatility not only serve to help keep appraised values low (particularly for assets valued based on discounted future cash flows) but also increase the likelihood that estate planning transactions will prove effective and increase the magnitude of the benefit they are likely to achieve.

- Low Interest Rates. In order for most transfer planning transactions (including the one discussed below) to be successful, the transferred assets must exceed certain “hurdle” rates established monthly by the IRS. Because these rates are tied to market interest rates, they currently are extremely low – 2.06% for January 2009.

Advantages for Fund Principals

Because of the illiquid and speculative nature of interests held by many fund principals in their fund management vehicles – particularly “carried interest”-type participations, but also including rights in asset-based management fees – there are significant valuation discounts available in almost any economic climate, but all the more so in the current environment for the reasons discussed above. While one can plan for management company or general partner interests at any stage of a fund’s life, planning transactions are particularly potent when implemented at the inception of a fund platform or even at the inception of a new fund on an existing platform – in short, situations where valuations are at their most speculative and the potential for future growth is the greatest. Situations of this sort create tremendous wealth transfer planning opportunities not generally available to other wealthy individuals whose assets are more liquid or susceptible to precise valuation.

Trust Planning

Depending upon the facts of each situation and the client’s objectives, there are many different ways to pursue wealth transfer planning, each of which has different benefits and drawbacks. A typical planning transaction might look like the following:

- Principal creates a trust for the benefit of children and future generations.

- Principal makes an initial “seed” gift to the trust equal to 10% of the total value ultimately to be transferred.

- Principal sells to the trust the remaining 90% interest in exchange for a promissory note from the trust bearing interest at the IRS rate mentioned above (2.06% for January 2009).

- Using income received from the acquired fund interests, the trust pays down principal and interest on the note over time, retaining any excess profits.

If properly structured, a transaction such as this can provide a variety of benefits:

- The transferred fund interests remains outside the US estate tax system at the principal’s death, and potentially for multiple generations.

- The gift/loan structure allows larger transfers while remaining below gift tax limitations and takes advantage of the current low interest rates.

- No income tax is triggered on the transfers.

- Trusts can be structured so that the principal continues to pay income tax on the trust’s income, enabling the trust assets to compound tax-free.

- Trusts can provide additional asset protection from divorcing spouses and other creditors.

Potential Pitfalls

Given the complexity of the rules in this area, a significant number of traps await the unwary, several of which can have serious consequences. Improperly structured trusts and other entities may result in trust assets being subject to US estate tax at the principal’s death, thus undoing the intended benefits of the transfer planning and wasting transaction costs. At the more extreme level, technical failures in the planning structure could result in substantial current income tax and gift tax liability. When dealing with complex fund structures, fund principals should pay particular attention to technical rules that may require the transfer of a “vertical slice” of the principal’s fund interests (essentially, a proportionate piece of each type of interest owned by the principal, directly or indirectly, in the underlying fund). Anyone engaging in this type of planning should engage counsel with a sophisticated understanding of not only the relevant tax rules but also the intricacies of fund structures and the various economic rights and interests that principals may own.

David A. Stein Partner | New Haven, New York, San Francisco

Category: Article