Planning for Carried Interests & Avoiding Section 2701

Alternative investments in private equity and hedge funds have gained in popularity over the last two decades and have become a regular allocation of many investment portfolios. During this period, significant wealth has been generated and continues to be generated by the fund managers. There are some unique opportunities available to these fund managers and significant estate tax savings can be achieved with careful planning.

The fund managers generally are compensated with an annual management fee equal to 1-2% of the value of the fund. In addition, the fund managers typically receive a "capital interest" and a "carried interest" in the fund. The capital interest represents the money committed to the fund by the fund managers to be invested alongside the amounts committed by the investors in the fund. Generally, the fund managers are required to contribute 1-5% of the fund so as to have some of their own money at risk ("skin in the game"). The capital contributed by the investors and the fund managers is entitled to a preferred return (typically 6-8%). Once the investors receive back their original investment and the preferred return, any remaining profits are typically split 80% to the investors and 20% to the fund managers. This 20% interest to the fund managers is typically referred to as the carried interest. If the fund is unable to return to the investors their original contribution plus the preferred return, the carried interest will have no value. However, if the fund's performance is successful, the fund managers may enjoy significant appreciation in the value of their carried interest.

Since the investors are entitled to the preferred return, the carried interest may be perceived...