Carried Interest - How to Use it for Charitable ImpactSubmitted by American Endowment Foundation on September 11th, 2017
By Rachelle Roberts, CPA, MSA, Wealth Transfer Specialist, Plante Moran - Chicago, Guest Columnist
Almost every private equity or venture capital fund provides a “carried interest” to the fund’s investment managers (“Manager(s)”). The carried interest is a share in the profits of the fund granted to the Managers once the fund’s investors have achieved a certain base level of return on their cumulative investment in the fund. Under current income tax laws, the return on a carried interest will be taxed at capital gains rates. In addition to the existing income tax advantages, a carried interest also presents interesting opportunities for charitable planning.
The investors are generally paid through a “Class A” interest that will be structured to give the investors 100% of all net distributable cash until the investors have received a return of all invested cash plus a designated return (the “hurdle rate”). The hurdle rate is generally a specified internal rate of return (IRR) on invested funds.
The calculation of IRR on the Class A Interest often varies from fund to fund. In addition to the Class A interests, most funds will have a “Class B” interest that represents the “carried interest.” The Managers often own the Class B carried interest or shares this interest with key employees or agents. The Class B interest allows the holders of this interest to participate in the upside of the fund once the Class A interests have realized the hurdle rate.
For example, a fund might provide that all funds are distributed to the Class A holders until the Class A holders received a cumulative IRR of 8%, at which point the Class B holders will receive 100% of all distributions until the Class B holders have received 20% of all distributions. Thereafter, all distributions shall be divided 80% to the Class A interests and 20% to the Class B interests. These structures are referred to as “waterfalls” in that one pool is filled up before the excess spills into the next pool.
Managers who own Class B carried interest have the opportunity to take advantage of charitable deductions through a donor advised fund (DAF). The donor receives an income tax deduction for the fair market value of the Class B carried interest donated to the donor advised fund, subject to AGI (adjusted gross income) limitations. If the charitable contribution deduction is not fully used in the initial year, it can be carried over for an additional five years.
First, the Manager acquires a valuation of the Class B carried interest to determine its fair market value. Second, the Manager donates a portion of the Class B carried interest to a donor advised fund. Third, the Manager’s personal income tax return reports the transaction with the valuation. The Manager benefits from an income tax charitable deduction for the fair market value of the donated Class B carried interest (subject to AGI limitations). The donated Class B carried interest provides distributions to the donor advised fund after the hurdle rate is achieved.
For example, assume that a Manager owns all of the Class B carried interest in the fund from the first example above. The Manager donates half of the Class B carried interest to a donor advised fund. The valuation and transaction reported on the Manager’s personal income tax return provides the Manager with a charitable deduction in the current tax year. If the cumulative IRR remains below the 8% hurdle rate, then the fund will not make distributions to the DAF. However, if the cumulative IRR is higher than the 8% hurdle rate, then the donor advised fund will receive a distribution.
In structuring a carried interest donation, a proper third-party valuation is critical. The valuation report must be done by a valuation firm with extensive experience in private equity. Since at the time of the creation of the derivative, little, if any, of the fund assets will have been deployed, the firm must evaluate the anticipated return of the fund based on data of comparable funds of similar size and focus, as well as factor in the variability of return. This concept has not been tested by the IRS and like many novel strategies carries with it significant audit risk.
With proper planning, carried interests can be ideal assets for use in charitable planning. This strategy may be particularly appealing to those clients who have a taxable estate, have already implemented other forms of wealth transfer, and are looking for a unique way to fulfill both philanthropic and income tax planning goals. It is also important to consult with tax advisors for proper tax advice. All investment returns and assumptions used in this material are for illustration purposes only.
At American Endowment Foundation, we look forward to discussing how DAFs can play a role in making a charitable impact. Contact us or call at 1-888-660-4508 to learn more.