No one enjoys paying taxes, especially unanticipated taxes. As a result, the constantly shifting and unpredictable tax landscape in recent years creates an unsavory state of affairs, particularly for hedge fund professionals.
Granted, on Jan. 1, 2013, Congress set some certainty into the transfer tax laws, making permanent a $5 million estate, gift and generation-skipping transfer (GST) tax exemption.1 For hedge fund professionals, this certainty only solved part of the equation. On the income tax side, there remains the pervasive, looming threat of legislation to characterize carried interest income as ordinary, rather than capital gain.2 Perhaps even more troublesome for these taxpayers is the 2017 deadline for mandatory recognition of income on certain offshore deferred compensation arrangements under Internal Revenue Code Section 457A. IRC Section 457A requires income recognition no later than 2017 on certain pre-2009 offshore deferred compensation arrangements, regardless of whether such income has actually been received by the fund principal, unless the arrangement continues to be subject to a substantial risk of forfeiture.3 Because many of these arrangements were traditionally used to defer tens of millions—if not hundreds of millions—of dollars from current income taxation, 2017 presents a substantial liquidity issue. For those professionals whose wealth is tied up in their funds, payment of the looming income tax liability is more than just unsavory—it’s a major source of financial and emotional stress.
One way to offset (or at least reduce) the Section 457A income tax bite is to generate significant income tax deductions. For those who are charitably inclined, an obvious solution is the creation of a charitable lead annuity trust (CLAT) that’s structured as a grantor trust for income tax purposes. A grantor CLAT achieves philanthropic goals by providing an up-front or “lead” stream of annuity payments to charity, achieves income tax goals by generating a corresponding current income tax charitable deduction and achieves transfer tax goals by passing all assets remaining after the annuity term to the remainder beneficiaries, free of gift or estate tax. Stated differently, a CLAT funded with assets that appreciate significantly during the charitable term effectively shifts future appreciation to the non-charitable remainder beneficiaries gift tax-free, while also generating a current income tax deduction in proportion to the value of the charitable annuity stream.
A major challenge is that a fund principal will typically have assets invested in his fund or other illiquid investments. As a result, he may not have sufficient liquid assets available to fund a sufficient cash gift into a CLAT so as to generate a meaningful charitable deduction in 2017. Instead, many fund principals may be forced to consider planning with interests in the fund itself (whether interests in the general partner (GP) carry vehicle (the GP carry vehicle) or limited partner (LP) interests).
If the CLAT is funded with carried interest in the grantor’s fund, there are thorny valuation rules that may result in a deemed gift under IRC Section 2701. These rules must be navigated carefully. In many cases, they would seemingly prevent planning with interests in the GP carry vehicle. Often, they may prevent the fund principal’s spouse or descendants from being named as the remainder beneficiaries of a grantor CLAT funded with carried interest in the grantor’s fund. In addition to Section 2701, fund principals will have to navigate certain private foundation (PF) rules that apply.
We’ll explore the concept of the “rising tide carry CLAT”—designed specifically to be funded with carried interests in a private investment partnership (a fund) without triggering those deemed gift rules under Section 2701.
The Rising Tide Carry CLAT
Typically, a primary objective of estate-planning transactions is the provision and preservation of family wealth in a tax-efficient manner for the benefit of a principal’s spouse and current and future descendants. Nonetheless, this is rarely the sole objective. In fact, many fund principals who represent first generation wealth are conflicted about wanting to provide for descendants, while not showering them with so much wealth so as to destroy their sense of responsibility and work ethic. Additionally, the principal may desire to provide support to extended family members, such as parents, siblings and perhaps nieces and nephews. In this way, the “rising tide” of the family’s wealth serves to “lift all boats.” Indeed, for many principals who’ve created significant wealth as a result of a combination of hard work, smarts (and yes, some luck), other family members may expect the golden child to share the largess with the broader family. Stacked yet on top of this, many fund principals are looking to weave philanthropy into their planning.
A CLAT with a remainder trust for the benefit of the principal’s parents, siblings, nieces and nephews can effectively create a broader family bank that provides support to extended or more remote family members (not including the donor’s spouse or lineal descendants) in a transfer tax-efficient manner, while also serving philanthropic endeavors. In addition, the beneficiaries of the remainder trust can be granted broad limited powers of appointment (POAs) that can be exercised, or not exercised, in the future, in whole or in part, for the benefit of others in a manner that shouldn’t implicate the thorny deemed gift tax rules under Section 2701.
Thus, transferring an interest in the GP carry vehicle of a fund into a rising tide carry CLAT can effectively achieve the multiple goals of:
1) generating a current income tax deduction to offset some or all of the year 2017 exposure,
2) giving to charities, and
3) providing for the potential transfer tax-free shift of future appreciation to extended family members beyond the fund principal’s spouse and descendants.
At the same time, it avoids a liquidity crisis by making use, instead, of illiquid assets, without running afoul of either the thorny deemed gift rules under Section 2701 or the rules relating to PFs.
After the annuity term, the trust could grant some or all of the beneficiaries, or perhaps a third party, broad special POAs. Provided that the trustee has absolute discretion to make or withhold distributions, arguably the lifetime exercise of that power shouldn’t be considered a taxable gift under traditional gift tax principles or Section 2701.4 It’s important to evaluate the risk of a gift occurring on the exercise by a beneficiary of a special POA based on the specific facts and circumstances before any decision to exercise such power is made.5 Treasury Regulations Section 25.2701-1(b)(3)(iii) explicitly states that a “transfer” doesn’t include a transfer resulting from “a shift of rights occurring upon the release, exercise, or lapse of a power of appointment other than a general power of appointment described in section 2514, except to the extent the release, exercise, or lapse would otherwise be a transfer under chapter 12.”6 In addition, such an exercise of a non-general POA shouldn’t change the grantor of the trust for income tax purposes.7
Example: Fred Fund Principal is one of the founders of a Hedge Fund (the fund) and is one of the partners of the GP carry vehicle, which is the GP of the fund. The fund is structured as a “2 and 20,” whereby a management company receives a management fee of 2 percent of the fund’s assets under management annually, and the GP carry vehicle receives an allocation of 20 percent of the profits (the carried interest). A valuation has determined that the fair market value (FMV) of Fred’s share of the carried interest in the GP carry vehicle is $10 million. Fred also directly owns $20 million of limited partnership interests in the fund. Fred is entitled to receive deferred fees from the fund’s offshore feeder in the amount of $25 million that he’ll need to recognize as taxable income no later than Dec. 31, 2017 under Section 457A, whether or not he actually receives those fees by that time. In 2017, Fred creates a 15-year zeroed-out CLAT, which is structured as a grantor trust as to him for income tax purposes. The lead annuity payments are payable only to public charities. At the end of the CLAT term, the remainder passes into a discretionary trust for the benefit of a class of people consisting of Fred’s parents, his siblings, nieces and nephews (the extended family members)—Fred’s spouse and lineal descendants aren’t beneficiaries of the remainder trust. An unrelated powerholder is also given a limited POA to appoint trust assets to a broad class of individuals, and Fred’s parents are granted testamentary limited POAs. Fred makes a gift of one-half of his interest in the GP carry vehicle, valued at $5 million (he doesn’t transfer any of his limited partnership interest in the fund). Fred is eligible for a charitable income tax deduction and a charitable gift tax deduction equal to the present value of the lead interest or $5 million. Due to the strong performance of the fund and the significant appreciation potential inherent in the carried interest, the gifted interest appreciates significantly over the first five years of the CLAT term, from $5 million to $20 million, at which point the CLAT’s interest in the GP carry vehicle is redeemed; the CLAT reinvests the $20 million redemption proceeds in other investments for the remaining balance of the CLAT annuity term in a manner so as to satisfy the remaining charitable annuity payments and continue to grow the significant pool of funds received from the redemption of the interest in the GP carry vehicle. At the end of the CLAT term, the remaining balance passes into the remainder trust for the benefit of the extended family members and provides a source of support for those family members who are important to Fred.
So far, so good, right? Based on the foregoing, a gift of a fund principal’s interest in the GP carry vehicle into a grantor CLAT looks like the way to go.
Before diving in, however, we need to recognize the risks that go along with a structure like this. From a tax perspective, there are two primary types: (1) valuation risks, and (2) compliance risks arising from the charitable nature of the trust. The valuation risk isn’t the typical, “it’s worth more than I thought it was” risk. Instead, there remains the risk that the draconian valuation rules applicable to intra-family transfers of subordinate equity interests under Section 2701 may still apply. The compliance risks, on the other hand, relate to the fact that a CLAT is treated as a PF for purposes of the strict standards under the self-dealing, excess business holdings and jeopardizing investment8 rules.
As a preliminary matter, charitable planning relies on obtaining a full FMV deduction for the property contributed to the CLAT. Whether the donor is allowed an income tax deduction equal to FMV (and not cost basis) will depend on the type of property contributed and the permitted charitable annuitants of the CLAT. In addition, deductibility can also be limited based on the donor’s adjusted gross income (AGI). Therefore, pay attention to the donor’s individual situation and the impact on the charitable deduction before funding the CLAT.
The Charitable Deduction
Under IRC Section 170, certain contributions to charitable organizations may be deductible for income tax purposes. However, contributions to charitable lead trusts aren’t treated the same as contributions directly to charitable organizations. To obtain an income tax deduction for a contribution to a CLAT, the donor must be treated as the owner of the trust property for income tax purposes under the grantor trust rules9—meaning the CLAT must be a grantor trust. This means the donor will continue to report the CLAT’s income, gain, deductions and losses on his personal income tax return for the term of the CLAT (a grantor CLAT).
In calculating the income tax deduction for a contribution to a grantor CLAT, the first step is to determine the portion of that contribution that’s deemed to be a contribution to charity. That portion is equal to the actuarial present value of the income interest in the CLAT (the annuity stream) divided by the FMV of the assets contributed to the CLAT. For example, in today’s low interest rate environment, assuming an IRC Section 7520 rate of 1.4 percent, the annuity interest in a CLAT that will distribute annuity payments equal to 5.768 percent of the initial trust asset over a term of 20 years has a present value equal to 100 percent of the CLAT’s initial asset value.10 So, 100 percent of a contribution of assets to such a CLAT is treated as a charitable contribution.11 The next step is to determine how much of that charitable contribution the grantor CLAT’s settlor may deduct for income tax purposes. To obtain the income tax charitable deduction, a valuation appraisal by a qualified appraiser will be necessary as required under Section 170.
In calculating the income tax deduction, the reduction rules reduce the contribution by the amount the settlor would have recognized as ordinary income or short-term capital gains if the settlor had sold the assets immediately before making the charitable contribution.12 These rules effectively limit the contribution to the settlor’s basis for all contributions other than cash or long-term capital gains (LTCG) property.13 Assuming the carried interest has been owned for at least 12 months, that interest is likely to qualify as LTCG property, so this first reduction rule may not have an effect.
Next, Section 170 provides that in the case of a contribution of LTCG property to a charity that’s a PF (other than an operating foundation or pass-through foundation), the deduction is limited to the donor’s basis unless the property is publicly traded securities.14 The carried interest is almost certainly not publicly traded, so this rule may motivate the settlor to select annuity beneficiaries for the CLAT that are publicly supported charities under Sections 170(b)(1)(A)(i) through (vi) or 509(a)(2) or (3), private operating foundations under IRC Section 4942(j)(3), private pass-through foundations under Section 170(b)(1)(F)(ii) or pooled income funds under Section 170(b)(1)(F)(iii). It’s important to remember that if one of the annuity beneficiaries of the CLAT is a PF (private operating foundations, pass-through foundations and pooled income funds excepted) or the annuity beneficiary could be changed to an organization that’s a PF, the charitable gift will be treated as made to a PF, and the income tax deduction will be calculated based on the settlor’s basis in the carried interest.
Next, the percentage limitation rules limit the income tax deduction to a percentage of the donor’s AGI.15 The percentage depends on the nature of the contributed asset and the nature of the recipient charity. In the case of a non-cash contribution, the percentage limitation is 30 percent if the recipient charity will be a public charity and 20 percent if the recipient charity will be a PF.16 Any unused amount over the AGI limitation can be carried forward up to five years. In addition, the limit on itemized deductions (known as the “Pease limitation”), revived by the recent tax legislation, may reduce the available deduction.17
Another potential risk to deductibility is that, in general, no income or gift tax deduction is allowed with respect to contribution of a split interest in property.18 A split interest is an interest of less than the donor’s entire interest in an asset.19 The split interest created by the CLAT itself, when the annuity interest passes to charity and the remainder interest will pass to family members, is an exception to the split-interest rule,20 but an issue may remain if the settlor funds the CLAT with a split interest in a given asset. The split-interest rule doesn’t apply to an undivided fractional portion of the donor’s entire interest, meaning a fraction or percentage of each and every substantial interest or right owned by the donor in such property.21 This could be an issue in the context of a closely held business interest if the donor retains an interest over the transferred property. An analysis of the entity’s operating agreement is appropriate to consider the potential application of the partial interest rules so as to avoid transferring “less than a donor’s entire interest” in property and risk not qualifying for the charitable deduction. This, of course, must be carefully considered based on the facts and circumstances of a given transaction. In the context of the transfer of a percentage interest in the GP of a fund, whereby the transferor retains his limited partnership interest in the fund, it would appear that this transfer shouldn’t constitute the transfer of a partial interest in an asset, but rather the transfer of separate and undivided interest in property. 22
If the CLAT becomes a non-grantor trust during the lead term because of the donor’s death or any other reason, a portion of the up-front income tax deduction is recaptured in an amount equal to the charitable deduction initially allowed, less the discounted value of all payments actually paid to charity.23 If the CLAT becomes a non-grantor trust, the CLAT becomes a taxpaying trust. In calculating the CLAT’s taxable income, the CLAT’s distributions to charity will be eligible for an income tax deduction under IRC Section 642(c); however, the deduction available under Section 642(c) may be limited if the trust has unrelated business income.24
A CLAT also carries an estate tax inclusion risk for the donor if he retains powers over any interests in the CLAT.25 As a result, assets distributed from the CLAT should be segregated from the recipient’s other funds if the donor has any involvement with the recipient (for example, as a board member of the recipient charity).26
Heads or Tails—I Win
Because a grantor CLAT provides both a current income tax deduction and a means to pass the remaining assets at the end of the charitable annuity term gift tax-free, there are relative benefits and costs to a higher valuation, as well as a lower valuation, of the gifted GP carry vehicle interest. The value of an interest in a closely held entity, such as the GP carry vehicle of a fund, isn’t an exact science, thus resulting in inherent valuation uncertainty. Regardless of the determination of value of the transferred interest, this structure provides a potential benefit.
Of course, from an income tax charitable deduction standpoint, a higher value of the transferred interest will be helpful, as it will generate a larger income tax deduction; this may be especially helpful in the case of a fund principal who has significant deferred compensation to offset. In addition, if valuation is higher than the principal can use in the year of the gift, the unused deduction can be carried forward five years and applied against future income. On the flip side, a lower valuation would result in a limited charitable deduction. From a gift tax standpoint, the valuation of the GP carry vehicle interest is somewhat neutral, in that the gift will typically be structured to be “zeroed out” so that the charitable lead annuity interest will equal the value of the gifted interest. Thus, funding won’t trigger gift tax. Nevertheless, a higher valuation of the interest disadvantages the non-charitable remainder beneficiaries in that a larger annuity will cannibalize more of the CLAT during the annuity term (though this may be in line with the settlor’s philanthropic goals). In contrast, while a lower valuation may be less beneficial from a charitable income tax deduction standpoint, it would reduce charitable annuity payments and thus increase assets passing gift tax-free to remainder beneficiaries at the end of the charitable annuity term.
Because of the competing nature of the income tax deduction and the gift tax-free transfer of the remainder interest, in some sense valuation becomes irrelevant—so long as it’s consistently determined for income and gift tax purposes. A lower value for income tax deduction purposes, while resulting in a smaller income tax deduction, will have more gift tax efficiency, and vice versa, thus in a sense achieving a win-win situation.
Variations on a Theme
Instead of gifting only a percentage interest in the GP carry vehicle interest to a grantor CLAT, a so-called “vertical slice” gift of the GP and LP interests might be considered as an alternative. Such a gift will still achieve the goals of generating an income tax deduction, fulfilling philanthropic objectives and providing a structure to benefit broader family members in a gift tax-free efficient manner. Additionally, because this approach would rely on a different exception to Section 2701, such a CLAT could also have the fund principal’s spouse or descendants as the remainder beneficiaries (which may not be the case for the rising tide carry CLAT).
The Risks Under Section 2701
The starting point for valuing any gift is generally the FMV of the gifted interest, meaning, “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.”27 The concern in the context of a private investment partnership, such as a hedge fund, is that the alternative, harsher valuation rules of Section 2701 may apply. Unfortunately, the scarcity of case law results in a state of uncertainty—and disagreement—among highly respected practitioners.28 As a result, many favor a more conservative approach, often going to great lengths to avoid application of Section 2701. Under certain circumstances, the rising tide carry CLAT steers clear of Section 2701, without jumping through hoops to do so.
With respect to gifts of carried interests (which is essentially a special profits allocation) in funds, the difficulty—and the risk—lies in the unexplored chasm between what’s clearly safe (that is, acceptable in the eyes of the IRS as not resulting in unforeseen tax liability), and what’s clearly foul (that is, potentially triggering a deemed gift under Section 2701). Carried interests in investment funds, as a major source of wealth, have evolved so quickly that case law hasn’t kept pace. As a result, practitioners struggle to dissect the gift tax consequences of transfers of fund interests in a high stakes environment against the potentially severe provisions of Section 2701 with a paucity of guidance. It’s not exactly a lawyer’s dream come true.
It’s therefore important to understand: (1) when Section 2701 may apply in the fund context, (2) why it shouldn’t apply to a rising tide carry CLAT, and (3) for those clients whose objectives favor keeping the property in trust for their own descendants, the well-reasoned arguments suggesting that Section 2701 shouldn’t apply to transfers of general or limited partnership interests in a fund.
Subject to certain exceptions, a transfer of an equity interest in a non-publicly traded entity to the transferor’s spouse, a descendant or the spouse of a descendant (a member of the family) will be valued under Sec-
tion 2701 if, after the transfer, the transferor, his spouse, an ancestor of the transferor or his spouse or the spouse of any such ancestor (an applicable family member) still holds a distribution right in a controlled entity or an extraordinary payment right, which is a liquidation, put, call or conversion right or similar right, the exercise or non-exercise of which affects the value of the transferred interest (either is an applicable retained interest), and the right so held is neither of the same class as, subordinate nor proportional to the transferred interest.
To elaborate on some of these defined terms, an “applicable retained interest” is an equity interest that carries an economic right to share (or not to share) in the growth of the entity. There are two types of applicable retained interests: (1) distribution rights,29 if and only if the entity is controlled by (a) the transferor, or (b) applicable family members and lineal descendants of the parents of the transferor and/or his spouse (a controlled entity);30 or (2) liquidation, put, call or conversion rights31 (extraordinary payment rights).32 To complicate matters, Section 2701 has a complex set of multiple attribution rules and tie-breaker rules, a discussion of which is beyond the scope of this article, allocating interests held in entities, estates and trusts among the owners, beneficiaries and even the grantor, generally in a manner that attributes senior interests to a senior generation and junior interests to a junior generation (thus pulling many transactions into the web of Section 2701).
A partnership is controlled if, immediately before the transfer, the transferor and applicable family members hold greater than 50 percent of the capital or profits interest (without regard to any right to a guaranteed payment of a fixed amount under IRC Section 707(c)).33 For this purpose alone, “applicable family member” is defined to include not only the senior generation family members, but also lineal descendants of any parent of the transferor or his spouse.34 Thus, the section casts a wide net in determining whether an entity is controlled. In addition, in the case of a limited partnership—which happens to be the most common fund structure—control means holding any interest “as a general partner.”35 Whether the transferor may hold an interest in a corporate GP without being treated as holding an interest as a GP is a question that must be considered when planning around Section 2701.36 With regard to a limited liability company, it could be argued that a member-manager shouldn’t be treated as holding an interest as a GP, although it isn’t clear.37
If Section 2701 applies, then the value of any transferred interest is determined for gift tax purposes by the subtraction method. Under this method, the value of all family-held senior equity interests and applicable retained interests are subtracted from the FMV of all family held interests before the transfer, and the remaining value is allocated among the transferred interest.38 Critically, the distribution right associated with the applicable retained interest is treated as having no value.39
Thus, the pivotal issue is whether the carried interest is a senior or junior equity interest. Some commentators believe that, by definition, the carried interest in a fund is a junior equity interest because LPs are generally entitled to a return of capital (plus some hurdle rate) before the GPs can begin to receive the profits (carried) interest.40 If this is true, and if a principal funds a CLAT for the benefit of his spouse and children with carried interest, then Section 2701 would seem to apply to value that transfer. Importantly, this doesn’t change even if the transferor’s spouse and children are only remainder beneficiaries.41
The rising tide carry CLAT draws on one of the fundamental principles of Section 2701. Namely, Section 2701 only applies to a transfer “to a member of the transferor’s family.”42 For this purpose, a member of the family is limited to the transferor’s spouse or junior generation family members. Because the rising tide carry CLAT will initially benefit the transferor’s parents, possibly siblings, their descendants and non-family members, there’s no concern that the gift will fall under Section 2701—unless, of course, the grantor isn’t comfortable with allowing those senior family members to dispose of the residual interests at their deaths.
To avoid the application of Section 2701 when funding a CLAT with interest in a fund GP, the safest choice would be to create a rising tide carry CLAT that
terminates on or before the death of the senior family members. This would mean, however, that the CLAT property would be includible in their estates, subject to their creditors, and could be disposed of in their unfettered discretion. In many instances, this may be perfectly acceptable. For example, a 10-year, zeroed-out43 CLAT funded in August 2016, with $10 million and a Section 7520 rate of 1.4 percent, would yield a $3,690,353 remainder at the end of the term, assuming a modest growth rate of 6 percent. A donor may be perfectly comfortable leaving this amount in the hands of his parents or siblings.
In some cases, a donor will insist on control through the generations in a manner that can only be accomplished with ongoing trusts. In this situation, it’s important to understand the arguments as to why Section 2701 shouldn’t apply in the fund context, with the caveat that these arguments haven’t been tested, proven or even commented on in any binding guidance.44
Notable commentators strongly disagree that carried interest should be considered subordinate to the limited partnership interest or that it should even be subject to valuation under Section 2701.45 For one thing, throughout the life of a fund, the carried interest may appear to be junior at one point in time (that is, early on, when the LPs are awaiting their return of capital), but senior at another point in time (that is, after the LPs have fully realized their capital and the next distributions out will be the carried interest).46 In practice, funds have evolved to where few are so cleanly divided between a senior and junior interest, and many have multiple classes of interests at different times.
For the sake of simplicity, consider the classic allocation of profits 80 percent to LPs and 20 percent to GPs. This 80/20 split generally follows the full return of capital to the LPs. Thus, in that early stage, the LPs may be senior because they would have the liquidation right. In the later stage, the carried interest may be viewed as senior because it’s entitled to the first 20 percent of all realized profit until distribution to the GP catches up to those made to the LP. Alternatively, some commentators suggest that the carried interest is neither senior nor junior because the 20 percent profit allocation isn’t a distribution right with respect to the equity. That is, whether the GP carry vehicle owns 1 percent or 10 percent, it receives 20 percent of the return on capital of the other partners. Thus, the carried interest isn’t a distribution right (a right to receive distributions with respect to an equity interest) with respect to the general partnership interest. Finally, the regulations define a junior equity interest as common stock or partnership interests, meaning the class “or classes of stock that, under the facts and circumstances, are entitled to share in the reasonably anticipated residual growth in the entity.”47 Absent junior and senior equity interests, the mechanical rules of the subtraction method of valuation under Section 2701 can’t be applied.
Application of the PF Rules
Aside from the Section 2701 issues, funding a CLAT with closely held business interests brings additional complexity because of the need to navigate certain PF provisions made applicable to CLATs under IRC Section 4947(a)(2). Pay particular attention to the prohibitions on self-dealing transactions, excess business holdings and jeopardy investments that could apply during the lead term of the CLAT. Failure to comply with these restrictions can trigger excise taxes imposed on the grantor, the trustee, any other disqualified person48 and/or the trust.
Further, if a GP interest in a fund is distributed from the CLAT in satisfaction of the annuity, the charitable recipient49 may be subject to the same prohibitions and related excise taxes in addition to the excise taxes imposed on unrelated business taxable income and investment income.50 Such an in-kind distribution might become necessary if the CLAT doesn’t hold sufficient liquid assets to satisfy a required annuity payment. For this reason and others discussed later in this article, consider the projected cash flow of the contributed property. If there’s insufficient cash flow from the desired asset, consider contributing additional liquid assets to the CLAT from inception.
1. Self-dealing. The prohibition against self-dealing applies generally to transactions between a CLAT and a disqualified person. An act of self-dealing can include, whether directly or indirectly, the following types of transactions:
• a sale, exchange or lease of property;
• the transfer or use of the income or assets by or for the benefit of a disqualified person;
• lending of money or other extension of credit, including the indemnification of a lender or a guarantee with respect to a loan to a disqualified person;
• furnishing of goods, services or facilities; and
• payment of compensation (or payment or reimbursement of expenses), unless the compensation is for certain personal services, provided it’s reasonable and is necessary to carry out the charitable purpose.51
To enforce the prohibition, a significant excise tax is imposed on each act of self-dealing between a disqualified person and a CLAT.52 It’s irrelevant whether the CLAT derives any benefit from the transaction. Technical faults are still subject to the excise tax, even if they’re well intentioned or even if they prove to be advantageous to the CLAT.
While the transactions listed above will constitute acts of self-dealing, the IRS has ruled that certain co-investment arrangements between a PF and a disqualified person won’t constitute self-dealing if the arrangement doesn’t disproportionately benefit the disqualified person or frustrate the PF’s exempt purpose.53 In addition, self-dealing doesn’t include a transaction between a CLAT and a disqualified person if the disqualified status arises only as the result of that transaction.54 Thus, arguably, the creation of a CLAT funded with a gift by the grantor (who would be a disqualified person) of partnership interests shouldn’t itself be an act of self-dealing, provided that the economic arrangement of the partners is such that the grantor (or any other disqualified person) doesn’t benefit disproportionately and wouldn’t frustrate the PF’s exempt purpose.
However, the self-dealing prohibition will limit transactions going forward. As a result, a donor or other disqualified person can’t purchase the GP carry vehicle interest from the CLAT. This prohibition effectively limits the CLAT’s potential exit strategies to liquidate the investment, which may be problematic if the CLAT needs liquidity to make an annuity payment or if holding the investment triggers an excise tax under the excess business holdings or jeopardizing investment rules (discussed below).
To the extent that the grantor, directly or indirectly, receives compensation from the CLAT, for example, through payment of a management fee to the management company,55 or is otherwise reimbursed for related expenses, the payment shouldn’t be an act of self-dealing provided that it’s reasonable and necessary and isn’t deemed excessive.56 Though this standard is subjective, an example is an investment management fee if the fee is applied in the same manner to the other investors.57 However, analyze any fee structure (or other financial transaction) between the GP carry vehicle and any disqualified person to determine whether the transaction could constitute an act of self-dealing.
Indirect self-dealing can occur if the GP carry vehicle deals with a disqualified person and the CLAT controls that entity.58 Control exists when the CLAT can require the GP carry vehicle to engage in a transaction that would be self-dealing if the CLAT engaged in the transaction directly, or when the CLAT, by aggregating its votes or authority with any disqualified persons, can require the partnership to engage in such a transaction (control may include veto power).59 The CLAT will be considered to control the partnership even if its voting power aggregated with that of disqualified persons is less than 50 percent of the governing body, if such persons are able to in fact control the organization, or if one of such persons has the right to exercise veto power over the actions of such organization relevant to any potential acts of self-dealing.60 Therefore, if a grantor who’s a disqualified person funds a CLAT with a partnership interest, he may be restricted from subsequent self-dealing transactions with that partnership, as well as with the CLAT. However, it would appear that a trustee who owns interests in the GP carry vehicle individually isn’t engaging in an act of self-dealing, so long as he doesn’t have control.
This isn’t to say that every transaction is an act of self-dealing. Indirect self-dealing doesn’t include a transaction between a disqualified person and a
controlled organization if: (1) the transaction results from a business relationship that existed before the transaction would have been self-dealing, (2) the
transaction is as favorable as one at arm’s length, and (3) the disqualified person couldn’t have engaged in the transaction with anyone else due to the uniqueness of the services provided by the organization or without incurring severe economic hardship.61
Given the depth of the downfall if the self-dealing rules are violated and the fact-specific nature of determination as to whether a transaction constitutes an act of self-dealing, it might be appropriate to consider obtaining a private letter ruling on this issue.62
2. Excess business holdings. In general, the excess business holdings rule63 would prevent a CLAT, in combination with the grantor and any other disqualified persons, from owning more than 35 percent of the profit interest in the partnership, provided that a non-disqualified person has effective control of the partnership64 or 20 percent if the CLAT can’t show that a non-disqualified person has effective control.65 Failure to satisfy one of these exceptions will trigger an excess business holdings tax. Although the initial tax is only at a rate of 10 percent, if the situation isn’t corrected, the tax increases to 200 percent of the excess business holdings.
Importantly, the excess business holdings limitation doesn’t apply to a business in which at least 95 percent of the income is generated from passive sources (for example, dividends, interest and capital gains).66 A GP carry vehicle that’s an investment partnership would often meet this criteria.67 Further, if the partnership is engaged solely in investment activities as a passive investor and an underlying investment includes more than 5 percent of active income, the investment partnership shouldn’t be treated as a business enterprise for purposes of IRC Section 4943.68 Additionally, there’s a grace period if a CLAT receives an interest that would otherwise be subject to the excess business holdings excise tax. The grace period gives a CLAT five years to dispose of excess business holdings received by gift or bequest.69 Under limited circumstances, a CLAT may be granted an additional 5-year period when the business interest received is unusually large or has a highly complex business structure, provided that it can be demonstrated that the CLAT has engaged in diligent efforts during the initial 5-year period to dispose of the holding.70
3. Jeopardy investments—IRC Section 4944. In its simplest terms, a jeopardy investment is an investment that could jeopardize the purposes for which the CLAT was formed (that is, to pay an annuity to charity).71 Violation of this rule results in an excise tax initially equal to 10 percent of the investment for each year thereof, increasing to 25 percent if not corrected. Avoiding this excise tax generally requires the trustees to exercise ordinary business care and prudence, based on the facts and circumstances, in providing for the long- and short-term financial needs of the PF to carry out its exempt purpose.72 In exercising ordinary business care and prudence, the trustee would consider the expected return, the risk involved and need for diversification of stock.73
While there are no investments that are per se jeopardizing investments, the IRS will more closely scrutinize certain transactions.74 These transactions include trading securities on margin, trading in commodity futures, investments in working interests in oil and gas wells, purchase of puts, calls and straddles, the purchase of warrants and selling short.75 A PF with a significant portion of its assets in an investment partnership trading in futures and forwards contracts was subject to this scrutiny in Technical Advice Memorandum 200218038. The IRS determined that the partnership wasn’t a jeopardizing investment on the basis that, under the facts and circumstances, the PF’s managers had exercised ordinary business care and prudence.76 The standards imposed are retrospective in nature, insofar as they look to judge a PF manager’s care and prudence with reference to the facts and circumstances prevailing at the time that the investment was made or retained. This is largely an inquiry that will look at whether the CLAT trustee exercised care and good judgment in deciding to make an investment or retain a particular interest. For instance, in TAM 8101007, the IRS determined that an investment was a jeopardy investment when the PF’s managers looked only at unaudited balance sheets that weren’t prepared in accordance with generally acceptable accounting principles.
Importantly, the jeopardy investment rules apply to a CLAT both with respect to new investments and, unlike a PF, to the retention of an investment received as a gift or bequest.77 As a result, when contributing a partnership interest to a CLAT, consider whether the interest would produce sufficient and predictable cash flow to pay the annuity or has an anticipated liquidity event in the near-term, and whether it’s necessary or appropriate to also contribute liquid assets to the CLAT.
The jeopardizing investments provisions should also be considered closely prior to contributing a partnership interest that’s subject to an outstanding capital commitment that would require the CLAT to contribute additional funding to the partnership. This is especially important to consider because the self-dealing rules discussed above limit the potential exit strategies to liquidate the interest.
4. Taxable expenditures—IRC Section 4945. To avoid the excise tax on taxable expenditures, a CLAT can’t make distributions for certain purposes. These include expenditures made: (1) to influence legislation, (2) to influence elections or voter registration, (3) as a grant to an individual for travel or study without IRS approval, (4) as a grant to certain non-qualifying organizations, or (5) for any purpose other than religious, charitable, scientific, literary, educational, national or amateur sports competition or prevention of cruelty to children or animals, as specified in Section 170(c)(2)(B).78
Careful Planning Required
The rising tide carry CLAT presents a potential solution for many hedge fund principals facing the prospect of a significant income tax liability in 2017. It allows a principal to: (1) use illiquid assets, (2) obtain an income tax deduction, (3) provide for extended family members in a transfer tax efficient way, and (4) provide for charity. Nonetheless, it’s a complex structure and must be planned carefully.
Every CLAT should be funded and administered with an awareness of the deductibility of the contribution and the applicable excise taxes to avoid triggering the penalty tax during the term of the CLAT. The potential for inadvertent deemed gifts under Section 2701 continues to exist, albeit minimally. These complexities should be carefully considered in advance of funding to understand the income tax consequences and avoid unexpected and onerous income, gift and excise taxes. Properly planned, the rising tide carry CLAT may prove to be a useful tool in the upcoming tax year and beyond.
—The authors would like to thank Jonathan G. Blattmachr, Steven J. Chidester and Eric Fischer for their comments with respect to various issues addressed in this article.
1. Indexed for inflation annually; at $5.45 million in 2016.
2. See, e.g., Obama Administration’s Revenue Proposals for Fiscal Year 2017 (the Greenbook), released Feb. 9, 2016.
3. Internal Revenue Code Section 457A(a).
4. This approach was originally discussed by one of the authors in N. Todd Angkatavanich and David A. Stein, “Going ‘Non-Vertical’ with Fund Interests: Creative Carried Interest Transfer Planning—When The ‘Vertical Slice’ Won’t Cut It,” Trusts & Estates (November 2010), at p. 22. To provide the strongest argument that the exercise of the limited power of appointment (POA) by the powerholder won’t cause a taxable gift to occur, the trust should be structured as an absolute discretion trust rather than a trust with an ascertainable standard or mandatory distribution standard. Perhaps an even more conservative approach to avoid the gift tax issue entirely would be for the powerholder to exercise a testamentary POA.
5. It should be noted, however, that the Internal Revenue Service has taken the position in certain cases that the lifetime exercise of a limited POA by a beneficiary constituted a taxable gift by such beneficiary. See, e.g., Estate of Regester v. Commissioner, 83 T.C. 1 (1984); Revenue Ruling 79-327; Private Letter Ruling 200427018 (March 10, 2004); PLR 200243026 (Oct. 25, 2002) (involving an absolute discretion trust); Technical Advice Memorandum 9419007 (May 13, 1994).
6. It should also be noted that in connection with the exercise of a limited POA to a new trust for the benefit of the parent’s children or remote descendants, to the extent that the original trust is a generation-skipping transfer (GST) tax-exempt trust, the provisions of Treasury Regulations Section 26.2601-1(b)(4)(A) regarding discretionary distributions should be carefully considered to preserve the trust’s GST status.
7. Treas. Regs. Section 1.671- 2(e)(5).
8. Although the unrelated business income tax shouldn’t be a problem during the annuity term, caution should be exercised before distributing fund interests to charity. More likely, the annuity payments will be made with cash as the carried interest pays out.
9. See IRC Sections 170(f)(2)(D), 671-679. Outside the charitable lead annuity trust (CLAT) scenario, trust settlors often retain the power to substitute assets of equivalent value as a means of causing the trust to be a grantor trust. With a CLAT, the rules on self-dealing, described below, would impose a heavy excise tax on a trust settlor who exchanges assets with the CLAT. Consequently, a grantor trust power commonly used by practitioners for CLATs is the power under IRC Section 675(4) to acquire trust property for property of equivalent value in a non-fiduciary capacity, held by a non-adverse individual who isn’t a disqualified person (not the trust settlor). A successor(s) to this powerholder should be named to avoid the risk that the powerholder will die during the CLAT term and cause the trust to become a non-grantor trust triggering the recapture rules. See Section 170(F)(2)(B).
10. Assuming an IRC Section 7520 rate of 2 percent and annual payment of the annuity at the end of each year.
11. This amount will qualify for the charitable deduction against the settlor’s gift tax.
12. Section 170(e)(1).
13. If the entity has liabilities or underlying debt, is a short-term capital asset or has interests that would generate ordinary income, the donor may not be eligible for a full fair market value (FMV) deduction in any event.
14. Section 170(b)(1)(D).
15. The deduction is limited to 10 percent of taxable income if the donor is a corporation. Section 170(b)(2).
16. Section 170(b)(1)(B). Here again, private operating foundations, pass-through foundations and pooled income funds are treated as public charities.
17. IRC Section 68.
18. Sections 170(f)(3) and 2252(c).
19. Treas. Regs. Section 1.170A-7(a).
20. IRC Section 642(c).
21. Treas. Regs. Section 1.170A-7(b)(1).
22. See N. Todd Angkatavanich, Jonathan G. Blattmachr and James R. Brockway, “Coming Ashore—Planning for Year 2017 Offshore Deferred Compensation Arrangements: Using CLATs, PPLI and Preferred Partnerships and Consideration of the Charitable Partial Interest Rules,” ACTEC Law Journal, Vol. 39 (Spring 2013/Fall 2013), for a more detailed discussion of the partial interest rules for gift and income tax purposes as may be applied to a partnership interest.
23. Treas. Regs. Section 1.170A-6(c)(4).
24. IRC Section 681(a); Treas. Regs. Section 1.681(a)-2.
25. IRC Sections 2036 and 2038.
26. See Rifkind v. United States, 5 Cl. Ct. 362 (1984). But see PLR 9542039 (Oct. 18, 1996).
27. Treas. Regs. Section 25.2512-1.
28. See Richard L. Dees, “Profits Interests Gifts Under Section 2701; I Am Not a Monster,” 123 Tax Notes 701 (May 11, 2009).
29. IRC Section 2701(b)(1)(A).
30. Treas. Regs. Section 25.2701-2(b)(5).
31. Section 2701(b)(1)(B).
32. Treas. Regs. Section 25.2701-2(b)(2).
33. Treas. Regs. Section 25.2701-2(b)(5)(iii); Under Proposed. Regs. Section 25.2701-2(b)(5)(iv), a limited liability company (LLC) is “controlled” if those persons hold at least 50 percent of either the capital interests or the profits interests or hold any equity interest with the ability to cause liquidation of the entity, in whole or in part.
34. Section 2701(b)(2)(C); Treas. Regs. Section 25.2701-2(b)(5)(i). Note that for purposes of determining whether an entity is controlled under Section 2701(b), the term “applicable family members” includes descendants. In contrast, the general definition of “applicable family member” noted above includes only the transferor, spouse and senior generations.
35. Treas. Regs. Section 25.2701-2(b)(5)(iii).
36. PLR 9639054 (Sept. 27, 1996). In this ruling, because the transferor held only a minority interest in the corporate general partner, it was determined that the prerequisite control didn’t exist. The result may be different if the transferor were to hold a majority interest. See Treas. Regs. Section 25.2701-6(a)(1).
37. As a practical matter, this encourages the use of LLCs over limited partnerships to minimize the possibility that a transaction will be subject to valuation under Section 2701.
38. Treas. Regs. Section 25.2701-3.
39. Section 2701(a)(3)(A); assumes the applicable retained interest isn’t a qualified payment right.
40. But see Dees, supra note 28.
41. Treas. Regs. Section 25.2701-6(b), ex. 4 and 5. Although it might appear that a transfer of a junior equity interest for the benefit of a charity shouldn’t trigger the application of Section 2701, the attribution rules don’t distinguish between current and remainder beneficiaries. Treas. Regs. Section 25.2701-6. As a result, even the future remaindermen of a trust will be attributed ownership of an entity interest. Thus, a gift of merely the general partner (GP) carry vehicle in a fund, by itself, to a CLAT in which the fund principal’s descendants are remainder beneficiaries may trigger a deemed gift under Section 2701 to the extent that the principal continues to own limited partner (LP) interests in that fund.
42. Section 2701(a)(1).
43. Meaning that a sufficient annuity is paid to charity such that there would be no taxable gift on creation of the CLAT.
44. But see ILM 201442053.
45. For a detailed analysis of this issue, see Dees, supra note 28.
46. See Lawrence M. Lipoff, “Estate Planning with Interests in Private Investment Partnerships Advanced Planning Issues: Chapter 14 of the Internal Revenue Service Code,” Tax Management Memorandum, Advisory Board Analysis, Vol. 45, No. 1 (January 2004).
47. Treas. Regs. Section 25.2701-3(c)(2).
48. In the context of a CLAT, a disqualified person generally includes: (1) the grantor, (2) the trustee, (3) a member of the family of the grantor or trustee, or (4) a corporation, partnership, trust or estate when the grantor, the trustee or their family members have more than 35 percent combined voting power, profits interest or beneficial interest. IRC Section 4946(a).
49. An example of such a charitable recipient is a donor-advised fund (DAF). While certain of these excise taxes don’t apply to public charities, unrelated business taxable income does apply to charities and DAFs alike and for practical reasons, some charities may not be willing to accept a GP interest as a contribution without an imminent liquidity event.
50. See IRC Section 4940.
51. IRC Section 4941.
52. Section 4941(a). The excise tax assessed on the disqualified person is equal to 10 percent on the amount involved for each taxable year, with an additional tax assessed on a trustee who knowingly and willfully participated in the transaction equal to 5 percent of the amount involved for each year. If an act of self-dealing is identified and not corrected, then an additional tax of 200 percent may be imposed on the disqualified person, and an additional 50 percent tax may be imposed if the trustee refuses to approve the correction under Section 4941(b).
53. PLR 200420029 (May 14, 2004).
54. Treas. Regs. Section 53.4941(d)-1(a). See, e.g., PLR 9623018 (March 5, 1996). Investment in an investment partnership with disqualified persons doesn’t constitute an act of self-dealing. See PLR 200420029 (Feb. 19, 2004) and PLR 200423029 (June 4, 2004). Similarly, coinvestment arrangements have been found not to constitute acts of self-dealing. See PLRs 200551025 (Sept. 28, 2005), 200043047 (Oct. 30, 2000) and 200018062 (May 8, 2000).
55. Because the CLAT would be a partner in the GP carry vehicle of the fund, the payment by the fund of a management fee to the management company, in which the grantor also has an ownership interest, could arguably be considered an indirect payment of such management fee by the CLAT to the grantor.
56. Treas. Regs. Section 53.4941(d)-3(c).
57. Ibid., Ex. 2. In many fund structures, LP interests held by related parties aren’t subject to the incentive allocation paid to the GP carry vehicle; but, if that isn’t the case, such an economic arrangement may constitute self-dealing.
58. See Michael V. Bourland, Estate Planning for the Family Business Owner, Volume 2, SM003 ALI-ABA 689 (2006).
59. Treas. Regs. Section 53.4941(d)-1(b)(5).
61. Treas. Regs. Section 53.4941(d)-1(b)(1).
62. Under IRC Section 6110(k)(3), neither a PLR nor a TAM may be cited or used as precedent.
63. The rules on excess business holdings and jeopardizing investments don’t apply to a CLAT if the value of the charitable deduction doesn’t exceed 60 percent of the FMV of the interest held by the trust. However, this exception wouldn’t apply to a zeroed-out CLAT when a deduction was taken for the full value of the interest transferred to the trust. Section 4947(b)(3).
64. Treas. Regs. Section 53.4943-3(b)(3)(ii). Effective control means possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a business enterprise, whether directly or indirectly.
65. IRC Sections 4943(c)(2)(A)-(B), 4943(c)(3). For corporations, the test is focused on voting control and not the economic interest. There’s a de minimus rule when the CLAT owns less than 2 percent of the voting stock or other value. Section 4943(c)(2)(C).
66. See, e.g., PLR 201333020 (Aug. 16, 2013). In the ruling, the IRS stated that an interest in an investment hedge fund organized as an LLC wouldn’t be an excess business holding and that the LLC didn’t constitute a business enterprise.
67. See PLR 199939046 (Oct. 4, 1999). Here, the IRS looked through to the underlying investments of an investment partnership, in which private foundations held both the LP and GP interests in the investment partnership.
68. See PLR 200611034 (March 17, 2006). This ruling contains an ancillary discussion of treating LP distributions as passive source income akin to a stock dividend when the partnership holds an interest as a LP in an active trade or business. This ruling doesn’t extend to a GP interest with underlying LP interests.
69. Section 4943(c)(6).
70. Section 4943(c)(7).
71. Treas. Regs. Section 53.4944-1(a)(1).
72. Treas. Regs. Section 53.4944-1(a)(2)(i).
73. See ibid.
74. See supra note 72.
76. TAM 200218038 (May 3, 2002). See also supra note 72.
77. Treas. Regs. Section 1.170A-6(c)(2)(i)(D). Importantly, the CLAT instrument needs to prohibit both the acquisition and retention of assets that would give rise to a tax under IRC Section 4944 if the trustee had acquired the assets.
78. IRC Section 4945(d).