If you’re a private equity partner, you likely have a lot on your plate. You have to spend a lot of your time taking care of your team, portfolio companies, and limited partners. You must also take advantage of every opportunity that comes your way, and close new deals. With the economic uncertainty and upheaval brought on by the pandemic, private equity partners have more demands than ever before. However, you must always think of your personal financial planning needs and review them. A powerful planning tool for private equity partners is carried interest. This is a truly compelling asset that has significant growth potential.
Since it is prudent to plan, we’ve developed a guide for carried interest financial planning. With this guide, you can make the most of your role as a private equity partner and create long-term, sustainable investment growth.
What Is Carried Interest?
The principle that those who create value with their efforts and work should be rewarded is an essential component of today’s American economic system. Carried interest is found throughout various industries and is viewed as a performance bonus. In a way, it is another name for how investment funds, set up as partnerships, split the rewards of a joint venture between the partners who provide capital and those who provide sweat equity. The more money the fund makes, the more profit there is for managers to share.
Usually, investment managers pay a low tax rate on the earned carried interest and it is lower than what most people pay on their wages. This has made carried interest controversial and many people define it as a tax loophole.
The amount of carried interest that general partners receive typically stands at around 20% of the fund’s profits but this can vary. This is paid on top of a management fee, which is usually 2% of the fund’s assets. The limited partners (investors), receive the remaining 80% of the fund’s profits in addition to receiving their initial investment amount back.
SLATs
Spousal Lifetime Access Trusts (SLATs) is a flexible and rather affordable estate planning tool for married couples who are looking to shelter assets from future tax liability. This strategy allows assets to be moved into a trust and away from the grantor spouse’s name and taxable estate. The beneficiary spouse and other designated beneficiaries may access the trust’s assets if needed and also shelter them from creditors.
Private equity partners can take a relatively low valuation asset and remove it from their taxable estate, and thereby shelter its potential growth from future estate tax by simply funding a SLAT with newly granted carried interest.
Donor-Advised Funds
A donor-advised fund (DAF) is considered a charitable investment account that is aimed at supporting causes you genuinely care about. By contributing cash, securities, and other assets to a donor-advised fund, you’re, in general, eligible to take an immediate tax deduction. These funds, in turn, can then be invested for tax-free growth and allocated to charitable causes in the upcoming years.
Private equity partners who hold carried interest that has appreciated significantly can look at the option of gifting a portion of their carry to a donor-advised fund in exchange for a charitable deduction at its fair market value. As an alternative, partners can keep the interest and make cash donations in high-income tax years to make up for gains. These two types of contributions can reduce your tax bill while providing you and your family with a way to support causes that are close to your heart.
Dynasty Trusts
A dynasty trust holds assets for multiple generations in a tax-advantaged environment, without the need to terminate on a set date. A dynasty trust is designed to protect assets, with minimal exposure of the wealth to the federal estate tax, federal gift tax, and the generation-skipping tax.
Private equity partners can fund a dynasty trust with carried trust that is anticipated to appreciate considerably. Private equity partners who reside in high-state-income-tax jurisdictions could look into the option of setting up a dynasty trust in a state like Nevada and take advantage of the solid asset protection laws, as well as the absence of state income tax.
Conclusion
Carried interest plays a vital role in the private equity field, with enormous potential to grow compensation and rewards. While carried interest varies between funds and firms, it is important to first learn how it works to ensure the compensation is fair.
This can especially be an effective financial planning tool and a compelling asset for private equity partners. Those who use the aforementioned strategies can pay tax on their income at lower capital gains.