Because of the structure and economics of a private equity fund, fund managers are in a unique position to take advantage of various gifting strategies to reduce their overall wealth transfer tax burden.
Structure and Economics of a Private Equity Fund
In a typical private equity fund structure, fund managers will typical own two types of equity interests – a capital interest and a carried interest. The capital interest, typically in the form of a limited partnership interest, is received in exchange for the fund manager’s contribution of capital to the fund. The carried interest, which is typically owned by the fund manager indirectly through an entity serving as general partner of the fund, is received in exchange for investment services provided to the fund by the fund manager.
The distribution rights associated with a capital interest and a carried interest in a private equity fund typically differ. Distributions rights are defined in the private equity fund's partnership agreement and often referred to as a “distribution waterfall.” A typical distribution waterfall provides for distributions to be made in the following order: first, all capital investors are entitled to a return of invested capital; second, capital investors receive a preferred return (e.g., 8-9%); third, a catch up distribution is made to the carried interest holders to make up for the preferred return paid to capital investors; finally, any remaining profits are then allocated 20% to the carried interest holders and 80% to remaining capital investors.
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