Monograph

Transforming Wealth Transfers

The case study presented below is only current as of the date delivered, and it is provided for illustrative and informational purposes only. It is not intended to nor should be construed as a guarantee or assurance of future financial outcomes. The content discussed reflects the specific financial circumstances of the respective client; each client’s individual circumstances are unique, and outcomes will vary. Past performance is not indicative of future results; projections have inherent limitations and may not come to fruition. The statements contained herein do not constitute nor should be construed as personal financial, tax, or legal advice, nor a solicitation of any type. Each client's situation is unique and thus requires individualized financial, tax, and legal advice from a qualified financial professional, CPA, and attorney, respectively.  The client situation discussed within reflects that of a current client; such client did not receive any cash or non-cash compensation  in relation to this case study. The firm’s disclosures are available here or upon request.

Transforming Wealth Transfer with Carried Interest

At Monograph Wealth, we have developed tools and strategies for the successful general partner or business owner more intentionally plan for a future liquidity event or successful transaction.

The following case study illustrates our approach to constructing a flexible and dynamic tool for managing future liquidity and intergenerational transfers within a holistic wealth strategy.

  • This is a private investment fund manager’s (general partner) compensation from the investment profits. The interest is usually a set percentage of realized profits, usually, but not always, paid after profits clear a certain threshold called a hurdle rate.

The Client

The client leads an accomplished private equity firm and has earned meaningful returns through successful investing and carried interest.

This client was seeking to entrust some of their excess wealth to future generations in a thoughtful, tax-conscious fashion.

Monograph identified the general partner’s (GP) carried interest as an optimal asset to transfer, with low current value and substantial upside potential.

Due to concerns surrounding the legal complexities of such GP transfers, as well as a desire to maintain control over the interest, the client required a detailed plan before executing this unique transfer of assets to their heirs.

The Challenge

Engineering a precise outcome cannot be achieved through traditional gifts or sales of GP interests to trusts. As the future receipts are unknown, gifts of interest can result in substantial over- or under-gifting.

When transferring GP interests to heirs, requirements to transfer pro-rata slices of the partnership can be a challenge, along with control concerns, funding requirements, governance implications, investor relations, and regulatory hurdles. All these complexities must be balanced with the desire to transfer wealth and optimize desired tax outcomes.

The Solution

Before developing entity structures and instruments, Monograph worked with the client to define intentions and financial needs by asking the following questions:

● Does G1 (the client) have all they need to enjoy the life they envision?

● Does G1 have enough to face adverse scenarios?

● How much does G1 intend to leave G2?

● Has a purpose been clarified for the assets being transferred to G2 (i.e. education, financial support, investment in own business, or professional ventures)?

After the client answered these planning questions, Monograph designed the transfer strategy with the client and advisory team, which took the form of a financial derivative.

  • A financial contract whose value is based on that of another underlying asset or assets, such as a stock or commodity.

In the next fund vintage, the client (G1) wished to keep the first $50 million of carried interest receipts, transfer the next $25 million, and retain all amounts over $75 million.

Below are the general design and implementation steps of a transfer strategy using a financial derivative on a non-publicly traded asset (such as carried interest) to maintain gift tax compliance, and to minimize gift and estate taxes liabilities:

  • The year in which the fund is founded and/or when fund’s capital is first invested.

  • A grantor trust, preferably set up in a dynastic jurisdiction, is established. 

  • An independent valuation of the GP /entity that holds the carried interest is obtained.

  • With a payoff schedule similar to the above illustration, the cost of a derivative agreement is calculated by an independent appraisal using options pricing models.

  • The legal arrangement is defined, and the derivative is sold to the trust, typically in exchange for a note, limiting the amount of lifetime gift exemption used during the transaction.

  • A trust in which the creator (grantor) retains one or more powers over the trust and is responsible for taxes on the trust’s income. However, the trust is considered outside the creator’s estate for estate tax purposes.

These factors serve to minimize the value of the GP for gift tax purposes:

● Timing – if pre fundraise or pre investment period, GP value of a specific vintage could be lower.

●The persistence of vintage success could impact GP value.

●Discounts for lack of control or marketability.

Factors that serve to minimize the value of the derivative for gift tax purposes:

● Out of the money options impact derivative value

●Duration of agreement

●Discounts for lack of marketability.

The derivative interest structure functions like a series of call options where the grantor trust is the buyer and the client/GP the seller.

The strike prices are set at the levels at which economic benefits are exchanged. In practice, the GP sells a share of the upside to the family dynasty trust. There’s no income tax associated with the transaction because the GP remains the income taxpayer for the trust. The value of the transfer is multi-generationally amplified as income taxes can be funded by G1.

  • A financial contract that gives the buyer the right (but not the obligation) to purchase a security (the underlying) at a set price (the strike price). In this study, the trust is being given the right to purchase set levels of proceeds from an investment fund payout.

  • An option is “in the money” when the value of the underlying security is higher than the strike price. An option is “out of the money” is when the strike price is higher than the value of the underlying. Call buyers usually look to exercise when the underlying is worth more than the strike price to sell the underlying at a profit.

As an example, on a realized $100 million of value, the GP keeps the first $50 million, sells the right to the next $25 million, then buys the right to everything above $75 million.

The GP protects his desired pre-tax floor of $50 million, tax efficiently transfers $25 million, and retains the final $25 million.

Monograph worked with tax and legal counsel to design and implement a precise solution for economic transfer. With the success of this strategy for GPs, we have created similar solutions for sellers of businesses who want to engineer a precise outcome.

Monograph guided the development of this flexible strategy by determining the following from the client:

  1. Identified their financial needs, especially resources needed to protect against future risks.

  2. Identified goals for G2, and assessed the appropriate resources needed to productively enhance G2’s experience.

  3. Assessed the current value and potential gains from the liquidity event.

  4. Calculated pre-tax and post-tax proceeds.

  5. The strategy was stress-tested and implemented by a team of astute financial, legal, and tax advisors, along with valuation experts.