Private derivatives
A wealth transfer strategy for business owners and fund managers
Business owners and fund managers can face challenges when transferring wealth, and private derivatives may help them overcome those challenges. A private derivative can offer a way to transfer wealth based on the financial performance of assets like unvested or non-transferrable shares of company stock or a carried interest in a fund.
Business owners and fund managers can face challenges when transferring wealth, and private derivatives may help them overcome those challenges. A private derivative can offer a way to transfer wealth based on the financial performance of assets like unvested or non-transferrable shares of company stock or a carried interest in a fund.
Because it doesn鈥檛 require the transfer of the asset, a private derivative can be attractive when an asset has the potential to appreciate substantially but a transfer of the asset isn鈥檛 feasible or possible.
Addressing common challenges
A business owner or executive who owns shares of their company鈥檚 stock may find transferring the stock is not feasible because:
- The shares are not vested, so gifting them would likely be ineffective for gift tax purposes
- There may be contractual obligations that bar their transfer
- There may be concerns around how the market may view the transfer
- A transfer may require the consent of other investors
A manager of a private equity, venture capital or hedge fund typically owns聽a carried interest in their fund, which entitles them to a share of the fund鈥檚 profits. Since it may potentially generate significant wealth, carried interest is often an attractive asset to gift, so that any future wealth doesn鈥檛 become part of the manager鈥檚 estate. However, a gift of carried interest may trigger special valuation rules. While gifting a vertical slice (a proportionate share of their carried interest and ownership or capital interest) can avoid triggering these rules, this may be impractical or undesirable.
In these cases, a private derivative may be a useful strategy. Very simply,聽this most commonly involves selling the right to some or all of the future appreciation of the stock or carried interest to a grantor trust. The derivative usually is designed so that the sale price equals the fair market value of the future appreciation, so that the transaction isn鈥檛 a gift. This strategy generally is successful if the actual appreciation exceeds the anticipated appreciation.
Understanding private derivatives
A private derivative is a contractual arrangement, typically between an individual and聽an irrevocable trust that鈥檚 a grantor trust with respect to the individual. When designed in that fashion, the derivative transaction is ignored for federal income tax purposes.
The contract specifies the purchase price, contract鈥檚 term and amount payable to the trust upon the contract鈥檚 settlement. The purchase price that the trust pays to the individual equals the current fair market value of the derivative.
The contract defines the amount payable to the trust upon the contract鈥檚 settlement, which may:
- Be equal to the appreciation of the underlying asset, including or excluding the amount of distributions made during the term of the contract
- Specify a hurdle, so the trust would only receive any appreciation that exceeds the hurdle
- Split the appreciation between the individual and the trust
- Cap the amount payable to the trust
The person selling the derivative must settle upon the end of the contract鈥檚 term, which should be sufficiently long to allow the underlying asset to appreciate. The trust bears the financial risk of the purchase price exceeding the amount it receives upon the contract鈥檚 settlement.
Learn more
To see how a private derivative strategy may make sense for your situation, please contact a 斗牛棋牌在线 Financial Advisor.
For a more in-depth discussion of private derivatives, see Todd D. Mayo, Using Private Derivatives in Wealth Planning (a publication of the 斗牛棋牌在线 Advanced Planning Group). For a more in-depth discussion of carried interest, see Ann Bjerke, Planning with Carried Interest (a publication of the 斗牛棋牌在线 Advanced Planning Group).
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