Derive time

Private derivatives can play a valuable role in US wealth structuring. A private derivative is a contractual arrangement that potentially enables an individual to transfer wealth based on the financial performance of an asset. It is especially attractive when it is not feasible or possible to transfer the asset. Private derivatives are useful in a variety of situations, especially when working with business owners, executives and managers of private equity, venture capital and hedge funds.

A business owner or executive sometimes owns unvested shares of their company’s stock. A gift of unvested shares is not complete for US gift tax purposes until the shares vest, so it is not feasible to gift those shares. A business owner or executive sometimes owns vested, non-transferable shares. For example, securities laws or contractual obligations may bar the transfer of certain shares.

A business owner or executive sometimes owns vested, transferable shares but feels it is impractical or undesirable to transfer those shares. For example, the chief executive of a publicly traded company may be reticent to transfer shares out of concern for how the markets might view the transfer; or an owner of a privately held company may be reticent to transfer shares because they would need to obtain consents from other investors. In each of these cases, the business owner or executive might consider using a derivative to transfer wealth based on the financial performance of some or all of the shares they own.

A manager of a private equity, venture capital or hedge fund may own a carried interest in their fund, which entitles them to a share of the fund’s profits.

In addition to other potential tax issues, a gift of a carried interest may trigger special valuation rules. Under these rules, the value of a carried interest gifted by the manager would potentially equal the combined value of the manager’s carried interest and capital interests. The manager might give a proportionate share of their carried interest and their capital gains so they can potentially avoid triggering these rules, but giving such a vertical slice of their interests may be impractical or undesirable. Moreover, it may not solve other tax issues. Accordingly, the manager might consider using a derivative to transfer wealth based on the financial performance of their carried interest.

Structuring the private derivative

In a typical structure, an individual enters into the derivative contract with an irrevocable trust that is a grantor trust with respect to them. A grantor trust is tax-transparent for US income tax purposes, so this transaction is ignored for US income tax purposes. The derivative contract specifies the purchase price, the contract’s term and the amount payable to the trust upon the contract’s settlement. The purchase price, which the trust pays to the individual, equals the current fair market value (FMV) of the derivative. Although the derivative transaction can potentially be an effective means of transferring wealth, the trust bears the financial risk of the purchase price exceeding the amount it receives upon the contract’s settlement.

The individual selling the derivative must settle upon the expiration of the contract’s term. The term may be a fixed number of years. Alternatively, it may be the lesser of a fixed number of years or the death of an individual, such as the individual selling the derivative. The term should be sufficiently long as to allow the underlying asset to appreciate, so that there is a good opportunity to transfer wealth using the derivative.

The derivative contract defines the amount payable upon settlement. For example, the contract may provide that this amount equals the appreciation in the value of the underlying asset (either including or excluding the amount of distributions made with respect to the asset during the term of the contract). It might specify a hurdle, so that the amount payable upon settlement is only the appreciation that exceeds the hurdle. It may split the appreciation between the individual and the trust, and it may cap the amount payable to the trust upon settlement. The individual and the trust have a lot of flexibility in defining the amount payable to the trust upon the contract’s settlement. The individual ordinarily settles the derivative in cash. Settlement does not require the transfer of the underlying asset.

The purchase price equals the current FMV of the derivative. For the purposes of substantiating the purchase price for the derivative, the individual should obtain an appraisal from an independent, professional appraiser. The appraisal would consider the value of the underlying asset, any hurdles and the term of the contract. The appraisal helps ensure that the purchase price equals the current FMV of the derivative. If the current FMV of the derivative exceeds the purchase price, the individual would likely be making a gift to the trust. If the purchase price exceeds the current FMV, the trustee (or other trust official) may be violating their fiduciary duties (e.g., by improperly transferring economic benefits from the trust to the individual selling the derivative to the trust).

Tinkering with factors affecting the contract’s term and the amount payable upon settlement affects the derivative’s current FMV and, by extension, the purchase price. For example, increasing the hurdle can reduce the amount that the trust must pay to buy the derivative. This can enable the individual selling the derivative to design a derivative that the trust can afford to purchase.

The trustee or other trust official entering into the derivative contract on the trust’s behalf should be independent. The trust official should not be the individual selling the derivative to the trust or anyone related or subordinate to them. This independence can help to ensure the derivative contract is respected for US gift and estate tax purposes. If, for example, the individual selling the derivative to the trust is also the person directing the trustee to enter into the derivative contract, the transaction may be more susceptible to a claim that it is not arm’s length.

Reporting

The derivative is designed as a non-gift transfer for US gift tax purposes. The purchase price equals the current FMV of the derivative. The individual selling the derivative consequently does not have an obligation to report the derivative on a gift tax return. The individual may nonetheless wish to report the derivative, so they can limit the period during which the Internal Revenue Service (IRS) can challenge it. The IRS ordinarily cannot challenge a non-gift transfer more than three years after it is adequately disclosed on a gift tax return. If a non-gift transfer is not adequately disclosed, the IRS can challenge the transfer during the transferor’s life or after the transferor’s death.

Even though the individual normally would not have an obligation to report the derivative on a gift tax return, they may have an obligation to report some related aspects of the structure. If, for example, the individual made gifts to the irrevocable trust that purchased the derivative (perhaps so that the trust would have adequate financial resources with which to purchase the derivative), the individual would usually have an obligation to report those gifts.

In a typical structure, there are not any reporting obligations for US income tax purposes. The derivative contract between the individual and the trust is ignored for US income tax purposes, and the individual selling the derivative does not have an obligation to report the transaction on their income tax return.

Conclusion

Private derivatives can overcome some practical and legal impediments to using certain assets in connection with US wealth structuring. Instead of directly gifting or otherwise transferring assets, private derivatives provide a mechanism for using the value associated with those assets.