Complex Carried Interest Valuation Gets Additional Scrutiny by IRS

In recent years, our team has seen an increasing number of valuation requests from general partners (“GPs”) of venture capital and private equity funds related to carried interest. For those unfamiliar, the carried interest is also referred to as “the profits interest” because it entitles the GP to a portion of the profits earned by the fund. There are a variety of reasons why a GP might want to have his or her carried interest valued: Wealth transfer planning, i.e. “gifting”, is a prominent one.

The appeal of gifting future profits via the carried interest is two-fold:

(1) First off, those profits are expected – but not yet tangible – and therefore the value is likely lower in early years of the fund;

(2) Second, those profits will be comprised of aggregate realized capital gains, and therefore, the character of that income can be characterized as a capital gain (not ordinary income). Capital gains – in most cases – are favorable to ordinary income taxes.

As one might expect, these benefits can represent significant savings to the grantor – measuring in the millions of dollars depending on the size of the fund. However, they can only be captured under one condition: There is a reasonable and defensible valuation of the carried interest.

The valuation is the lynchpin. It must adequately incorporate key factors like discounts, volatility of the instrument, and appropriate allocation methods. Second, it must pass muster in the eyes of the IRS.

A lack of valuation experience in the private equity and venture capital markets could lead to a failed strategy for a GP looking to gift carried interest.

This is territory we know well at Redwood given our roots working with funds in Silicon Valley. Over time, our team has expanded and we can now serve funds across the nation.

Our expertise in this matter was recently illustrated when a carried interest valuation we prepared for a multibillion-dollar family office was audited by the IRS. Out of consideration for the client’s privacy and privileges, we will refrain from discussing the details or names involved in the matter. The key players in the engagement, however, were featured in an in-depth story in a prominent financial publication. Redwood’s work led to a “no-deficiency” letter from the IRS. In short, the IRS provided affirmation that the client would not have to worry about further scrutiny related to the valuation of their carried interest.

In conclusion, the use of carried interests for wealth transfer planning by GPs can produce impressively successful results in shifting their wealth to future generations. Advisors with the appropriate understanding of the fund’s structure and experience with the proper valuation techniques will be critical in a positive outcome for the client.