The Untapped Potential of Private Derivatives in US Wealth Structuring

By: Matthew Ledvina, JD, LLM (US Taxation)

Introduction

Navigating the labyrinthine complexities of wealth structuring in the United States often requires innovative financial solutions. Private derivatives, lesser-known but increasingly important tools, offer a unique way to transfer economic value tied to an asset without actually transferring the asset itself. This article aims to shed light on the role and intricacies of private derivatives in wealth structuring, particularly in scenarios involving business owners, corporate executives, and managers of investment funds like private equity, venture capital, and hedge funds.

The What and Why of Private Derivatives

A private derivative is a contractual arrangement that allows for the transfer of economic benefits based on the financial performance of an asset. This tool is exceptionally useful when traditional methods of transferring assets are impractical or subject to stringent tax implications. Private derivatives provide the versatility needed to bypass various legal or practical challenges that often complicate asset transfer.

Business Owners and Executives

Often, business owners or executives hold vested or unvested shares in their companies. The laws or contractual obligations might restrict these shares, making them non-transferable. In such cases, transferring the economics tied to these shares via a private derivative can solve the dilemma, enabling wealth transfer without actually parting with the asset.

Fund Managers

Fund managers, especially those in private equity, venture capital, and hedge funds, frequently deal with carried interests. Transferring these carried interests can trigger special tax regulations, further complicating the wealth structuring process. Here too, private derivatives come into play, offering a streamlined solution that transfers the economics tied to the carried interests without triggering complex tax issues.

Structuring the Private Derivative

When setting up a private derivative, it is commonly executed between the individual and an irrevocable grantor trust, which is tax-transparent for US income tax purposes. The contract defines everything from the purchase price, the term of the contract, and the amount payable upon settlement, providing flexibility and a layer of safety for both parties.

The In-Depth Mechanics: Crafting the Derivative Contract

Crafting a private derivative contract is crucial in leveraging this financial tool for wealth structuring. Flexibility manifests in various contract clauses, such as setting a hurdle rate, specifying a profit-sharing arrangement, or setting an upper limit on the financial benefits transferred to the trust.

Flexibility in Terms

• The Hurdle: A hurdle rate can specify a minimum rate of return on the underlying asset before any economic benefits pass on to the trust.
• Profit Sharing: The contract can define a profit-sharing arrangement, wherein the individual and the trust share the economic upside based on pre-agreed ratios.
• Caps: Setting an upper limit on the benefits transferred to the trust can serve as a risk mitigation strategy.

The Need for Expert Consultation

Legal and financial consultation is strongly advised due to the specialized nature of private derivatives. Advisors ensure that the contract is compliant with existing laws and protects the interests of all parties involved.

The Art of Risk Management

Although private derivatives offer an effective tool for wealth structuring, they are not devoid of risks. Market volatility affecting the underlying asset can impact the economic benefits transferred to the trust. Hedging strategies can be employed to counterbalance these risks.

Monitoring and Adjustment

Constant monitoring and adjustments of the derivative contract are vital for effective risk management. Contract clauses may allow for reviews at set intervals, providing an opportunity to tweak the terms in light of any new developments.

Ethical and Regulatory Considerations

Ethics and compliance should be at the forefront when implementing private derivatives for wealth structuring. Fairness, transparency, and regulatory compliance are crucial for maintaining the integrity of the transaction.

Conclusion

As the landscape of wealth structuring becomes increasingly complex and regulated, the importance of innovative financial instruments like private derivatives cannot be overstated. They offer a legitimate and flexible means of asset transfer, invaluable for business owners, executives, and fund managers. Private derivatives are likely to become an essential part of the financial toolkit for those grappling with the challenges of wealth transfer in modern-day United States.