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Carry + BDIT = 0% State Taxes

âś… A New York City venture GP who receives carried interest expected to be worth $10 million could earn an extra $2.5 million in the 10 years after cashing out with a tax-advantaged trust called a BDIT.

We started with a short primer on the BDIT, or “parent-seeded trust”—the tool many professional investors in high-tax states use to eliminate state taxes on their carry. (If you haven’t checked that post out yet, take your time, and we’re always happy to help jumpstart your learning with a quick phone call.) Today, we’ll use a case study—drawn from our real-world experience—to help illustrate the benefits (and, of course, the tradeoffs) of BDITs.

Kevin, a General Partner in NYC

Kevin lives in Chelsea and has been a GP for 5 years. His firm has raised two funds in the last 4 years, and he expects to earn $10 million from his carried interest over the life of those funds. That’s great news, of course, but it doesn’t account for the (very high) taxes he’ll owe to the federal, state, and New York City governments.

If Kevin cashes out the proceeds from his carried interest without using a tax-advantaged vehicle, he will pay about $3.7 million in taxes. That number is too big to stomach, so Kevin wants to see what he can do to lower his bill today without sacrificing his long-term financial prospects.

In what follows, we’ll look at how Kevin’s using a BDIT to avoid state and local taxes on his carried interest will affect his up-front tax bill, his liquidity, and his long-term returns. Spoiler alert: His taxes will go down, his returns will go up, and this kind of trust doesn’t significantly reduce liquidity. Good news all around!

The Assumptions

Kevin’s cost basis: ~$0. (Carry is typically worth $0 when a fund is established, so that’s usually the cost basis.)

Expected value upon cashing out: $10,000,000

Annual growth rate after cashing out: 8%

The Top-Line Results

Using the assumptions outlined here, Kevin can expect to earn $2,500,000 more with a BDIT (over the 10 years after he cashes out) than he would have without a tax-advantaged plan.

How Do BDITs Work?

BDITs have a simple structure:

  1. Set up the trust.
    • To be precise, someone other than Kevin and his spouse would set up an irrevocable trust in a no-tax state such as Nevada or South Dakota and fund that trust with a nominal amount. Kevin, meanwhile, would be the the beneficiary of the trust.
    • Why is this important? The irrevocable trust will be the owner of the assets, and it will be the taxpayer. By setting up in a no-tax state, the trust will pay 0% in state income taxes on any income received from assets the trust holds.
  2. Transfer assets.
    • Next, Kevin would sell his carried interest to the trust at its current fair market valuation.
    • When to transfer? As soon as possible.
    • Why now? The sale has to happen at the current FMV, so it’s typical to sell carry to a trust when it has a low value (usually around the time of fund formation, or before portfolio assets have been marked up significantly).
  3. Eliminate state taxes.
    • When income is realized on assets that have been moved to the trust, the trust will pay only federal taxes. The less you pay in taxes, the more you’ll have to reinvest, and the faster your assets will grow.
  4. Distribute trust assets
    • The trust will distribute assets to you when you need them, and, in the meantime, your investments will grow free of state and local taxes.

    Moving Carried Interest Out of State: Why This Is a “Parent-Seeded” Trust

    As a quick reminder, to transfer his carried interest out of New York’s tax jurisdiction. Kevin sold the carry to a BDIT trust his parents set up for him in South Dakota. A third party has to set up the trust because if a Kevin, a New York resident, does it, New York will attempt to tax it—and will probably succeed!

    It’s important to understand, though, that Kevin is the beneficiary of the trust, and he will still ultimately control the proceeds. But by structuring things this way, he will be able to avoid state and local taxes.

    No State or Local Taxes When Carry Pays Out

    If he had kept his carry in his own name, Kevin would have owed about $3.7 million in taxes. (That’s about 24% federal capital gains taxes, 10% state, and 3% local.) By moving the carry to a South Dakota trust instead, Kevin will zero out the state and local portions of that tax bill, saving about $1.3 million dollars in the process.

    Instead of owing $3.7 million in taxes, the trust—which is a legal resident of South Dakota—would owe just $2.4 million in taxes. The key here is that South Dakota does not have a state tax, so the trust, as the owner of the carry, only has to pay federal taxes!

    Reinvest the Savings

    That’s the story on the up-front taxes (or lack thereof). But just as important is what happens going forward: Kevin gets to reinvest the proceeds from his carry—including the millions in tax savings—free and clear of state and local taxes. By reinvesting tax free his after-tax carry proceeds of $7.6 million (instead of the $6.3 million he would have had without tax planning), Kevin is able to create even more long term wealth.

    Total Returns

    What would all of these tax savings and investment gains mean for Kevin’s bottom line? If he has his money in a BDIT, then 10 years after the realization of his carried interest—just to pick a reasonable time frame—he’ll end up with about $14.5 million in after-tax assets that he can distribute to himself.

    If, instead, Kevin had kept his money in his own name, he would have instead ended up with about $12 million. In addition, Kevin’s assets in the trust will be protected against creditors because the assets are owned by the trust instead of by him, giving his assets an additional layer of protection.

    In short, Kevin will pocket an extra $2.5 million after 10 years, all because he put his carry into a BDIT back when his carry was worth almost nothing.

    ScenarioCarry ProceedsUp-Front TaxesAmount Reinvested10-Year ReturnsExtra Return
    No Tax Plan$10,000,000$3,700,000$6,300,000$12,000,000$0

    Next Steps

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    About Valur

    We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cos of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.