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Using Loan Method Split Dollar to Recreate the Benefit of Tax Deferral for Carried Interest

One of the things that Mrs. Nowotny (aka Long Suffering) and I enjoy doing is watching movies. In particular, we like foreign films. I caught the foreign film "bug" as a double major in Spanish and Portuguese. Following graduation and reporting to my Officer Basic Course at Ft. Eustis, Virginia, I spent some time in New York. While my wife worked at her alma mater in the Admissions Department, I killed some time and watched a foreign film called Les Uns et les Autres' (Bolero). It is possibly one of the most wonderful and deeply moving films, I have ever seen. It is a film about humanity, about love, war, loss, and redemption. From that time on, I embraced foreign films. One of Mrs. Nowotny's movie favorites is The Way We Were. She has seen it ten-twelve times. It is a good movie but probably more of a Robert Redford thing if you ask me!

Hedge Fund managers previously had an unprecedented ability to defer their carried interest. IRC Sec 409A put an end to those deferrals and required hedge fund managers to repatriate their offshore carried interest no later than December 31, 2017. On a personal level, I was aware of small hedge fund managers with $30-50 million of deferred carried interest. On the flip side of things, I was aware of large fund managers with $750 million to $1 billion of deferred carried interest. These deferred funds were in the hedge fund manager's taxable estate and subject to ordinary income taxation. The combination of income and estate taxation much like qualified retirement would have resulted in a 70-80 erosion due to taxes. The deferrals were usually ten-year deferrals with no taxation during the deferral period. The deferred fee income exploded in growth earning the investment return of the hedge fund manager's funds.

But when all of the laughter dies in sorrow, we need to find the next big thing. Since that time hedge fund managers have lacked an effective compensation strategy to replicate the way things were in the time of wine, women, and song. This summary outlines the power of Loan Method Split Dollar as compensation technique for hedge fund managers that in the current environment is arguably a better solution than the prior deferral strategy after consideration of income, and estate taxation as well as asset protection.

For many hedge funds, most of the investors are invested in the offshore fund. These investors include tax exempt investors such as large pension plans, endowments and foundations and foreign high net worth and institutional investors. The investment management company typically structured as a domestic limited liability company taxed on a pass-through basis entered into a contractual agreement with the offshore fund which is taxed as a corporation in a jurisdiction where the corporation is not taxed, to defer payment of its 20-50 percent incentive fee or carried interest.

The proposed strategy using Loan Method Split Dollar seeks to provide hedge fund managers with financial and tax leverage using Private Placement Life Insurance (PPLI). In Loan Method Split Dollar, a corporate entity functions as the lender in the arrangement providing a long-term loan. The current long term applicable federal rate in September 2020 is 1.0 percent. The offshore fund would provide this loan based in lieu of payment of the incentive fee for a particular year. In the initial year, the corporation might calculate a loan amount based upon the average amount of annual carried interest in the offshore fund over the preceding three-five years. The hedge fund manager could structure an Irrevocable Trust such as a Spousal Lifetime Access Trust (SLAT) or Spousal Lifetime Access Non-Grantor Trust (SLANT) to serve as the policyholder for the arrangement. The trustee of the family trust to fund the policy rapidly on a non-modified endowment basis so that future lifetime distributions from the policy receive tax-free treatment.

The offshore fund would receive a restricted collateral assignment interest in the policy equal to the amount of the loan plus accrued interest. The corporation's access would be restricted until the earlier of the death of the insured (hedge fund manager), surrender of the policy or termination of the Split Dollar Agreement. The trustee of the family trust would look to terminate the Split Dollar Arrangement once the policy is fully funded. The Split Dollar Rollout or termination using the Leveraged Split Dollar™ technique would provide the trustee to purchase the collateral assignment interest at a large discount of 65-90 percent depending upon actuarial and financial considerations. The trustee could use a tax-free distribution from the policy or other trust assets to accomplish this termination. The balance of the fees retained by the corporation would be used to provide a death benefit only benefit for the hedge fund manager which would be paid in a lump sum at the hedge fund manager's death.

The policy ownership within the family trust shields the policy from the hedge fund manager's business and personal creditors. The trust allows the hedge fund manager to receive tax-free benefits during his lifetime from the trust. The tax-free distributions from the life insurance policy receive tax-free treatment. The policy death benefit receives income and estate tax treatment within the trust. The policy accumulates on a tax-free basis. Exercising planning care, the policy is able to invest premiums into a series of funds managed by the hedge fund as well as other funds.


Sometimes a desire for things to return to the way things were misses the possibility that maybe the planning opportunities available might be better than the planning utilized in the past.

Split Dollar life insurance has been on a long hiatus since the long-anticipated passing of Equity Split Dollar. The low interest rate environment has created an unprecedented opportunity for the second coming of the Split Dollar through the Loan Method of Split Dollar life insurance. The combination of the Loan Regime of Split Dollar with Private Placement Life Insurance within a family trust provided unparalleled asset protection and tax-advantaged wealth accumulation opportunities.


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