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Private Derivatives: A Wealth Structuring Solution in the US

By Matthew Ledvina, JD, LLM (US Taxation)

Matthew Ledvina

Introduction 

When it comes to wealth structuring in the US, traditional methods often center around the direct transfer of assets. However, there are circumstances where such asset transfer becomes either impractical or impossible, or where doing so could trigger complex tax implications. This article explores how private derivatives can serve as a versatile alternative for wealth structuring in the US. 

Why Is This Important? 

If direct asset transfers pose difficulties due to taxation, legal constraints, or other issues, private derivatives present an avenue for transferring the economic value associated with an asset. This is especially applicable to business owners, executives, and fund managers in the realms of private equity, venture capital, and hedge funds. 

Understanding Private Derivatives 

Private derivatives are contractual frameworks that enable individuals to transfer the economic upside linked to an asset. This becomes particularly handy when the asset itself cannot be easily transferred for a variety of reasons: 

Unvested Shares: Some business owners may hold shares that have not yet vested. The gift tax laws in the US do not recognize the transfer of unvested shares as complete until the shares have vested. 

Non-Transferable Shares: In other instances, vested shares may be subject to securities laws or contractual obligations that prevent their transfer. 

Impractical Transfers: There are cases where a business owner could technically transfer vested, transferable shares but opts not to for strategic or practical reasons, such as market perception or the need to get approval from other stakeholders. 

Structuring a Private Derivative 

The typical arrangement involves an individual entering into a derivative contract with an irrevocable grantor trust. This type of trust is tax-transparent for US income tax purposes. Therefore, the transaction becomes tax-neutral. The terms of the contract lay out specifics like the purchase price, contract duration, and the settlement amount payable to the trust. 

Risk and Reward 

It's crucial to note that the trust takes on the financial risk of the purchase price, which should equal the current fair market value (FMV) of the derivative. To establish this FMV, an independent, professional appraisal is generally advised. This ensures that the transaction is aligned with current market valuations, thus avoiding complications like gift tax or fiduciary duty violations. 

Reporting Requirements 

For US gift tax purposes, a properly structured private derivative is considered a non-gift transaction. However, individuals may opt to report the derivative to limit the timeframe within which the IRS could question its legitimacy. Although there's usually no obligation for income tax reporting, additional reporting may be required if the individual makes gifts to the irrevocable trust that buys the derivative. 

Conclusion 

Private derivatives offer a robust and flexible mechanism for those facing challenges with conventional methods of wealth transfer in the US. By enabling the transfer of an asset's economic value instead of the asset itself, private derivatives serve as an invaluable tool in the landscape of US wealth structuring. 

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