The Art of the Split: Carried Interest and Divorce
Divorce proceedings involve the meticulous dissection of a couple’s financial life, requiring the equitable division of assets and liabilities. One of the more complex financial elements to navigate during this process is the treatment of carried interest, an issue particularly prevalent in divorces involving private equity, hedge fund, real estate, or venture capital professionals. This guide aims to shed light on the intricacies of carried interest and how it is treated in California divorce cases.
Carried interest is essentially a financial interest in the future profits of an investment vehicle. For example, a private equity manager might receive a percentage of a fund’s profits as carried interest, aligning the manager’s financial incentives with the fund’s performance.
Unlike regular income, carried interest may only be realized when the fund or investment vehicle clears a certain target return rate and has some form of liquidity event, which could take several years.
The lag in timing between the grant and the realization of carried interest is particularly important in community property states, such as California, where income generated from a spouse’s labor during the marriage is treated differently than income or investment interests earned before the marriage or after separation.
Legal Considerations of Carried Interest in Divorce:
California is a community property state, meaning, in general, that assets acquired during the marriage are considered joint property and are subject to division upon divorce. The challenge with carried interest arises in determining its characterization - is it a marital asset, earned as a result of work efforts during the marriage? Is it a separate asset, related to work after the separation? Is it a bit of both?
To make a determination as to the treatment and division of carried interest, California courts will consider many factors, including:
Characterization: the first hurdle in dealing with carried interest in a divorce is how to characterize the carry. Characterization hinges on when the interest was acquired, for what reason, and the nature of its vesting. If it was earned during the marriage, it is likely community property. If it is also tied to future (i.e. post-separation) performance or efforts, however, a portion might be classified as separate property.
Valuation: following characterization, the next step is the valuation of the carry. Unlike a fixed asset or a steady W-2 income stream, carried interest depends on future fund performance, making its current value speculative. Divorcing spouses often need to employ sophisticated financial models and forensic accountants to value the carry accurately.
Division: the most complex aspect of asset division for private equity, venture capital, or hedge fund professionals and their spouses is how to divide unrealized carried interest. With both the timing of future cash flows and the amount of those distributions being speculative, a few different approaches may be adopted:
Deferred distributions - where the division of the carried interest is postponed until actual realization - allows for a more accurate and fair split, based on real receipts rather than speculative projections. On the flip side, however, this approach prolongs the financial ties between the divorcing parties, requiring ongoing communication and cooperation until the carried interest is realized - a process that can take years.
Offsetting - where a spouse entitled to a share of the carried interest is compensated with other assets of equivalent current value - provides immediate closure and financial independence for both parties, eliminating the need for prolonged financial entanglement. The primary challenge with offsets lies in accurately valuing the carried interest and finding sufficient other liquid assets to offset the carried interest’s estimated value. Alternatively, if there are no other assets to offset, the parties may negotiate a buy out of their spouse’s interest. This approach is expedient, but may result in one spouse taking a discount for an immediate distribution or the other spouse assuming realization risk.
Structured payments - where a payment plan is established and the entitled spouse receives payments over a set period, often contingent on realization - can provide financial stability for the entitled spouse by providing more predictable distributions, while limiting the payor spouse’s realization risk. Similarly to deferred distributions, however, structured payments extend the parties’ financial entanglements and can also present compliance and enforcement challenges, particularly if the realization of the carried interest is spread out over several years.
Liquidity and Taxes: carried interest is not liquid, can be clawed back in certain instances, and can have significant tax implications when realized. The divorcing couple must consider these factors in their settlement negotiations. For instance, if a spouse is awarded a share of carried interest that is realized after the divorce, they may be responsible for the associated tax liabilities. These elements must be weighed closely throughout the negotiation and division process.
Dividing unrealized carried interest requires a nuanced approach that balances immediate financial needs with future uncertainties. It involves a combination of expert valuation, financial analysis, and legal strategy. Due to the complexities involved, parties often prefer to negotiate settlements rather than litigate.
Whether litigating in court or negotiating a settlement, protecting one’s interests requires skillful negotiation and an understanding of both the asset class and divorce law. To learn more about your rights, contact Shayan Family Law, APC.
