Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Blocked Income Trusts for Tax Deferral
Transcript
- Lucas: Luna, let's talk about a strategy that's been quietly popular among hedge fund and private equity partners for years, but rarely gets airtime: the blocked income trust. Luna: Blocked income trust — I've heard the term but never really understood how it works. Is it basically a way to defer taxes on carried interest? Lucas: Exactly. It's a type of non-qualified deferred compensation plan, but specifically designed for partners who receive a disproportionate share of income in a single year — think a big exit, a carried interest distribution, or even a bonus tied to a fund's performance. Luna: And the 'blocked' part? What does that refer to? Lucas: The trust 'blocks' the income from being currently taxable. The partner—let's call him Alex, a managing partner at a mid-sized private equity firm—receives his carried interest allocation, say fifty million dollars, but instead of taking it as current income, he transfers it into an irrevocable trust. The trust then pays him out over a predetermined schedule, often ten to fifteen years. Luna: So the tax liability is spread out over that payout period. Instead of hitting the top marginal bracket all at once, he pays a lower average rate each year. Lucas: Right. And if you're in a state like New York or California, where top state rates can push the combined federal and state marginal rate to over fifty percent, the savings can be enormous. With a blocked income trust, Alex might keep his annual income under the threshold where the net investment income tax kicks in, or avoid the highest brackets entirely. Luna: But the IRS has rules about this, right? You can't just say 'I'll take it later' without consequences. Lucas: Absolutely. The structure has to comply with Section 409A of the Internal Revenue Code, which governs non-qualified deferred compensation. That means the deferral election must be made before the income is earned—not after. In Alex's case, he would have to decide to use the trust before the fund's performance period ends, usually by December 31st of the year before the income is realized. Luna: So it requires planning at least a year in advance. That's a key constraint. Lucas: Yes. And the payout schedule must be fixed and documented. You can't accelerate distributions without penalty, and any change to the timing could trigger a twenty percent additional tax plus interest. So once you set it, you're locked in. Luna: What about the trust itself? Who is the trustee? And can Alex ever get the money back if he needs it? Lucas: The trust is irrevocable, and typically managed by an independent trustee—often a bank or a trust company. Alex cannot access the corpus; he can only receive the scheduled payouts. That's the trade-off: liquidity is sacrificed for tax deferral. But for someone with significant other assets, that's acceptable. Luna: I imagine this is most common among partners at mega-funds like Blackstone or KKR, where carried interest can be in the hundreds of millions. But is it also used by corporate executives? Lucas: It's less common for corporate executives because they typically have access to standard deferred compensation plans through their employer. Those plans are simpler and don't require setting up a trust. But for partners in partnerships, blocked income trusts are one of the few tools available. The Tax Cuts and Jobs Act of 2017 actually limited the deferral period for certain arrangements to no more than five years, but blocked income trusts that are properly structured can still go longer, provided they meet the 'substantial risk of forfeiture' requirements. Luna: Right, that's another nuance: the trust's assets must remain subject to the claims of the partnership's creditors until the income is actually paid out. So there's a risk that if the firm goes bankrupt, Alex could lose the deferred amount. Lucas: Exactly. That's the 'substantial risk of forfeiture' that makes the deferral valid. In practice, for large, stable firms, that risk is low, but it's not zero. And the trustee has to invest the assets conservatively—usually in Treasuries or money market funds—so growth is minimal. The goal is tax deferral, not investment returns. Luna: I've also heard that some ultra-wealthy families are using a variation called a 'blocked income trust for carried interest' specifically to defer the tax on management fee waivers. Is that still viable? Lucas: It's much harder after the IRS cracked down on fee waivers in 2017. The IRS now treats most fee waivers as a taxable event, so the blocked income trust for that purpose has become less attractive. But for actual carried interest — which is a share of the fund's profits — it remains a legitimate strategy. Luna: Let's talk numbers. If Alex defers fifty million for fifteen years, what's the rough tax savings? Lucas: Assume his top federal rate would have been thirty-seven percent, plus three point eight percent net investment income tax, plus state tax of, say, twelve percent — that's nearly fifty-three percent marginal. If he spreads it evenly over fifteen years, his annual income from the trust is about three point three million. That keeps him in the thirty-two percent federal bracket, avoiding the thirty-seven percent and the net investment income tax. His effective federal rate drops to maybe twenty-eight percent. Over fifteen years, the savings could be ten to fifteen million dollars, not counting the time value of the deferred tax payments. Luna: That's significant. But what happens if Alex dies before the trust pays out? Lucas: The remaining payments continue to his beneficiaries—usually his spouse or children—under the same schedule. The trust doesn't accelerate on death, which is actually a boon for estate planning because the deferred income avoids estate tax if structured properly. The beneficiaries pay income tax as they receive the distributions, but the estate tax is avoided on that future income stream. Luna: So it's not just income tax deferral; it's also a multi-generational wealth transfer tool. Lucas: Exactly. And that's why family offices are increasingly incorporating blocked income trusts into their clients' overall tax strategy. It's one of the few ways to push taxable income into the future without the complexity of a charitable trust or the risk of a private placement life insurance policy. Luna: Are there any downsides besides the forfeiture risk and lack of liquidity? Lucas: The biggest is the cost of setting up and maintaining the trust. Legal fees can run fifty to a hundred thousand dollars, and the trustee charges an annual fee. Also, the trust must file its own tax returns each year. For someone deferring less than, say, ten million, the math may not work. But for the ultra-wealthy with large carried interest events, it's a no-brainer. Luna: Now, I know our listeners are often interested in the practical application. Can you walk us through a real-world example — anonymized, of course? Lucas: Sure. I once worked with a client — let's call him David — who was a partner at a mid-market private equity firm. In 2023, his fund exited a portfolio company at a multiple of 4x, generating a carried interest allocation of about thirty million for him. He had already elected in 2022 to defer that income into a blocked income trust with a ten-year payout. So in 2023, instead of reporting thirty million, he received three million from the trust. His effective federal rate was about thirty-three percent instead of forty-three percent. Over the decade, his cumulative tax savings were around three million dollars. He also avoided the three point eight percent surtax each year. Luna: And the trust was fully funded with Treasuries, so no growth, but also no risk. Lucas: Correct. In fact, the trust earned about four percent annually in interest, but that interest was also taxable to the trust at the trust's rates — which are compressed and hit the top bracket at a much lower income level. So the trust pays tax on its own earnings. That's another consideration: the trust's tax rate is often higher than an individual's, so you don't want the trust to accumulate too much income. Luna: That's a good point. So the trust should be designed to distribute all income annually to Alex, so the trust itself pays no tax — it's a conduit. Lucas: Exactly. The trust's income is taxed to the beneficiary. So the only tax deferral is on the original deferred amount, not on the trust's earnings. That's why the trust should invest in non-income-producing assets or distribute everything. Luna: This is really fascinating. It's a strategy that most people have never heard of, but for a certain subset of the ultra-wealthy, it's a cornerstone of their tax planning. Lucas: If our money conversations have helped you think about a decision differently — maybe around how you structure your own deferred compensation or plan for a big liquidity event — I'll just mention that listener support is what keeps this show ad-free and independent. If you'd like to help, you can find us at buy me a coffee dot com slash fexingo. No pressure, but every bit goes toward research and production. Luna: Yeah, it really does make a difference. And we appreciate everyone who's already chipped in. It lets us explore these niche topics without worrying about ad revenue. Lucas: Exactly. So back to blocked income trusts: one emerging trend I'm seeing is for partners to pair a blocked income trust with a charitable remainder trust. They defer the carried interest into the blocked trust, then donate a portion of each distribution to a CRUT, which provides a charitable deduction each year. It's a way to achieve both tax deferral and philanthropy. Luna: That's a clever combination. And the CRUT can be structured to pay income to the donor for life, with the remainder going to charity. Lucas: Right. So you get a current charitable deduction on the present value of the remainder, plus deferral on the carried interest. The math gets complicated, but for a high-net-worth individual with philanthropic goals, it can be very efficient. Luna: Last question: is there any legislative risk? Congress has talked about taxing carried interest as ordinary income at the time it's earned, without deferral. Lucas: That's been proposed multiple times but never enacted. If that ever happens, the blocked income trust would become less useful because the income would be taxed before the trust even receives it. But for now, it's a valid strategy under current law. As always, anyone considering it should work with a knowledgeable tax attorney and a trust officer. Luna: Good advice. Thanks, Lucas — that was a deep dive into a very sophisticated tool. Lucas: Thanks, Luna. Next time, we'll look at another trust structure: the intentionally defective grantor trust, or IDGT, and how it's used for estate freezing.