How Connecticut judges approach carried interests in divorce

On Behalf of | May 16, 2024 | Property Division

Carried-interest payments can be a lucrative source of wealth for a Connecticut family. As such, in divorce proceedings in which one or both spouses have been successful in meeting professional goals that triggered significant carried-interest payouts, both litigants will likely consider the disposition of carried interests as a major issue in the dissolution of their marriage.

The nature of carried interests

From a high level, a carried interest (also called a carry, performance fee, promoted interest or promote) is a potential financial return for an individual (or entity) – usually an executive who is a general partner (GP) or fund or project manager – involved in a long-term investment, fund or project.

Most commonly, carried interests are tools used in real estate development, hedge funds, venture capital or private equity funds. Other industries that may use this structure include oil-and-gas well development or health care.

The carried interest normally pays out a percentage of profits (usually 20%) to the GP or manager after the limited partners (LPs) or investors have recouped their investments plus received an agreed-upon level of profits (usually 8%, called the hurdle rate or preferred return level). Usually, the manager gets their carried interest at this point with the LPs sharing in the rest of the profits.

Depending on the contractual arrangement and industry, the returns may generate from investments or from the sales proceeds of a real estate development project, for example.

Carried-interest structures inherently urge elevated levels of risk. When profits are lower than hoped for, the project agreement may allow LPs to “claw back” losses from the GP.

Why structure a fund or deal using carried interests?

The person with the carried interest normally has power to influence or push up the profit level through successful strategy and management. The policy behind carried interests is to incentivize the manager to take risks and work hard, financially benefitting both the investors and the GP.

So, the carried interest motivates that person, who likely has absorbed significant personal and financial risk, to take commercial gambles that might push up returns for everyone involved. For the extra risk taken, the enhanced carried-interest payout is the reward.

Examples of risks a manager may agree to assume to incentivize investors and strengthen the n GP’s negotiation position for a higher carry rate include absorption of excess costs, unexpected debts, environmental liabilities or litigation costs.

The IRS taxes a carried interest as a long-term capital gain if the owners hold the fund, project or asset for at least three years. Congressional compromise added the three-year holding requirement as a trade-off for not changing the tax treatment to more expensive income tax rates. Carried interests are above and beyond management fees for services (usually 2% of profits taxed as ordinary income).

Connecticut divorce proceedings and promoted interests

Promoted or carried interests could be major assets or income sources in a divorce, but very few cases in Connecticut address this, nor do many divorce cases in other states. Two key issues rise to the top: the likelihood carried interests will pay out and their actual values. We have the guidance of a few trial-level divorce cases in Connecticut in which the judges address carried interests.

In one recent case, the wife’s financial expert, an attorney, said she expected the husband would continue to receive carried-interest payouts on capital balances totaling $462,383. The judge ordered monthly alimony of $8,750. In addition, when the husband receives more than $500,000 of “net income received on gross annual income,” 30% of the excess is added to the base alimony amount. The judge specifically included carried interests as part of gross annual income. Any variation on the amount of carried-interest distribution is accounted for by use of a percentage instead of a set amount. Morgan v. Whitticom, 2023 WL 9054421 (unpublished 2023). See also Busch v. Busch, 2022 WL 21780705 (unpublished 2022); Winslow v. Winslow, 2018 WL 1056216 (unpublished 2018).

In Briggs v. Briggs, 2022 WL 21740468 (unpublished 2022), the wife asked the court to divide ownership of a fund that generated carried-interest distributions to the husband. The judge refused to treat the fund like other accounts they ordered split between the litigants. Instead, the court let the husband keep the fund because it was the source of carried-interest payouts that will “create the annual income that he is to share with Ms. Briggs.”

The court in Manero v. Manero, 2017 WL 2539416 (unpublished 2017), credited the opinion of the husband’s expert that his 10% carried interest in a condominium development project was worth nothing because it is not likely to generate payouts. The judge did include a provision that if the husband did get any carried-interest payments he was to split them equally with the wife.

Future of carried interests in Connecticut divorces

The limited number of cases about this topic leaves it open for further development by our courts. A couple of observations:

  • Valuation of carried interests involves complex mathematical, financial and business concepts plus informed risk assessment. Although judges have used percentages of carried-interest amounts to supplement a base alimony payment, there may be times when actual valuation may be necessary. The property distribution and support payments in a divorce judgment must be carefully balanced to achieve what the court decides is just.
  • Funds and projects that include carried interests have attributes of property (husband kept fund instead of splitting with wife in Briggs), but judges have treated the carried interests they generate as income for purposes of alimony. These concepts may become complex such as when the fund or project is “owned” by others and the litigant is only a manager with carried-interest rights.

An experienced, knowledgeable divorce attorney can provide advice about what to advocate for when carried interests are at issue in a dissolution of marriage. The lawyer can also assist in retaining an appropriate expert who can assist with issues of valuation and the likelihood of projected distributions.