For Houstonians working in private equity, hedge funds, or energy investment management, carried interest is often the most significant component of their long-term compensation and can represent the difference between a comfortable settlement and a truly life-changing one. Carried interest is also among the most technically complex assets in Texas divorce law, sitting at the intersection of partnership law, federal tax, investment management regulation, and family law.
What Is Carried Interest?
Carried interest (also called “carry”) is the general partner’s share of a fund’s investment profits, typically 20 percent, that the GP receives after the fund has returned investors’ contributed capital and met a minimum return threshold called the hurdle rate. The general partner contributes a small amount of capital (usually 1 percent of fund assets) and receives a disproportionate share of profits in return for managing the fund.
From a tax perspective, carried interest is currently taxed as long-term capital gains when the fund invests in assets held for more than three years, a preferential treatment that has been the subject of considerable legislative debate. The three-year holding period rule under the Tax Cuts and Jobs Act of 2017 means that some carry income is taxed as short-term capital gain or ordinary income, depending on the fund’s investment horizon.
Community Property Characterization in Texas
The community property analysis for carried interest turns on when the general partner’s right to carry was acquired and to what extent the carry represents compensation for services performed during the marriage versus services to be performed after the divorce.
Carry earned by a spouse who was a general partner during the marriage is community property to the extent it compensates for services performed during the marriage. The difficulty is that carry may not be received until the fund exits its investments, which can be seven to ten years after the fund’s formation. A fund formed before the marriage may generate carry that is partly separate property and partly community property, depending on how much of the service was rendered during the marriage.
Texas courts analyzing carried interest generally apply the same time-based apportionment principles used for stock options and other deferred compensation, looking at what fraction of the total service period fell within the marriage. But because carry also depends on investment performance and market conditions that extend well beyond the divorce, the analysis is more complex than a simple time fraction would suggest.
Valuation Challenges
Valuing carried interest at the time of divorce is extremely difficult. The carry has no current market price. Its value depends on the eventual investment returns of the fund, the timing of exits, market conditions, and whether the fund meets its hurdle rate. Competing experts can produce wildly different present values using different discount rates, different assumptions about exit timing, and different probability weights for various performance scenarios.
For this reason, deferred distribution is almost always the preferred structure for carried interest in Texas divorces. Rather than valuing the carry now, the decree specifies that the non-carry-holding spouse receives a defined percentage of carry distributions actually received by the carry-holding spouse over the life of the fund. This approach requires careful attention to the fund documents, which may prohibit assignment of carry interests or may require GP approval for any transfer.
Capital Call Obligations
One issue that is often overlooked is that GPs typically have capital call obligations. A spouse receiving a share of a fund’s carry may also, indirectly, be receiving exposure to future capital calls that require the GP to invest additional funds on short notice. The decree should be clear about whether and how capital call obligations are shared with the non-GP spouse.
For background on how business ownership stakes are analyzed in divorce, see our article on minority vs. majority business ownership stakes in divorce. For related reading on other complex income streams, see dividing royalty streams and intellectual property income.