Carried Interest and Partnership Profits: The Tax Treatment Partners Need to Understand

What Carried Interest Is

In a typical investment fund, the manager or general partner receives a share of the fund’s profits, for example 20% of profits above a preferred return to investors, without contributing a corresponding share of capital. This is usually structured as a “profits interest”: a right to share in future profits and appreciation, but not in the partnership’s existing capital.

Under IRS revenue procedures, receiving a profits interest for services is generally not a taxable event if certain conditions are met. A capital interest received for services, by contrast, is generally taxable compensation under IRC §83, measured by its fair market value when it is received or vests.

Once the interest is held, partnership income keeps its character as it passes through. A manager’s share of long-term capital gain, qualified dividends, or other items is reported with the same character the items had at the partnership level, subject to §1061.

Section 1061: The Three-Year Rule

Section 1061 applies to an “applicable partnership interest”: an interest transferred to or held by a taxpayer in connection with the performance of substantial services, by the taxpayer or a related person, in an “applicable trade or business.” That term covers an activity conducted on a regular, continuous, and substantial basis that consists of raising or returning capital and either investing in, disposing of, or developing “specified assets.” Specified assets include securities, commodities, real estate held for rental or investment, cash, and related options and derivatives.

For these interests, the taxpayer’s net long-term capital gain is recomputed using a holding period of more than three years instead of more than one year. Any excess is treated as short-term capital gain, which is taxed at ordinary income rates.

For example, if a fund sells stock it has held for two years and allocates $1 million of the gain to the manager’s carried interest, that gain is treated as short-term capital gain under §1061. If the fund had held the stock for more than three years, the gain would remain long-term capital gain.

Exceptions and Exclusions

• Corporate holders. The rule does not apply to an interest held by a corporation. Under the regulations, an S corporation is not treated as a corporation for this purpose.
• Capital interests. The rule does not apply to a capital interest that gives the holder a right to share in partnership capital commensurate with the capital contributed, or with the value of the interest taxed under §83. Returns on a manager’s own invested capital can therefore fall outside §1061 if the allocations meet the requirements of the regulations.
• Excluded gains. The regulations exclude certain items from the recharacterization, including §1231 gain, §1256 gain, and qualified dividends.

Transfers to Related Persons

If a taxpayer transfers an applicable partnership interest to a related person, such as a family member, §1061(d) can require the taxpayer to recognize short-term capital gain on the portion of long-term gain attributable to assets held for three years or less. Estate planning involving carried interests should take this rule into account.

Compliance Points

Applying §1061 requires holding period information at both the partnership and the asset level. The regulations require partnerships to provide holders of applicable partnership interests with the information they need to compute the recharacterized amount. Fund documents should address how this information is tracked and reported, and how capital commitments by the manager are distinguished from the carried interest.

The Bottom Line

Carried interest can still produce long-term capital gain, but for interests held in connection with investment management services, §1061 generally requires that the underlying assets or the interest be held for more than three years. The capital interest exception, the excluded categories of gain, and the related-party rule all deserve attention when funds and their managers structure and document these arrangements.