Carried interest is the defining economic feature of the fund management business. It is the mechanism through which fund managers participate in the upside of the assets they manage — not as employees receiving a salary, but as partners receiving a share of profits. The tax treatment of that profit share has been contested, litigated, regulated, and legislated for decades. The Tax Cuts and Jobs Act of 2017 changed the rules materially for many managers, and the Section 1061 regime it created continues to require careful structuring to preserve capital gains treatment. This post covers how carried interest is structured, why it qualifies for capital gains treatment, and what Section 1061 actually does — and does not — require.
What Carried Interest Is and Why It Exists
Carried interest — "carry" — is the GP's contractual right to receive a percentage of the fund's profits (typically 20%) after limited partners have received their preferred return. It is not a salary, not a fee, and not a return on invested capital. It is a share of the profits of the partnership, allocated to the GP as compensation for managing the fund's assets and generating returns for investors.
The economic logic is alignment: a manager who receives 20% of the upside has strong incentives to maximize returns, because their primary compensation depends on performance rather than asset gathering. Whether this logic fully holds in practice is a separate debate. What is unambiguous is that carry is the largest economic prize available to a successful fund manager — on a $500 million fund returning 2.5x after fees, 20% carry on $750 million of profit above a preferred return represents a $150 million economic interest to the GP. The tax treatment of that interest determines how much of it the GP actually keeps.
The Profits Interest Structure
Carried interest is almost universally structured as a profits interest in the fund partnership, not as a fee payable to the manager. The distinction is fundamental to tax treatment.
A fee paid to the manager for services rendered is ordinary income, taxed at rates up to 37% federally. A profits interest — a partnership interest that entitles the holder to a share of future profits but has zero liquidation value at the time of issuance — is treated differently. Under Revenue Procedure 93-27, when a service provider receives a profits interest in exchange for services, the receipt of that interest is not a taxable event, provided the interest has no current liquidation value (i.e., if the fund were liquidated on the day the interest was granted, the recipient would receive nothing). The profits interest holder then participates in subsequent appreciation of the fund's assets, and when those assets are sold and gains are recognized at the fund level, the character of those gains — long-term capital gain, short-term capital gain, ordinary income — flows through to the profits interest holder based on the nature of the underlying assets and holding period.
This is the mechanism through which fund managers historically converted what would otherwise be ordinary compensation income into long-term capital gain: by holding the fund's portfolio assets for more than one year before sale, the resulting gains allocable to the profits interest were taxed as long-term capital gain at the preferential rate (currently 20% for high-income taxpayers, plus the 3.8% net investment income tax, for a top federal rate of 23.8% versus 40.8% on ordinary income). The tax benefit was — and remains — substantial.
The Section 83(b) Election
When a fund manager receives a profits interest in a partnership that has a vesting schedule — which is standard, because carry is typically subject to multi-year vesting tied to continued service — the manager should virtually always file a Section 83(b) election within 30 days of receiving the interest. The Section 83(b) election tells the IRS that the manager is electing to be taxed on the value of the interest at the time of receipt, rather than at the time it vests. Because a profits interest has zero value at grant (by definition — it has no current liquidation value), the Section 83(b) election results in zero taxable income at receipt. More importantly, it starts the holding period clock running on the date of grant rather than the date of vesting, which matters enormously for long-term capital gains analysis — and has additional implications under Section 1061.
Missing the 30-day window for a Section 83(b) election is a permanent and irreversible error. There are no extensions, no exceptions for oversight, and no administrative remedies. If the election is not filed within 30 days of receiving a vesting profits interest, the tax treatment on vesting events may result in ordinary income recognition at much higher values. Every fund manager receiving a profits interest in a newly formed fund should confirm with counsel that the Section 83(b) election has been filed — not assumed, not delegated, confirmed.
Section 1061: The Three-Year Holding Requirement
Section 1061 was enacted as part of the Tax Cuts and Jobs Act of 2017 and took effect for taxable years beginning after December 31, 2017. It targets "applicable partnership interests" — which is the statutory term for carried interest held by fund managers — and imposes an extended holding period requirement to qualify for long-term capital gains treatment.
Under Section 1061, gain allocated to an applicable partnership interest from the sale or exchange of a capital asset is treated as short-term capital gain (taxed at ordinary income rates) unless the underlying asset was held for more than three years. The standard long-term capital gains holding period is one year. Section 1061 effectively adds two years to that requirement for carried interest holders.
The analysis operates at the asset level, not the fund level or the profits interest level. When a fund sells a portfolio company or disposes of a securities position, the holding period of that specific asset determines whether gain allocable to the carried interest is long-term (held more than three years) or short-term under Section 1061 (held one to three years). A portfolio company acquired in year one and sold in year four clears the three-year threshold; one acquired in year two and sold in year four does not. For a private equity fund with a five-to-seven year typical hold period, most exits will comfortably clear three years. For a venture fund with early partial liquidity events, a hedge fund with portfolio turnover, or a fund making short-duration credit investments, the analysis is considerably more complex.
Who Section 1061 Applies To
Section 1061 applies to any "applicable partnership interest" — defined as a partnership interest received by a taxpayer in connection with the performance of substantial services in an "applicable trade or business." An applicable trade or business is one that consists of raising or returning capital and either investing in or developing specified assets, or developing specified assets on behalf of others. Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options and derivative contracts on any of the above, and interests in partnerships holding any of the above.
In practice, this covers the carried interest of virtually every private equity, venture capital, hedge fund, real estate fund, and credit fund manager. The provision was drafted broadly and the Treasury regulations interpreting it (finalized in 2021) have not narrowed the scope materially.
The S-Corporation Workaround and Its Limits
Shortly after Section 1061 was enacted, some practitioners proposed holding the carried interest through an S-corporation rather than directly or through an LLC taxed as a partnership. The theory was that Section 1061 applies to partnership interests, and an S-corporation is not a partnership — so gain flowing through an S-corporation to its shareholders might avoid Section 1061's three-year rule.
The 2021 Treasury regulations addressed this directly by providing that the three-year rule applies to gain recognized by the S-corporation on the sale of the applicable partnership interest, and to gain allocated to S-corporation shareholders that is attributable to the applicable partnership interest. The S-corp wrapper does not shelter the carry from Section 1061. Managers who implemented this structure before the regulations were finalized should confirm their current exposure with tax counsel.
The Capital Interest Exception
Section 1061 contains a critical carve-out: it does not apply to gain allocable to the manager's "capital interest" — the portion of the manager's partnership interest that represents a return on actual capital contributed to the fund, not compensation for services. If the GP or its principals co-invest alongside the LPs — contributing their own capital to the fund on the same economic terms as limited partners — the gains attributable to that co-investment are not subject to Section 1061's three-year rule. They are subject to the standard one-year long-term capital gains holding period.
This means that a manager who co-invests 2% to 3% of the fund (a common GP commitment requirement for institutional LPs) and who carefully documents the economics of that investment as a capital interest rather than a compensatory interest preserves the standard one-year long-term capital gains treatment on that portion of their returns. The documentation requirements are specific — the capital interest must be on terms no more favorable than those of the LPs — and the allocation between the capital interest and the profits interest must be clearly tracked. Conflating the two destroys the exception.
Interaction with the Waterfall and Early Distributions
Section 1061's asset-level holding period analysis creates particular complexity when a fund makes early carry distributions — distributions of carried interest before the fund's investment period is complete or before most assets have been held for three years. In a deal-by-deal waterfall, the GP may receive carry on early exits that occur before the underlying assets have been held for three years. Those distributions are short-term capital gain under Section 1061, taxed at ordinary income rates, even if the underlying investment was profitable and the manager had every expectation of long-term treatment when the investment was made.
For managers using a whole-fund waterfall, the issue is somewhat less acute because carry distributions are delayed until the fund as a whole has returned capital and the preferred return — which typically means carry distributions begin in the later years of the fund's life, by which point many assets will have cleared three years. But the asset-by-asset analysis still applies to each investment in the final distribution.
State Tax Treatment
Section 1061 is a federal provision. States do not all conform to it. California, for example, does not recognize preferential long-term capital gains rates to begin with — all capital gains are taxed as ordinary income at the state level regardless of holding period. States that do provide capital gains preferences vary in whether they have adopted the Section 1061 three-year rule. Florida has no individual income tax, which means Florida-resident fund managers have no state-level carried interest tax issue to analyze. New York and New York City both impose high marginal rates on ordinary income and generally conform to federal capital gains treatment, making Section 1061 compliance directly relevant to New York-based managers.
Practical Implications by Fund Type
For private equity managers with typical three-to-seven year hold periods, Section 1061 is manageable but requires discipline: tracking asset-level holding periods for every portfolio company, flagging positions approaching the three-year mark before sale, and structuring exits with the tax calendar in mind where deal economics permit. For venture managers with early liquidity events — secondary sales, tender offers, IPO lockup expirations — Section 1061 requires careful attention to whether each liquidity event involves assets held more than three years. For hedge fund managers with active trading strategies, Section 1061 effectively eliminates long-term capital gains treatment on most carry, because few positions are held for three years. The economics of carry for a hedge fund manager are therefore taxed largely at ordinary income rates regardless of the profits interest structure. Understanding this at fund formation — not after the first carry distribution — is the starting point for intelligent tax planning.