Carried Interest

Carried interest is the portion of a private investment fund's profits allocated to its general partner or manager, conventionally around 20 percent and paid only after limited partners have received their capital back and any agreed preferred return. It is compensation for performance rather than a charge on assets, and because it is delivered as a partnership allocation rather than a fee, the character of the fund's income passes through to the manager. The Internal Revenue Code never uses the phrase. What it regulates is the "applicable partnership interest", defined in Section 1061, whose heading is "Partnership interests held in connection with performance of services". Carried interest is the market's name for that interest; applicable partnership interest is the law's.

Why the character question exists at all. A partnership does not pay tax on its own income; it allocates income to its partners, and the character of that income, whether it is long-term capital gain, short-term gain, interest, or dividends, follows it through. A manager who receives a fee is receiving compensation. A manager who receives a profits interest in the partnership is receiving an allocation of the partnership's own income, so if the fund's gains are long-term capital gains, the manager's share arrives as long-term capital gain too. That structural fact, rather than any special exemption, is what the long-running political argument is about.

What Section 1061 actually does. Added by the Tax Cuts and Jobs Act in December 2017, Section 1061 does not deny capital-gain treatment. It changes the holding period used to test it. Section 1061(a) takes the taxpayer's net long-term capital gain with respect to applicable partnership interests, subtracts the same figure recomputed by substituting "3 years" for "1 year" in the definitions of long-term and short-term gain, and treats the difference as short-term capital gain. In practice: gain from an asset the fund held more than three years keeps its long-term character; gain from an asset held more than one year but not more than three is recharacterized.

Short-term capital gain is not ordinary income, and the difference is real. Recharacterized carry is taxed at ordinary rates, which is where the two are often conflated, but it remains capital gain, so it enters the capital gain and loss netting rules rather than becoming compensation. Nothing in Section 1061 converts carried interest into wages, and nothing in it makes carried interest subject to employment taxes.

The definitions do the real work. An applicable partnership interest is an interest transferred to or held by a taxpayer "in connection with the performance of substantial services" in an applicable trade or business. An applicable trade or business, in turn, is an activity conducted on a regular, continuous, and substantial basis consisting of raising or returning capital and either investing in, disposing of, or developing specified assets. Specified assets are securities, commodities, real estate held for rental or investment, cash and cash equivalents, options and derivatives on those, and partnership interests to the extent of the partnership's proportionate interest in any of them. The definition is drawn to capture investment fund managers and to leave operating businesses outside it.

Two carve-outs worth knowing. Section 1061(c)(4) excludes an interest held by a corporation, and it excludes a capital interest that gives the holder a right to share in partnership capital commensurate with the capital they actually contributed, or with the value already taxed on receipt or vesting. A manager who invests real money alongside the fund's investors is holding a capital interest for that money, and the three-year rule is not aimed at it. Section 1061(d) then closes an obvious route out: transferring an applicable partnership interest to a related person, defined to include family within the meaning of Section 318(a)(1) and people who performed services in the same applicable trade or business in the current or preceding three calendar years, can trigger short-term gain on the transfer itself.

The state of the argument. Whether a profit share earned for managing other people's money should be taxed at capital-gain rates has been contested in Congress for well over a decade, and proposals to change it appear regularly. Section 1061 is the one change that has been enacted, and it narrowed the treatment rather than ending it. A reader should treat any description of this area written before 2018 as describing a rule that no longer applies in full.

A fund is organized as a partnership. Investors are limited partners and the manager is the general partner, holding an interest that entitles it to a stated share of profits, commonly 20 percent, typically only after the limited partners have received their contributed capital and a preferred return. When the fund sells an investment at a gain, the partnership allocates the manager's share to it as an allocation of partnership income, carrying whatever character that income had inside the fund. Section 1061 is then applied at the manager's level to test how much of that long-term gain survives the three-year holding period.

A hypothetical example of the Section 1061 arithmetic. Suppose a manager's carried-interest allocations for a year produce $10,000,000 of net long-term capital gain under the ordinary one-year rule. Of that, $6,000,000 came from portfolio investments the fund had held for more than three years, and $4,000,000 came from investments held more than one year but not more than three. Section 1061(a) compares the two figures: net long-term gain under the normal rule, $10,000,000, minus net long-term gain recomputed with a three-year requirement, $6,000,000, leaves $4,000,000. That $4,000,000 is treated as short-term capital gain and taxed at the manager's ordinary rates. The remaining $6,000,000 keeps long-term treatment.

Two details change the answer and are easy to miss. If the manager also put its own cash into the fund, the return on that money is a capital interest rather than an applicable partnership interest, and the three-year rule does not reach it. And for gain allocated from the fund's own sale of an investment, the holding period being tested is the fund's holding period in that asset rather than how long the manager has held its interest in the fund. A sale of the manager's interest itself is a separate case, tested on that interest's own holding period.

Pros

• It ties the manager's pay to realized results rather than to the size of the pool, which is the alignment argument for the structure.
• It is generally paid only after investors receive their capital back and a preferred return, so investors are ahead of the manager in the queue.
• The three-year rule reaches only the manager's profit share, leaving an outside investor's own gains under the ordinary one-year holding period.

Cons

• It is charged on gains without a symmetric charge for losses, so the manager participates in the upside more than in the downside.
• The three-year holding period can push a manager toward holding an investment longer than the investors' interests would otherwise justify.
• The rules are complex enough that whether a particular interest is an applicable partnership interest is a real question requiring professional advice, not a lookup.
• The tax treatment has been politically contested for years, so a manager or an investor planning around it is planning around a rule that has already changed once and may change again.