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Welcome to the second issue of The Deal Tax — a weekly newsletter where we take one tax topic and break it down two ways. First comes Plain English: short, jargon-free, and written for anyone who works in finance or business but didn't specialize in tax. Then comes The Deep End: the full technical analysis, written for tax practitioners who want something they can actually use at work or for self-study. Same topic, two depths — pick whichever fits, or read both. We're glad you're here. Let's get into it.

There's a number that lives at the center of almost every private equity and venture capital fund: 20%. That's the share of profits that goes to the fund managers — the GPs — after investors get their money back. It's called carried interest, or just carry, and it's how most GPs make the majority of their income.

It's also been called a loophole by politicians on both sides of the aisle for nearly two decades. Here's why — and why it matters for you.

What carried interest actually is

When a fund makes money on an investment, those profits get split between the investors (LPs) and the fund managers (GPs). The LPs put up the capital. The GPs put up the expertise, the deal sourcing, the portfolio management, and — critically — the risk that they'll spend years working on a fund that returns nothing. The carry is the GP's share of the upside above a certain return threshold.

The important thing is that carry isn't a salary. It's a profits interest in a partnership. That distinction matters enormously for how it gets taxed.

Why GPs currently pay capital gains rates on carry

Under the U.S. tax code, when a partnership makes money on an investment held long enough to qualify as a long-term capital gain, that character flows through to every partner — including the GP receiving carry. The fund held a company for four years and sold it at a profit? That's a long-term capital gain. It passes through to the GP as long-term capital gain. They pay around 23.8% on it, not the 37% ordinary income rate that would apply to a salary or bonus.

Critics call this a loophole. Their argument: you're being paid for services, so it should be taxed as ordinary income. The counterargument is that carry is deferred, illiquid, uncertain, and reflects real economic risk. You don't get paid until the fund performs. A salary shows up every two weeks regardless.

Both of those things can be true at the same time. That's what makes this debate so durable.

What Congress already changed in 2017

The Tax Cuts and Jobs Act didn't end the capital gains treatment, but it did add a speed bump: Section 1061. Under the new rule, to get long-term capital gain rates on your carry, the fund's underlying investment has to be held for more than three years — not just the standard one year. Exit a deal in year two, and that carry gets recharacterized as short-term capital gain, taxed at the same rates as ordinary income.

For traditional buyout funds with five-to-seven-year hold periods, this was manageable. For growth equity, venture, and credit strategies with faster cycles, it created real complications. And it set up the political framework for what's coming next.

What's being proposed now — and why it's different this time

The three-year rule was a compromise. What's been circulating in Congress now is a full reclassification: carry taxed as ordinary income, period. No holding period that saves you. No pathway to capital gain treatment. Management fee rates — up to 37% — on every dollar of carry, in some proposals also subject to self-employment tax.

The gap between 23.8% and 37% is around 13 percentage points. On $10 million of carry, that's $1.3 million more in federal tax. On a large fund with multiple senior GPs, the economics shift meaningfully — for the managers, for future fund terms, and potentially for how funds are structured.

This isn't the first time these proposals have surfaced. They've come and gone for years. But the current legislative environment — revenue needs, political appetite on both sides for this particular reform — means this round deserves to be taken seriously.

What you should be thinking about

The instinct to wait and see is understandable. Legislation has failed before. But the time to understand your exposure isn't after a bill passes — it's now, while there's still runway to plan. That means mapping how Section 1061 currently applies to your specific fund and investment mix, understanding which of your carry streams are most at risk, and having a real conversation with your tax advisors about what fund formation and waterfall design looks like in a world where carry is ordinary income.

The structure of your economics may need to change. The moment to think about that is before your next fund raise, not after your first exit.

In The Deep End below, we get into the technical mechanics — how Section 1061 actually works, the regulations Treasury has issued, the exceptions that matter in practice, and what the current legislative proposals look like on the statute.

Carried interest is economically a profits interest — an interest in the future appreciation of a partnership, granted in exchange for services, that carries no entitlement to existing assets. Under Rev. Proc. 93-27 and Rev. Proc. 2001-43, the receipt of a profits interest in exchange for services is generally not a taxable event, provided certain conditions are met (principally, that the interest does not relate to a substantially certain and predictable stream of income, and the partner does not dispose of it within two years).

The baseline federal income tax treatment flows from the aggregate theory of partnership taxation: income, gain, loss, and credit retain their character as they pass through the partnership to partners. §702(b). A GP receiving an allocation of long-term capital gain through its carried interest receives long-term capital gain — the same character the fund recognized on disposition of the underlying investment. Pre-TCJA, the only requirement was the standard §1222 one-year holding period at the fund level. The §1402 self-employment tax generally did not apply to limited partnership allocations, and §3101 FICA taxes did not apply to distributive shares.

The policy objection — that carry is compensation for services and should be ordinary income — never succeeded legislatively before 2017, despite multiple attempts (including the Levin bills of 2007–2015). Section 1061 was the first statutory restriction enacted.

Statutory Framework

Section 1061(a) provides that if a taxpayer holds an Applicable Partnership Interest (API), any net long-term capital gain attributable to that API with respect to assets held for three years or less is recharacterized as short-term capital gain — taxed at ordinary income rates. The recharacterization operates at the asset level, meaning it is the fund's holding period in the underlying investment that governs, not the GP's holding period in the carry interest itself.

Definition of an API

An API is any interest in a partnership transferred to or held by a taxpayer in connection with the performance of substantial services in an applicable trade or business. §1061(c)(1). The definition is intentionally broad and captures virtually all traditional carried interest structures in the private funds context.

Key exclusions from API status:

Applicable Trade or Business

An applicable trade or business is any activity conducted on a regular, continuous, and substantial basis consisting, in whole or in part, of: (i) raising or returning capital; and (ii) either investing in or disposing of specified assets, or developing specified assets. §1061(c)(2). Specified assets include securities, commodities, real estate held for rental or investment, cash equivalents, options or derivative contracts with respect to such assets, and interests in partnerships that are themselves applicable trades or businesses.

Treasury issued final regulations (T.D. 9945) in January 2021, effective for taxable years beginning on or after January 19, 2021. Several provisions are particularly significant in practice.

The Look-Through Rule on API Disposition — Reg. §1.1061-4(b)(7)

When an API holder disposes of the carried interest itself (rather than the fund disposing of underlying investments), the gain on that disposition is subject to Section 1061 through a look-through analysis. Specifically, the regulations require the selling GP to look through to the fund's underlying assets and determine what portion of the gain would be Section 1061 gain if the fund had sold its assets at their pro-rata fair market value on the date of the API sale. Only the portion attributable to assets held more than three years qualifies for long-term capital gain treatment. This significantly complicates secondary sales of carried interest and GP-led secondaries.

The Capital Interest Exception — Documentation Requirements

Treas. Reg. §1.1061-3(c)(2) requires that for an allocation to qualify as attributable to a capital interest (and thus excluded from API treatment), the allocation methodology must be the same as allocations to unrelated non-service partners with similar capital accounts. In structures where carry and capital are held in the same vehicle, this requires either explicit tracking mechanisms or bifurcation of the interest into separate carry and co-investment components. In practice, many funds now issue GPs separate co-investment interests alongside carry to preserve the capital interest exclusion cleanly.

The API-to-API Transfer Rule

When an API is transferred in a transaction that would otherwise be non-recognition (e.g., a contribution to a partnership under §721), the transfer is respected as non-recognition. However, the transferee takes the API with the same API character — it does not restart the clock or cleanse the Section 1061 taint. Related party transfers receive particular scrutiny.

S Corporation and Passive Foreign Investment Company Interactions

The regulations confirm that the Section 1061 rules apply to API holders who hold their interest through an S corporation, consistent with S corporation pass-through treatment. Separate guidance addresses PFIC intersections for offshore fund structures.

Section 1061's three-year rule has varying impact depending on fund strategy:

Traditional PE/Buyout: Typical hold periods of four to seven years mean most exits will clear the three-year threshold. The primary risk areas are (i) dividend recapitalizations recognized as gain (which may be characterized as short-term depending on when the recap occurs), (ii) early-life exits on underperforming investments sold in year two or three, and (iii) gain recognized on certain derivative instruments at the fund level that don't benefit from the underlying equity's holding period.

Venture Capital: Early exits, M&A transactions within three years of initial investment, and secondary sales of fund positions create significant Section 1061 exposure. The practical effect has been to make the first three years of a fund's investment period a heightened risk period for carry characterization.

Real Estate Funds: §1231 gains from real estate held more than one year can qualify as long-term capital gain at the fund level, but Section 1061 imposes its own three-year overlay. Note, however, that §1061(b) provides that Section 1061 does not apply to gains treated as capital gain under §§1231 or 1256 that would not otherwise apply — a provision that in practice is narrower than it appears and requires transaction-specific analysis.

Credit and Distressed: Gains on debt instruments generally produce ordinary income (OID, market discount) or short-term capital gain, so Section 1061 often has limited incremental impact. However, equity conversion features and warrant gains require analysis.

Legislative proposals to tax carried interest as ordinary income have resurfaced with renewed momentum. The current proposals share a common structural approach: eliminating the API concept and recharacterizing all carried interest gain — regardless of holding period — as ordinary income under §§61 and 83, or alternatively, imposing a self-employment tax on carry distributions to the extent attributable to services.

The §83 Theory

The most technically aggressive proposals would apply §83 to carry — treating the receipt of a profits interest as compensation income, with ongoing allocations and distributions taxable as ordinary income in the year received. This would require overriding Rev. Proc. 93-27 (which has provided a non-recognition safe harbor for profits interest grants for 30 years) and would have significant retroactive effect on existing fund structures. The §83 approach has drawn substantial practitioner objection and is generally viewed as the most legally contested framing.

The Direct Recharacterization Theory

More moderate proposals would expand Section 1061 — eliminating the three-year holding period pathway entirely and simply mandating ordinary income treatment on all API gain, while preserving partnership taxation mechanics for non-carry partners. This approach is structurally cleaner and more likely to survive administrative challenge.

Self-Employment Tax Exposure

Current law is unsettled on whether carry distributions are subject to self-employment tax under §1402(a). The IRS has not issued definitive guidance. Several proposals would expressly subject carry to SE tax, which at 3.8% (net investment income tax equivalence) or the full 15.3% self-employment rate would represent a significant additional cost layered on top of ordinary income treatment.

Planning Implications if Ordinary Income Treatment Passes

Fund formation decisions that become structurally relevant include: (i) restructuring waterfalls to increase the nominal GP capital commitment and shift economics to capital interest allocations (which would survive ordinary income treatment of pure carry); (ii) introducing management fee offsets or crystallization mechanisms that alter the timing of carry recognition; and (iii) evaluating whether offshore structures provide any deferral benefit for non-U.S. GPs, subject to PFIC and Subpart F analysis. None of these is a clean solution — each involves trade-offs that require transaction-specific modeling.