On July 31, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) issued proposed regulations (REGS-107213-18) (Proposed Regulations) governing the treatment of "carried interests" (also referred to as "profits interests") under Section 1061 of the Internal Revenue Code (the Code). As discussed below, the 2017 tax legislation, known as the Tax Cuts and Jobs Act (TCJA), limited the availability of long-term capital gain treatment with respect to gain attributable to certain profits interests held for less than three years. The Proposed Regulations provide much-needed guidance to private equity and hedge fund managers. In some respects, Treasury clearly felt constrained by the words of the statute in determining the scope of the rules, while in others it arguably expanded their reach beyond the boundaries set by the statute.


Gain from the sale of capital assets held for more than one year (long-term capital gain) is generally taxed at preferential rates (currently 20%) for noncorporate taxpayers. Section 1061 increased the requisite holding period for such preferential rates from one year to three years with respect to gain attributable to "applicable partnership interests" (APIs). As explained more fully below, APIs are certain profits interests typically granted to private equity and hedge fund managers, as well as real estate developers.

Gains Subject to Section 1061

The one-year holding requirement described above is set forth in Section 1222, and Section 1061 specifically cross references that section in establishing the increased holding period requirement to three years. However, other sections of the Code also provide for long-term capital gain treatment or the preferential rates afforded to such gains in certain circumstances. Section 1061 does not by its terms apply to gain subject to such other sections. Consistent with the narrow language of the statute, the Proposed Regulations provide that Section 1061 applies only to capital gains that would be treated as long-term capital gains pursuant to Sections 1222(3) and (4). As a result, other forms of tax-favored income, such as qualified dividend income, gain on the sale of property used in trade or business under Section 1231, and mark-to-market capital gains under Section 1256, all of which are taxed at favorable rates, are not subject to Section 1061.

While this provision is consistent with the text of the statute, it is most likely not in line with congressional intent. As discussed below, Congress explicitly included real estate development within the scope of an "applicable trade or business." Yet, much of the gain from real estate investments is subject to Section 1231 and therefore outside the scope of Section 1061. Thus, the Proposed Regulations in this regard operate such that much of the gain from real estate promote interests will not be subject to the three-year holding requirement under Section 1061. Similarly, if a sale of a business held through a tax partnership is structured as a sale of assets, rather than as a sale of partnership interests, the gain attributable to the goodwill of the business would be treated as Section 1231 gain and thus would not be subject to Section 1061 regardless of the holding period.

Definition of an Applicable Partnership Interest

Under Section 1061, a profits interest qualifies as an API if it is directly or indirectly 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" (ATB).

An ATB is generally defined in the Proposed Regulations as a trade or business that consists in whole or in part of both (i) raising or returning capital and (ii) investing or developing "specified assets." "Specified assets" generally means securities, commodities, real estate held for rental or investment, and certain derivatives.

Partnership Interests Excluded from the Definition of an API

Under Section 1061, certain partnership interests are specifically excluded from the definition of an API. The Proposed Regulations clarify the following exceptions:

Profits interests granted in connection with a non-ATB.

Many profits interests will not qualify as APIs because such profits interests are not granted to or held by a taxpayer in connection with the performance of services in an ATB. For example, profits interests granted to a portfolio company's management team typically should not qualify as APIs because such taxpayers are not engaged in raising or returning capital or investing in "specified assets." Instead, the taxpayers holding profits interests of this type are engaged in the active management of portfolio companies that are not typically engaged in an ATB. This is so, even though the carried interests earned by the general partner of the fund with respect to the same portfolio investment would be subject to Section 1061.

Capital interests.

Capital interests — interests in a partnership received in exchange for a capital contribution — generally fall outside the definition of an API. Further, even if a partner holds an API, Section 1061 should not apply to the portion of his or her partnership interest that is a "capital interest."

Given this exception, the Proposed Regulations set forth the following rules to thwart attempts to disguise an API as a capital interest:

  • Converting an API to a Capital Interest. The Proposed Regulations provide that if a partner converts, through a recapitalization or contribution, its API to a capital interest, the resulting capital account balance will continue to be subject to Section 1061 and the aforementioned three-year rule. This type of partnership recapitalization is not uncommon in certain instances — for example, a real estate developer may choose to "crystallize" its profits interest (i.e., promote interest) and participate thereafter in the recapitalized waterfall of the real estate joint venture as if it had contributed cash equal to the crystallized profits interest. Although the Section 1061 "taint" would apply to the crystallized amount, it appears that any allocations of gain that are attributable to appreciation of partnership investments arising after such recapitalization would be excluded from Section 1061, so long as the resulting gain attributable to such post-capitalization appreciation is allocated in accordance with the rules for Capital Interest Allocations described below.

Though arguments can be made in support of the Proposed Regulations' approach of turning off Section 1061 with respect to post-crystallization gain, the better analysis would appear to be that such gain should also be subject to Section 1061. While all carried interests only share in future appreciation, some interests are designed with a "catch-up" feature that once achieved (whether through actual gains or as a result of a nontaxable book-up), are crystallized so that the holder thereafter suffers risk of a subsequent decline in value in proportion to other capital holders (thus solidifying the holder's interest) without suffering any cost in terms of lost option value. It is not clear why such an interest should escape the reach of Section 1061 on appreciation following such a book-up, when the interest provides the holder with a greater share of the company's growth and with less risk as compared to more typical profits interests. 

Contrarily, it is not clear why in all instances a crystallized profits interest should be able to ride out the three-year holding period requirement to avoid the application of Section 1061 with respect to pre-crystallization gain. That may make sense when the post-crystallized interest still bears meaningful risk of loss and appreciation for gain. But that should not be the case if the profits interest is crystallized into a debt-like preferred security with a debt-like return and a priority on liquidation. Similarly, an in-kind distribution (discussed below) to an API holding partner may represent an opportunity for an API holder to ride out the three-year holding period with a low-risk asset (e.g., a note receivable). 

  • Debt-Financed Capital Interests. A capital interest may nonetheless be subject to Section 1061 if a partner's share of capital is attributable to any amounts borrowed from (or guaranteed by) another partner, the partnership, or persons related to such other partner or the partnership.

The Proposed Regulations do not distinguish between recourse and nonrecourse loans in this regard. Yet, strong arguments can be made that an interest acquired with a true recourse obligation should be respected. In an analogous area, long-standing Treasury Regulations provide that a partnership interest acquired with a nonrecourse note is treated as an option, while an interest acquired with a note a substantial portion of which is recourse is generally respected as the acquisition of a partnership interest. 

Interests held by corporations.

Section 1061 does not apply to a partnership interest that is held by a corporation. However, the Proposed Regulations provide that Section 1061 will apply to APIs held through an S corporation. This is consistent with Notice 2018-18, which the IRS published shortly after enactment of the TCJA. Additionally, the Proposed Regulations provide that Section 1061 will apply to any API held by a "passive foreign investment company" (PFIC) if the taxpayer makes a "qualified electing fund" election with respect to the PFIC, even though a PFIC is also a corporation for United States federal income tax purposes. 

The reason for the narrow scope of the corporate exception is clear — an exception that applied to S corporations and PFICs would enable taxpayers to effectively avoid application of Section 1061 with little or no cost. Nonetheless, many practitioners have questioned Treasury's authority to limit the exception in this manner given the clear wording of the statute. This issue likely will be decided in the courts.

Bona fide unrelated purchasers.

The Proposed Regulations provide that an interest in a partnership that would be treated as an API but is purchased by an unrelated buyer for the fair market value of the interest is not an API with respect to the buyer if the buyer (1) does not currently provide and has never provided services in the relevant ATB, (2) does not contemplate providing services in the future, and (3) is not related to a person who provides services currently or has provided services in the past.

Application of the Three-Year Holding Period

Consistent with other areas of the Code, the Proposed Regulations provide that the relevant holding period of an asset for purposes of Section 1061 is measured at the level of the seller of the asset. However, as noted below, certain exceptions may apply. 

Gain from the sale of partnership assets.

The application of Section 1061 with respect to allocations of gain arising from the sale of partnership property is generally based on the partnership's holding period in such assets. For example, if a fund sells an investment that it has held for more than three years, the gain from the sale will satisfy the three-year holding period requirement under Section 1061 for all taxpayers allocated a portion of the gain from such sale, including any API holders who have held their APIs for less than three years. As Treasury noted, the foregoing approach is consistent with other long-term capital gain treatment determinations in the partnership context. 

Sales of APIs

Under the Proposed Regulations, in the event of a sale of an API to a third-party buyer, the seller's holding period in the API is generally the holding period of the API (rather than the holding period of the underlying partnership assets). Thus, so long as a taxpayer's holding period in its API is more than three years, it should generally qualify for the preferential long-term capital gain treatment on any gain arising therefrom, even with respect to gain attributable to underlying assets that have been held for less than three years. However, the Proposed Regulations provide two exceptions to this general rule where "look-through" treatment may apply: 

  • Two-Tier API Structures. If a taxpayer sells an API in an upper-tier partnership and the upper-tier partnership in turn holds an API in a lower-tier partnership (Lower-Tier API), the upper-tier partnership's holding period in the Lower-Tier API will determine whether Section 1061 applies to the taxpayer's gain attributable to the Lower-Tier API. The foregoing exception is particularly relevant for many fund managers who hold profits interests in general partnerships that in turn hold profits interests in underlying funds. 
  • Substantially All Test. In the case of a sale of an API that a taxpayer owns for more than three years, the Proposed Regulations may recharacterize a portion of the gain from the sale of such API as short term if 80% or more of the fair market value of the partnership's assets consist of capital assets with a holding period of three years or less. 

Distributions in kind

The Proposed Regulations provide that if a partnership distributes property in kind to an API holder, gain from the subsequent sale of the distributed property is subject to Section 1061 unless the property has been held on a cumulative basis (whether by the partnership or the API holder) for more than three years. 

Carried interest waivers. 

Following the enactment of Section 1061, many fund sponsors have adopted "carry waiver" provisions that would permit the general partner of a fund to defer capital gains from fund investments that do not satisfy the three-year holding period requirement, and in exchange for such deferral, receive priority allocations of long-term capital gains from future profits if/when realized by the fund (often referred to as catch-up allocations). Although careful structuring is required, carry waivers have been viewed favorably by many tax practitioners, provided there is true entrepreneurial risk associated with realizing the future catch-up allocations in a manner consistent with regulations proposed by Treasury in 2015 concerning waivers of management and similar fees by fund advisors. While the Proposed Regulations do not address carry waivers, Treasury's explanation thereof states that waivers may be subject to challenge under existing tax rules and principles, including the entrepreneurial risk doctrine mentioned above. That explanation has generally been taken to mean that a waiver may be respected so long as entrepreneurial risk is maintained and the other guidelines set forth in the 2015 proposed regulations are met. 

Allocations Attributable to a Capital Interest

As stated above, if a partner holds both an API and a capital interest in a partnership, Section 1061 does not apply to allocations of gain attributable to a partner's capital interest (Capital Interest Allocations). However, for purposes of determining whether an allocation is attributable to a partner's capital interest versus an API, the Proposed Regulations generally apply rigid rules that may inappropriately treat some allocations as attributable to an API, when as a commercial matter, such allocations are actually attributable to a partner's capital interest. 

Under the Proposed Regulations, an allocation of gain will be treated as a Capital Interest Allocation (and thus not subject to Section 1061) only if: 

  • The allocations are made in the same manner to persons holding APIs and unrelated nonservice partners (i.e., limited partners) with a significant aggregate capital account balance (an aggregate capital account balance equal to 5% or more of the aggregate capital account balance of the partnership at the time the allocations are made will be treated as significant). 
  • The partnership agreement and the partnership's books and records clearly distinguish between such Capital Interest Allocations and allocations with respect to APIs. 

The Proposed Regulations provide that allocations with respect to a partnership interest that otherwise satisfies the Capital Interest Allocation requirements will not be disqualified if such allocations (i) are subordinate to that of unrelated partners or (ii) are not reduced by the cost of services charged to unrelated partners. 

The foregoing Proposed Regulations with respect to Capital Interest Allocations may create uncertainty for many common commercial situations. For example, traditional waterfall structures may not properly support Capital Interest Allocation treatment because the partners participate in portfolio investments in varying percentages — a common arrangement for some private equity funds with separate waterfalls for each portfolio investment. This presumably can be addressed in clarifications when the Proposed Regulations are finalized but does not appear to present a fundamental problem with the overall approach of the Proposed Regulations in this context. 

Effective Date

With limited exceptions, the Proposed Regulations are proposed to be effective when finalized, but may be relied on as of the date of publication in the Federal Register, pending the issuance of final regulations, provided taxpayers follow them in their entirety and in a consistent manner. One significant exception to the prospective nature of the Proposed Regulations is the provision that Section 1061 applies to interests held through S corporations and PFICs. As noted earlier, shortly after the TCJA's enactment, in Notice 2018-18, Treasury put taxpayers on notice that the corporate exception would not apply to S corporations. 


The Proposed Regulations provide clarity with respect to the application of Section 1061. However, with such clarity comes complexity. In addition to properly reporting gains to API holders based on the relevant holding period of partnership assets, funds will need to carefully consider how to distinguish Capital Interest Allocations from API allocations. 

Originally published August 19, 2020.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.