Carried interest is taxed under a specific set of tax rules built around Section 1061 of the Internal Revenue Code. Fund managers who receive a share of investment profits pay the long-term capital gains rate (capped at 20%) on that share instead of ordinary income rates (up to 37%), but only if the fund held the underlying asset for more than three years. Miss that three-year window and the gain gets recharacterized as short-term and taxed at ordinary rates. The rules also cover related-party transfers, several important exceptions, and layered issues around self-employment tax and the 3.8% net investment income tax.
What Carried Interest Actually Is
Investment fund managers are typically paid two ways. A management fee, usually around 2% of assets, is taxed immediately as ordinary income like a salary. A profit share, usually around 20%, is the carried interest. It only materializes if the fund makes money, and most fund agreements require the fund to clear a minimum return (a hurdle rate) before the manager receives anything.
Managers receive their carried interest as a “profits interest” in the partnership. A profits interest gives you a right to future gains and appreciation but no claim on the partnership’s existing assets, which distinguishes it from a “capital interest” representing actual ownership of the current asset pool. The IRS generally does not treat the grant of a profits interest as a taxable event.1Internal Revenue Service. Revenue Procedure 2001-43
These arrangements run through partnerships or LLCs taxed as partnerships. The partnership pays no federal income tax; income, gains, losses, and deductions flow through to partners on Schedule K-1, and each partner reports their share on their personal return. That flow-through is what lets the character of the gain (long-term capital gain versus ordinary income) reach the manager intact, subject to Section 1061.
The Three-Year Holding Period
For everyone who does not hold a carried interest, gain from an asset held more than one year qualifies as long-term capital gain, taxed at a maximum rate of 20% for high earners.2Internal Revenue Service. Topic No. 409 – Capital Gains and Losses Section 1061, added by the Tax Cuts and Jobs Act, extends that threshold to more than three years for holders of an “applicable partnership interest,” meaning a partnership interest received in connection with performing investment management services. If the underlying asset was held three years or less, the manager’s share of what would have been long-term gain is recharacterized as short-term capital gain and taxed at ordinary rates up to 37%.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection with Performance of Services
The three-year clock runs on each individual asset the fund sells, not on how long the manager has been a partner. A fund that buys a company on March 1, 2023 and sells it on April 15, 2026 clears 36 months, and the manager’s share qualifies for long-term treatment. Sell the same company on February 28, 2026, and the 35-month hold means the manager’s gain is recharacterized as short-term even though it easily cleared the normal one-year rule.
A single fund may sell a dozen investments in a year, some held four years, others eighteen months. The partnership has to track exact acquisition and disposition dates for every asset and separately categorize the gains flowing to carried interest holders. The three-year rule does not apply to gains from assets held one year or less; those are short-term under normal rules regardless.
Income That Falls Outside the Three-Year Rule
Several categories of income and gain are carved out of Section 1061:
- Capital interest gains. If a manager contributes their own capital to the fund, the portion of gain attributable to that capital contribution is excluded entirely. Only the services-based profits interest is subject to the three-year threshold. The capital interest must be proportional to the actual contribution, not an inflated allocation dressed up as capital.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection with Performance of Services
- Section 1231 gains. Gains from property used in a trade or business, including real property and depreciable assets held long-term, are excluded under the Treasury regulations implementing Section 1061.
- Section 1256 contracts. Gains from regulated futures contracts, foreign currency contracts, and similar instruments with mark-to-market treatment are excluded.
- Qualified dividends. Dividend income that qualifies for preferential rates under Section 1(h)(11) is not subject to recharacterization.
- Non-disposition income. Interest, dividends, rents, and other income that does not come from selling a capital asset fall outside Section 1061; the rule only touches gains from the sale or exchange of assets.
- Corporate holders. A partnership interest held directly or indirectly by a corporation is not treated as an applicable partnership interest at all.3Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection with Performance of Services
The capital interest exception is where much of the planning happens. Managers who co-invest meaningful personal capital alongside their investors can shield the corresponding share of returns from the three-year rule.
Transfers to Related Persons
A manager cannot escape the three-year rule by gifting or selling the carried interest to a spouse, child, or controlled entity. Section 1061(d) recharacterizes long-term capital gain as short-term capital gain on sales or exchanges of an applicable partnership interest to a related person when gain is triggered.4eCFR. 26 CFR 1.1061-5 – Section 1061(d) Transfers to Related Persons The Treasury regulations set the recharacterized amount as the lesser of the net long-term capital gain on the transfer or a calculated recharacterization amount under the regulation.
The final regulations also include a lookthrough rule for sales of partnership interests. Under certain conditions, the IRS can look through the partnership interest being sold and recharacterize gain based on the holding periods of the underlying assets. One trigger is a partnership interest held for three years or less where no unrelated outside investor was committed to contribute at least 5% of total capital.
Self-Employment Tax and the Net Investment Income Tax
Section 1061 governs the income tax rate on carried interest, but two other taxes can raise the total bill.
Fund managers have historically treated their carried interest as exempt from the 15.3% self-employment tax by relying on the limited partner exclusion in Section 1402(a)(13). The IRS has been challenging that position and winning. Recent Tax Court decisions, including Soroban Capital Partners LP v. Commissioner (2025), apply a functional analysis: partners who actively run the fund’s investment strategy are not treated as passive investors and do not qualify for the limited partner exclusion, whatever their state-law title. Active managers face real risk that the IRS will assert self-employment tax on their distributive shares.
On top of that, high-earning managers may owe the 3.8% Net Investment Income Tax. NIIT applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly).5Internal Revenue Service. Net Investment Income Tax Income from a trade or business in which the taxpayer materially participates is generally excluded, so a manager who actively runs the fund may be able to shield some income.6Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Certain items like interest, dividends, and some capital gains may still be subject to NIIT even where the manager materially participates, depending on how the income connects to the business activity. For managers at the top of the scale, carried interest that qualifies as long-term gain typically carries a combined federal rate of 23.8% (20% plus 3.8% NIIT).
How Carried Interest Gets Reported
Reporting starts at the partnership level on Form 1065. The partnership tracks the holding period of every capital asset it sells during the year and sorts gains into three buckets: short-term (held one year or less), long-term from assets held more than three years, and gains recharacterized from long-term to short-term under Section 1061.7Internal Revenue Service. Instructions for Schedule D (Form 1065)
Each partner receives a Schedule K-1 with Section 1061 information in Box 20 and an attached statement breaking down the gain categories. The partner then works through the IRS Section 1061 worksheets. Worksheet A aggregates Section 1061 gain across all applicable partnership interests. Worksheet B calculates the recharacterization amount, which is the difference between what would qualify as long-term gain under the normal one-year rule and what actually qualifies under the three-year rule.8Internal Revenue Service. Section 1061 Worksheet B
The recharacterization amount flows to Form 8949 as an adjustment that increases short-term capital gain and decreases long-term capital gain by the same amount. Totals then carry to Schedule D on Form 1040.8Internal Revenue Service. Section 1061 Worksheet B Overstating long-term gain means underreporting tax; overstating short-term gain means overpaying.
Penalties for Getting It Wrong
Mischaracterizing carried interest gains is more than a reporting error. If the mistake produces a substantial understatement of tax, the IRS can impose an accuracy-related penalty equal to 20% of the underpayment.9Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments An understatement is “substantial” when it exceeds the greater of 10% of the tax that should have been shown or $5,000. The penalty also reaches underpayments caused by negligence or disregard of rules, which the IRS reads broadly.
Accurate records at the partnership level are what keep this from becoming a problem. That means exact acquisition and disposition dates for every asset, clean tracking of which gains flow to applicable partnership interests versus capital interests, and careful categorization on every K-1. Errors surfaced in audit tend to cascade, because a single asset’s miscategorized holding period can affect every partner’s return.