IRS Issues Carried Interest Final Regulations

On January 7, 2021, the IRS issued final regulations under § 1061 of the Internal Revenue Code (“Code”)[1]. These final regulations largely adopt the proposed regulations issued in July 2020[2] but contain a number of taxpayer favorable changes. As discussed below, the rules under § 1061 can apply in a number of situations such as investment fund management, real estate development, and similar structures where a profits interest is issued in a partnership in exchange for services. This writing is not intended to go into detail about § 1061 or the regulations but is intended to explain some of the changes that are part of the final regulations.[3]

History of Section 1061

The Tax Cuts and Jobs act of 2017[4] added § 1061 to the Code effective for tax years beginning after 2017. Often, a “carried interest” or “promote” is issued to private fund managers allocating to them a percentage of profits from operations of the fund (usually after certain waterfall distributions to investors). Allocations of partnership profits to fund managers generally are taxed as long term capital gains from the sale of capital assets of the fund provided the assets sold are held for more than a year by the fund. The result is that the fund manager receives long term capital gain treatment for profits received in exchange for services.

New § 1061 was added to address concerns that many had raised with certain private equity fund managers being able to essentially convert income from their services from ordinary income to long term capital gains. Under § 1061, the holder of an “applicable partnership interest” (“API”) only recognizes long term capital gain treatment if the interest is held for at least three years. Otherwise, what otherwise would be long term capital gain will be treated as short term capital gain[5] which is taxed at ordinary income rates.

An API is a partnership interest held, directly or indirectly, by the taxpayer in connection with the performance of substantial services in any “applicable trade or business” (“ATB”).[6] An ATB is an activity which consists of (a) raising or returning capital; and (b) either (i) investing in “specified assets,” or (ii) developing “specified assets.”[7] A “specified asset” generally includes securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s interest in any of the foregoing.[8] These rules do not apply to carried interests held by C corporations, but do apply to S corporations.[9] API does not include partnership interests held by employees not engaged in an ATB.[10]

As a result of these new rules, the holder of an API may be subject to potential short term capital gains. These rules can implicate a number of transactions such as investment management and real estate development where the manager or developer retains a profits interest, including possible family investment partnership structures. Further, the impact of these rules can alter estate planning considerations for holders of an API. As such, tax planning advisors, whether attorneys, accountants, financial advisors, or otherwise, should gather some familiarity with § 1061 as its provisions may have broader reach than many may realize.

Final Regulations

Many provisions of the proposed regulations only served to raise additional questions or were subject to criticism. The final regulations generally are taxpayer friendly in handling issues left open after issuance of the proposed regulations. Some highlights of the final regulations are as follows:

Related Party Transfers

The proposed regulations interpreted 1061(d) such that transfers of API, even to related parties in a non-taxable transaction, could accelerate recognition of gain. This was subject to much criticism and could significantly restrict the ability to engage in estate planning with API. The final regulations make clear that the transfer to a related party merely requires retained status as API in the transferee’s hands but is not an acceleration event for transactions that otherwise are non-taxable.[11]

Look-Through Rule

The proposed regulations established complex rules which would recharacterize certain gain from a taxable disposition of API held for more than three years as short term capital gains if assets of the partnership were held for a shorter period by looking through the partnership interest to the assets of the partnership. This rule was created to avoid fund managers forming “dormant funds” for purposes of lengthening their holding period. The change in the final regulations generally disregards, for holding period purposes, periods before significant unrelated non-service partners become legally obligated to contribute funds to the partnership. The look-through rule also applies to transactions with the principal purpose of avoiding 1061.[12]

Capital Interest Exception

Capital interests held by a fund manager or other API holder are excepted from the application of 1061. For these purposes, a capital interest is one with a positive liquidation value at grant, such as interests received in exchange for a capital contribution or reinvestments of allocated gains. The proposed regulations only allowed this exception to apply if the capital interest of the API holder is held on the same terms (priority, type, risk, rate of return, rights, etc.) as other partners. The final regulations merely require the interests to be held in a similar manner, rather than the same manner as significant unrelated partners. While it is unclear how different this standard will allow interests to be held, it is clear that some level of difference is permitted. To qualify for the exception, the capital interests held by the service partner must be clearly identified in the partnership agreement, books, and records.

Capital Interest in Exchange for Loans or Guarantees

The final regulations allow the capital interest exception to be met with funds loaned from, or guaranteed by, another partner (or someone related another partner). For borrowed funds to qualify for the capital interest exception, subject to certain other technical requirements, the final regulations require that the service partner must be personally liable on the loan, the service partner must have no right to reimbursement, and the debt must not be guaranteed by anyone other than the service partner.

The items listed above are the most significant areas where the final regulations differ from the proposed regulations. Many of the provisions from the proposed regulations are unchanged such as rules relating to: (a) aggregation of gains/losses from multiple carried interests; (b) confirmation that § 1061 does not apply to § 1231 assets or § 1256 commodity contracts; and (c) application to S corporations. An issue left unaddressed by the final regulations is the effect of carry waivers where the API holder waives distributions allocable to API during early years in favor of subsequent distributions and allocations outside the scope of § 1061. To date, other than an admonition in the preamble about attempts to circumvent § 1061, there is no guidance as to how waivers during the three year required holding period will be treated.


Anytime there is a significant change in tax law, tax professionals must grapple with how those new rules will be interpreted. Regulations under § 1061 followed a fairly typical pattern of issuance of proposed regulations, followed by significant commentary about issues the proposed regulations create. Thankfully, Treasury listened to a number of those comments. From reading the explanation of revisions in the final regulations, it is clear that Treasury did not follow all of the desired recommendations. However, the changes are largely taxpayer friendly. As stated above, while most people will not want to become § 1061 experts, knowing generally where the rules apply can avoid significant problems. The rules of § 1061 can apply broadly and in situations that may not be obvious.

[1] T.D. 9945,

[2] Reg. 107213-18,

[3] For a summary of the contents of the proposed regulations see Schreiber, Sally P., “Proposed Rules Govern Carried Interests,” The Tax Advisor, August 3, 2020,; and Whelan, Gerald, David Franklin, and Joseph Bianco, “Proposed Regs. On Carried Interests,” The Tax Advisor, January 1, 2021,

[4] P.L. 115-97,

[5] Prior to adoption of § 1061, there were arguments made to treat allocations to API holders as ordinary income rather than short term capital gains. Without discussing the breadth of those arguments, capital gains treatment was retained under arguments based on the risk undertaken by API holders with respect to assets held for at least three years looking more like a capital investment rather than merely performance based compensation.

[6] IRC § 1061(c)(1)

[7] IRC § 1061(c)(2)

[8] IRC § 1061(c)(3)

[9] See Notice 2018-18 and Treas. Reg. § 1.1061(b)(2)(i)

[10] § 1061(c)(1)

[11] Note that, notwithstanding treatment under § 1061, transfers of profits interests within the first two years of grant may eliminate certain safe harbor tax treatment under Rev. Proc. 93-27 and Rev. Proc. 2001-46.

[12] Note that § 751 still applies to with respect the sale or API regardless of the application of § 1061.


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