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Taxation of Carried Interests: 2017 Tax Act and Supplemental Guidance

Tax Alert | April 24, 2018
By: John Eagan

The ability of a partnership to grant service providers (typically key management) an interest in a partnership on a non-taxable basis, with potential long-term capital gain treatment on post-grant appreciation, is unique to partnerships. This same approach, whether in the form of stock options or various types of equity compensation, generally cannot be replicated in a C corporation or an S corporation. The type of compensatory equity grant issued by a partnership is commonly referred to as a “profits interest” or a “carried interest.” These same rules apply to a limited liability company taxed as a partnership. Code Section 1061 of the 2017 Tax Cuts and Jobs Act, which is effective for tax years beginning December 31, 2017, creates a new standard for "applicable partnership interest."


In Rev. Proc. 93-27, 1993-2 C.B. 343, the Internal Revenue Service (IRS) said that it would treat the receipt of a partnership profits interest in exchange for services as a non-taxable event as long as (1) the profits interest does not relate to a substantially certain and predictable stream of income from partnership assets (such as income from high-quality debt securities or a high-quality net lease), (2) the recipient does not dispose of the profits interest within two years of receipt, and (3) the issuing partnership is not a publicly traded partnership. The IRS supplemented this guidance in Rev. Proc. 2001-43, 2001-2 C.B. 191, to allow the favorable tax treatment even if the profits interest was unvested at grant.

The key aspect of both Revenue Procedures is that the favorable profits interest rules apply only if the recipient is entitled to the “post-grant appreciation” in the value of the partnership. The IRS uses a deemed liquidation analysis at the time of grant, which states that only the existing partners (at the time of the grant) can share in the proceeds of the partnership had it been liquidated. This rule means that “pre-grant appreciation” is for the benefit of the existing partners and the profits interest holder shares only in appreciation in the value of the partnership after the grant of the profits interest.

Since the issuance of Rev. Proc. 93-27, there have been frequent commentaries about whether Congress would revise the profits interest rule. The target of the potential statutory change seemed to be the hedge fund industry where there was concern that hedge fund managers were converting payments that would normally be treated as compensation into partnership equity that could result in long-term capital gain.


Nearly 25 years after Rev. Proc. 93-27, the 2017 Tax Act adopted a new provision (Code Section 1061) that creates a special three-year long-term capital gain holding period for an “applicable partnership interest.” In the event such an interest is sold and would otherwise result in long-term capital gain under the current more-than-12-months-rule, Code Section 1061 reclassifies the gain as short-term capital gain (taxed at ordinary income rates) unless the interest is held for the required three year period. If Code Section 1061 does not apply, the profits interest rules of the Revenue Procedures continue to apply. 

An “applicable partnership interest” is defined as an interest in a partnership which, directly or indirectly, is transferred to a taxpayer in connection with the performance of “substantial services” by the taxpayer or by a person related to the taxpayer. In order for these rules to apply, the partnership must be involved in an “applicable trade or business.” An applicable partnership interest does not include an interest held by a corporation and it excludes a capital interest, i.e., an interest that is not a profits interest, that is either taxable to the recipient on grant or vesting or is issued for property. However, the capital interest exception only applies where the capital interest received is commensurate with the services provided or property contributed.

Substantial Services

The new provision does not define what constitutes “substantial” services, but the legislative history states that the rules will apply even if a taxpayer also makes a contribution to the partnership. The Treasury Department is specifically directed to issue guidance on when the rules apply in connection with contributions, although Code Section 1061 contains a specific grant of authority to the Treasury Department to issue such regulations and guidance “as is necessary or appropriate” to carry out the purposes of the legislation. Our view is that the level of services required to trigger Code Section 1061 will be fairly low. Given the capital interest exception, it is clear that the new rules are designed to apply to a profits interest in an applicable trade or business that would otherwise be non-taxable on grant under the Revenue Procedures.

Applicable Trade or Business

Assuming the substantial services requirement is met, the key issue is whether the activities of a partnership come within the definition of an “applicable trade or business.” Code Section 1061 defines this term as any “activity conducted on a regular, continuous, and substantial basis” which consists, in whole or in part, of raising or returning capital and involves either (1) investing in or disposing of specified assets, or (2) developing specified assets. The term “specified assets” means securities, commodities, real estate held for rental or investment, cash or cash equivalents, options, or derivative contracts with respect to these types of assets, and also includes an interest in a partnership to the extent of the partnership’s proportionate interest in such assets.

Special Rules 

Code Section 1061 has the following special rules:

  • The Treasury Department is authorized to provide rules that exempt income or gain from the three-year holding period requirement to the extent the income or gain is attributable to any asset that is not held for portfolio investment on behalf of a third party investor, provided that the third party investor (or a related person) is not and has not provided substantial services to the partnership.
  • Code Section 1061 applies even if a recipient of an applicable partnership interest includes an amount in income on receipt of such interest or makes a Code Section 83(b) election with respect to such interest.
  • A transfer of an applicable partnership interest to a related person within the three-year period results in short-term capital gain.
  • The Treasury Department is required to mandate reporting as is necessary to carry out the purposes of Code Section 1061.

Supplemental Guidance 

Shortly after the enactment of the 2017 Tax Act, certain partnerships attempted to avoid the application of Code Section 1061 by using the “corporation” ownership exception and have the service provider own the interest through an S corporation. In Notice 2018-18, the IRS announced that it intended to issue regulations, effective for tax years beginning after December 31, 2017 (the effective date of the new provisions), that the “corporation” exception does not apply to an applicable partnership interest held by an S corporation. This announcement closes what some people viewed as a way to circumvent the application of the three year holding period.


Code Section 1061 is directed at hedge funds, real estate investment partnerships, and other types of portfolio investment partnerships. The language of the statute is often not precise, but both the legislative history and the regulatory authority delegation in the statute make it clear that Congress intended for the three year holding period to be interpreted expansively. Partnerships engaged in non-passive/non-real estate activities are outside of the scope of these new rules and the issuance of a profits interest in these types of partnerships will continue to be governed by the Revenue Procedures.

Code Section 1061 is effective for tax years beginning after December 31, 2017. We suggest that you discuss with your tax advisors how the new rules will apply to the grant of profits interests/carried interests that are made after the effective date of the new law.

For questions, information, or guidance, please feel free to contact John Eagan (; 212.868.4835) or another member of our Tax and Estates Group.


This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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