Tax Planning for Private Equity Fund Managers: Carried Interest, IRC 1061, Management Fees, and Fund Structure

By Yarik Yarosh, CPA ·September 5, 2026 ·7 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

The tax treatment of carried interest has been one of the most debated issues in tax policy for over a decade, and IRC 1061 (enacted by the TCJA in 2017) changed the rules by requiring a 3-year holding period for carried interest to qualify for long-term capital gains treatment, up from the standard 1-year holding period that applies to other capital assets. Under IRC 1061, an “applicable partnership interest” (API) is any interest in a partnership that is transferred to or held by a taxpayer in connection with the performance of services (the carried interest), and any gain recognized on the disposition of the API (or allocated to the API holder from the fund’s investment activities) is treated as short-term capital gain unless the underlying assets have been held for more than 3 years. This means that a fund manager who receives a carried interest allocation from a fund that sells a portfolio company after holding it for 2 years and 11 months will pay ordinary income rates (up to 37%) instead of long-term capital gains rates (23.8%) on the entire allocation, even though the 2-year-11-month holding period would qualify any other investor for long-term treatment.

✓Key takeaway

Fund manager compensation structure:

Component	Typical Terms	Tax Character
Management fee	1.5-2% of committed capital (or AUM)	Ordinary income (self-employment income or W-2)
Carried interest (promote)	20% of fund profits above preferred return	Capital gain IF 3-year hold met (IRC 1061); otherwise ordinary
GP commit (co-investment)	1-5% of fund size (manager’s own capital)	Capital gain (standard 1-year holding period; IRC 1061 does not apply to capital contributions)
Catch-up provision	100% of profits after preferred return until GP reaches 20%	Same as carried interest
Clawback	Return of excess carry if fund underperforms	Reduces previously recognized income

IRC 1061 holding period requirements:

Holding Period of Underlying Assets	Tax Treatment of Carried Interest
Less than 1 year	Short-term capital gain (up to 37%)
1 year to 3 years	Recharacterized as short-term capital gain (up to 37%) under IRC 1061
More than 3 years	Long-term capital gain (23.8%)

IRC 1061 exceptions (NOT subject to 3-year rule):

Exception	Details
Capital interest (GP commit)	Manager’s own invested capital uses standard 1-year holding period
Income allocated based on capital	Allocations proportional to capital invested, not services
Section 1231 gain	Gain on business property held > 1 year
IRC 1256 contracts	Regulated futures, foreign currency contracts
Qualified dividend income	Dividends from portfolio companies

How are fund managers taxed on carried interest?

Hypothetical example

Round numbers. A PE fund manager runs a $100,000,000 fund with a 2% management fee and 20% carried interest over an 8% preferred return.

Annual management fee income:

Item	Amount
Fund size (committed capital)	$100,000,000
Management fee (2%)	$2,000,000
GP commit (2% of fund = $2M invested)	Owner’s capital in the fund
Management fee tax (37% + 3.8% NIIT if applicable)	$740,000
Management fee tax (SE tax if pass-through)	Additional ~$90,000 (2.9% Medicare on excess)

Carried interest on a successful fund exit:

Fund invests $25,000,000 in a portfolio company, sells for $75,000,000 after 4 years:

Item	Amount
Investment	$25,000,000
Sale proceeds	$75,000,000
Gross profit	$50,000,000
Preferred return to LPs (8% x 4 years x $25M)	($8,000,000)
Remaining profit after preferred return	$42,000,000
GP catch-up (100% until GP has 20% of total profit)	$10,000,000
Remaining after catch-up	$32,000,000
80/20 split on remaining	GP: $6,400,000 / LPs: $25,600,000
Total GP carried interest	$16,400,000
Plus: GP capital return on co-invest ($500K invested)	$1,500,000 profit on co-invest

Tax on carried interest (held > 3 years):

Item	Amount	Tax Rate	Tax
Carried interest (LTCG)	$16,400,000	23.8%	$3,903,200
GP co-invest gain (LTCG, 1-year rule)	$1,500,000	23.8%	$357,000
Total tax			$4,260,200

Tax if sold at 2 years 11 months (IRC 1061 recharacterization):

Item	Amount	Tax Rate	Tax
Carried interest (recharacterized as STCG)	$16,400,000	40.8% (37% + 3.8%)	$6,691,200
GP co-invest gain (LTCG, standard 1-year rule)	$1,500,000	23.8%	$357,000
Total tax			$7,048,200
Additional tax from IRC 1061			$2,788,000

Management fee waiver strategy:

Manager waives $1,000,000 of management fee in exchange for a priority allocation of $1,000,000 from fund profits:

Item	Without Waiver	With Waiver
Management fee income	$2,000,000	$1,000,000
Tax on fee (37% + SE)	$780,000	$390,000
Priority profit allocation	$0	$1,000,000
Tax on allocation (if LTCG, 3-year hold)	N/A	$238,000
Total tax	$780,000	$628,000
Tax savings		$152,000

IRS scrutiny: The IRS has challenged fee waivers under IRC 707(a)(2)(A) (disguised payments for services) and the economic substance doctrine. For the waiver to be respected, the manager must bear real investment risk (the waived fee is at risk of loss if the fund underperforms), the waiver must be made before services are performed, and the arrangement must have economic substance beyond tax reduction.

Fund structure and tax considerations:

Structure	Tax Treatment	Key Issues
Domestic LP (onshore fund)	Pass-through; K-1 to all partners	Standard carried interest rules apply
Offshore feeder (Cayman LP)	Tax-exempt and non-U.S. investors invest through offshore entity	Avoids UBTI for tax-exempt investors; no U.S. tax for non-U.S. investors
Parallel fund structure	Domestic + offshore funds invest side-by-side	Separate accounting; same investments
Blocker corporation	C-Corp between fund and tax-exempt/foreign investors	Blocks UBTI; converts to dividend income
Management company (S-Corp)	S-Corp receives management fees	Owner takes salary (FICA) + distribution (no FICA)

QSBS opportunity for fund managers:

Item	Details
Can carried interest qualify for QSBS?	Generally no (QSBS requires C-Corp stock acquired for cash/property, not services)
Can GP co-invest qualify?	Potentially yes (if invested in a qualifying C-Corp fund vehicle, held 5+ years, under $50M gross assets)
Strategy	Invest GP commit through a C-Corp blocker that holds qualifying small business stock
Exclusion	Up to $10,000,000 or 10x basis (IRC 1202)

State tax planning for fund managers:

Strategy	Details
State of residency	No state income tax in FL, TX, NV, WY, TN, SD
Management company location	Locate in a no-income-tax state
Fund domicile	Most funds domiciled in DE (LP) or Cayman (offshore); state tax based on manager’s location
SALT deduction limit	$80,000 MFJ under OBBBA (was $10,000 under TCJA)
Pass-through entity tax (PTET)	Many states allow fund-level PTET election to bypass SALT cap

Illustrative numbers only, not a real client and not advice for your facts.

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Cite this page

Yarik Yarosh, CPA. "Tax Planning for Private Equity Fund Managers: Carried Interest, IRC 1061, Management Fees, and Fund Structure." Blue Cloud CPA, September 5, 2026. https://bluecloudcpa.com/guides/small-business-tax-planning-private-equity-fund-managers-carried-interest-irc-1061

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.