For investment fund managers, the carried interest is the defining feature of their economic arrangement with the fund. It represents the general partner’s or managing member’s share of the fund’s profits — typically 20 percent of gains above a preferred return to the limited partners — and it is the primary mechanism by which fund managers are compensated for the services they provide in managing the fund’s investments. The carried interest is not a salary. It is a partnership interest that entitles the holder to a disproportionate share of future profits and capital appreciation, acquired in exchange for services rather than invested capital. This structure creates extraordinary estate planning opportunities, but also regulatory complexity — including the Section 1061 three-year holding period rule enacted as part of the Tax Cuts and Jobs Act of 2017 — that must be carefully navigated.
What Carried Interest Is and How It Works
A private equity fund, hedge fund, venture capital fund, or real estate fund is typically structured as a limited partnership or a limited liability company taxed as a partnership. The general partner (GP) or managing member manages the fund and bears unlimited liability (or, in the LLC context, serves as the manager with control rights). The limited partners (LPs) or investor members contribute the vast majority of the capital — often 99 percent or more — and receive a preferred return, typically 8 percent per year, before the GP participates in profits.
After the preferred return is satisfied, the carried interest entitles the GP to 20 percent (or sometimes higher, particularly in venture capital) of the remaining profits. If a fund raises $1 billion, deploys it in portfolio investments, and returns $2 billion to investors after satisfying the preferred return, the GP’s carried interest would entitle it to $200 million of those profits. The fund managers who own the GP entity share in this $200 million through their ownership of the GP, which holds the carried interest.
The key insight for estate planning purposes is that the carried interest is a partnership interest — and partnership interests have well-established rules governing their transfer, valuation, and taxation. Understanding those rules, and specifically the rules governing the taxation of services-based partnership interests under Revenue Procedure 93-27, is the foundation of any carried interest planning strategy.
Profits Interests Under Revenue Procedure 93-27 and Revenue Procedure 2001-43
Revenue Procedure 93-27 provides that a person who receives a profits interest in a partnership in exchange for services generally does not recognize income at the time of receipt, provided certain conditions are met. The fundamental condition is that the interest must be a genuine profits interest — meaning that if the partnership were liquidated immediately after the grant, the recipient would receive nothing. In other words, the profits interest has no current liquidation value. It is not a capital interest (which would entitle the holder to a share of currently existing assets), but rather a right to share in future profits and appreciation only.
The elegance of this rule is significant. A fund manager who receives a carried interest — which is structured as a profits interest with no current liquidation value because the fund has not yet generated returns above the preferred return — does not recognize ordinary compensation income on receipt. This is a powerful departure from the general rule that compensation received in exchange for services is included in income at the time of receipt. Revenue Procedure 2001-43 extended and clarified this treatment to cover profits interests subject to vesting conditions, providing that the same non-recognition rule applies even if the profits interest is subject to a substantial risk of forfeiture at grant — though the fund manager must make a Section 83(b) election to lock in the non-recognition treatment and start any holding periods running.
For estate planning, the non-recognition rule creates the pivotal opportunity: if the fund manager can transfer the profits interest to a trust or family member while it still has a very low (or zero) liquidation value, the gift tax cost of the transfer is minimal. All subsequent appreciation — the fund manager’s 20 percent share of every dollar of profit the fund generates — passes to the trust or family members with no additional gift or estate tax. In a successful fund that generates hundreds of millions of dollars in profits, a carried interest transferred when the fund was newly formed and had no liquidation value can become worth tens or hundreds of millions of dollars in the hands of the trust, having been transferred for a gift tax value close to zero.
Valuation of Profits Interests for Gift and Estate Tax Purposes
The gift tax value of a profits interest at grant or early in the fund’s life is typically very low — often near zero — because of the fundamental premise of the profits interest structure: the liquidation value is zero. A transfer of a profits interest made when the fund is newly formed and no profits have been earned can be reported on a gift tax return at a nominal value, potentially with a discount for the lack of marketability of a minority partnership interest. Treasury Regulation Section 25.2512-3 applies the willing-buyer, willing-seller standard, and an option-pricing or probabilistic model is typically used to value a profits interest for transfer tax purposes when the liquidation value is zero.
The valuation analysis becomes more complex as the fund matures and begins to generate unrealized appreciation. A carried interest in a fund that is significantly in the money — meaning the fund’s investments have appreciated well above the preferred return hurdle — has substantial value because liquidation at that moment would generate a distribution to the carried interest holder. The timing of any gift or estate tax transfer is therefore critical: the earlier in the fund’s life the transfer is made, the lower the gift tax cost.
At death, the fund manager’s estate must include the fair market value of any carried interest held at the time of death. A carried interest in a mature fund with substantial unrealized appreciation can be a very large estate asset. Valuing it requires a detailed analysis of the fund’s portfolio, the remaining term, the amount by which the fund’s value exceeds the preferred return hurdle, the discount rate, and various other factors. Estate tax counsel should work closely with a qualified business appraiser with experience in fund interests.
GRAT Strategies for Carried Interest
A Grantor Retained Annuity Trust is a statutory trust arrangement under Section 2702 that allows the grantor to transfer an asset to an irrevocable trust, retain the right to receive an annuity for a fixed term, and pass the remainder to beneficiaries free of gift tax to the extent the asset’s total return exceeds the Section 7520 hurdle rate. For carried interests, the GRAT strategy is particularly compelling because of the asymmetric appreciation profile of profits interests: they start with near-zero value and, in a successful fund, can generate enormous returns.
When a fund manager contributes a profits interest to a GRAT early in the fund’s life, while the interest has a very low liquidation value, the annuity retained by the grantor can be set at or near zero because the initial value of the contribution is so low. This is sometimes called a zeroed-out GRAT — a GRAT in which the annuity is set precisely so that the present value of the annuity stream equals the value of the asset contributed, leaving the remainder interest with a value of zero and therefore no taxable gift on funding. (Zeroed-out GRATs are permissible under Walton v. Commissioner, 115 T.C. 589 (2000), and have survived repeated attempts by the Treasury to restrict them.) If the profits interest generates significant returns during the GRAT term, all of that appreciation passes to the GRAT remainder beneficiaries — typically a trust for the family — with no gift or estate tax.
For a GRAT holding a profits interest to work, the grantor must survive the GRAT term (otherwise the GRAT assets are pulled back into the estate under Section 2036), the fund must generate returns above the Section 7520 rate during the term, and the distributions from the carried interest must be sufficient to satisfy the annuity payments if the annuity is not set to zero. In practice, a series of short-term rolling GRATs — each two years in duration — funded with profits interests or distributions from the carried interest reduces the mortality risk while capturing appreciation efficiently.
Installment Sale Strategies: Selling to an IDGT
An installment sale of a profits interest to an intentionally defective grantor trust is an alternative to a GRAT that offers certain advantages, particularly for fund managers who prefer a permanent transfer rather than the annuity-return structure of a GRAT. In an installment sale, the fund manager sells the profits interest to an IDGT — a trust that is irrevocable and outside the estate for estate tax purposes, but intentionally structured to be a grantor trust for income tax purposes under Sections 671 through 679 — in exchange for a promissory note bearing interest at the applicable federal rate.
Because the profits interest has a very low initial value, the promissory note can be quite small — reflecting the near-zero liquidation value at grant. The IDGT services the note using distributions from the carried interest as the fund generates profits. Any appreciation in the carried interest above the AFR on the note accrues to the trust beneficiaries free of gift or estate tax. Crucially, because the transaction is between the grantor and a grantor trust, the sale is disregarded for income tax purposes under Revenue Ruling 85-13 — no capital gain is recognized, and the interest payments on the note are not taxable to the grantor or deductible by the trust.
The installment sale strategy provides a hedge against mortality risk because the full transfer occurs at the time of sale, not at the end of a GRAT term. If the grantor dies after the sale, the profits interest is in the IDGT — outside the estate — regardless of whether the note has been fully repaid. The remaining note balance would be included in the estate as a receivable, but the full value of the profits interest (which could be many times the note balance if the fund has appreciated significantly) is outside the estate.
Section 1061: The Three-Year Holding Period Rule
Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017, fundamentally changed the income tax landscape for carried interest holders. Prior to 2017, a fund manager who held a carried interest for more than one year could characterize the income allocated to the carried interest as long-term capital gain, benefiting from the preferential capital gains rates applicable to the fund’s investments. Section 1061 extended the holding period requirement to three years for so-called applicable partnership interests (APIs).
An API is defined as a partnership interest that is transferred to or held by a taxpayer in connection with the performance of substantial services in any applicable trade or business. An applicable trade or business is any activity conducted on a regular, continuous, and substantial basis that consists in whole or in part of raising or returning capital, investing in or disposing of specified assets, or developing specified assets. For fund managers, virtually all carried interests will qualify as APIs.
The practical effect of Section 1061 is straightforward: gains allocated to an API that have been held for three years or less — even if the underlying fund investment has been held for much longer — are recharacterized as short-term capital gain and taxed at ordinary income rates, not long-term capital gain rates. Only gains attributable to assets held for more than three years by the fund (or other applicable partnership) are eligible for long-term capital gain treatment in the hands of the API holder. This is a significant increase in the tax burden on short-term carried interest income.
Planning around Section 1061 takes several forms. Fund managers may structure fund investments with longer holding periods, avoiding realizations before the three-year mark when possible. Some fund structures use “reinvestment” or co-investment vehicles that hold specific assets directly, potentially allowing the fund manager to point to assets held for more than three years when allocating gains to the carried interest. The specific mechanics of the Section 1061 regulations — which are detailed and technical — must be carefully analyzed by a tax attorney familiar with partnership tax before any planning strategy is implemented.
How Section 1061 Interacts With Estate Planning Transfers
A critical question for fund managers considering estate planning transfers is whether transferring a profits interest to a trust or family member affects the Section 1061 holding period. The Treasury regulations under Section 1061 address this issue. In general, a transfer of an API by gift does not reset the holding period — the recipient takes the transferor’s holding period. However, the regulations contain important limitations and anti-avoidance rules.
Under Treas. Reg. Section 1.1061-5, if an API is transferred to a related person (broadly defined), the transfer itself may not reset the API’s character as an applicable partnership interest, meaning the three-year rule continues to apply to gains allocated to the transferred interest. There is also a specific rule addressing transfers at death: the regulations provide that a transfer of an API at death to an estate or a trust does not cause a recharacterization under Section 1061, but the API character of the interest is preserved — meaning the estate or trust that receives the API will continue to be subject to Section 1061 when it receives gain allocations.
The practical lesson is that Section 1061 is not eliminated by an estate planning transfer. A trust that receives a profits interest via gift will still be subject to the three-year holding period rule for gains allocated to the interest. The income tax savings from estate planning transfers do not come from avoiding Section 1061 but rather from removing the appreciation from the transferor’s estate for estate tax purposes.
Planning for the GP Entity: FLPs, LLCs, and GP Interests
The carried interest is typically held not by the fund manager as an individual but by a general partner entity — a limited partnership or LLC controlled by the fund manager. This GP entity may also hold the management company that receives management fees. In large fund complexes, the GP entity itself can be worth hundreds of millions of dollars. Estate planning for the GP entity involves many of the same strategies applicable to other closely held businesses — family limited partnerships, valuation discounts, installment sales to IDGTs — but with the additional complexity of the carried interest rules.
A family limited partnership or LLC holding the fund manager’s GP interest can serve multiple purposes: it can facilitate the gifting of limited partnership or LLC interests to family members (taking advantage of valuation discounts for lack of control and lack of marketability), it can concentrate management control in the fund manager while distributing economic interests to the family, and it can serve as a vehicle for coordinating the carried interest with the broader estate plan. The creation and funding of a family partnership or LLC must be done carefully to comply with the economic substance and bona fide business purpose requirements under Section 2036 and related estate tax principles.
Estate Tax at Death: Valuation, IRD, and Basis Rules
When a fund manager dies holding a carried interest, the estate must include the date-of-death fair market value of that interest in the gross estate. Valuing a carried interest for estate tax purposes requires a careful economic analysis: what is the probability that the fund will generate returns sufficient to create value in the carry, what is the timing of those expected returns, and what discounts apply for lack of marketability and the unique service-based nature of the interest? These are contested questions that have generated significant litigation, and fund managers should work with experienced appraisers well in advance of any anticipated estate tax event.
A significant estate tax trap for fund managers involves the interaction of estate taxes and income taxes on carried interest. Gains that are allocated to a carried interest after the fund manager’s death — and that had not been recognized as income before death — represent income in respect of a decedent. The estate includes the fair market value of the carried interest (which reflects the present value of those future gains), and the estate or the heirs who later receive those gain allocations must also pay income tax on them. The Section 691(c) deduction for estate tax attributable to IRD provides some relief, but the combined tax burden can still be very high.
Unlike most assets, a carried interest generally does not receive a step-up in income tax basis at death to the extent it represents IRD. The unrealized gain attributable to the carried interest — the embedded profit in the fund’s underlying investments that will eventually be allocated to the carried interest when those investments are sold — is treated as IRD and remains subject to income tax in the hands of the estate or heirs. Only the portion of the carried interest’s value that does not represent IRD (for example, the value attributable to the ongoing services component or the capital account, if any) would receive a step-up in basis under Section 1014.
Practical Guidance for Fund Managers and General Partners
The ideal time for carried interest estate planning is at the very beginning of a new fund’s formation, when the profits interest has a near-zero liquidation value. At that point, the fund manager can transfer the carried interest (or an interest in the GP entity that holds the carried interest) to an irrevocable trust at minimal gift tax cost, removing all future appreciation from the estate. Waiting until the fund has matured and generated significant unrealized appreciation means a much higher gift tax cost — or forgoing the planning entirely.
The choice between a GRAT, an installment sale to an IDGT, and a direct gift depends on several factors: the fund manager’s mortality risk and the GRAT term, the available federal gift tax exemption, the desired beneficiaries, and the state of the law at the time of the transfer. GRATs work best when the fund is expected to significantly outperform the Section 7520 rate, which is generally true for well-performing private equity and venture capital funds. Installment sales work best when the fund manager wants a permanent transfer that is not subject to mortality risk.
Section 1061 planning should be integrated with the estate planning strategy. Fund managers should understand the holding period rules for the specific assets held by their funds and should consider whether any changes to the fund’s investment strategy or holding periods would affect the tax treatment of carried interest income. The regulations under Section 1061 are complex and continue to evolve, and tax counsel should be consulted before any significant transaction.
Finally, the coordination of carried interest planning with the broader estate plan is essential. A fund manager whose net worth is dominated by a single carried interest position has concentrated risk in a single asset class. Diversification strategies — including the use of charitable remainder trusts, exchange funds, and other techniques — should be considered alongside the transfer tax planning strategies described in this article. An estate plan that successfully removes the carried interest from the estate but leaves the family heavily concentrated in one fund may not achieve the fund manager’s ultimate goals.