Private Equity and Carried Interest: The Profits Interest, the Three-Year Rule, the Management Fee That Is Ordinary Income, the Deal Costs You Capitalize and the Broken Deals the Management Company Deducts, and the K-1 That Arrives in September

A fund principal is paid two ways: a management fee, which is ordinary income to the management company, and a carried interest — a share of the fund's profits — which is a profits interest in the fund partnership, taxed when the fund realizes gains and in the character the fund realizes them. Since 2018 the carry's long-term capital gain treatment requires a three-year holding period rather than one. Around those two streams sit the deal costs, the fund expenses, the net investment income tax, and K-1s that arrive months after the year ends.

The carried interest

The general partner's carried interest is a profits interest in the fund: granted for services, not taxed at grant under the safe harbor of Rev. Proc. 93-27 and Rev. Proc. 2001-43 (which says no Section 83(b) election is needed for an unvested profits interest, though a protective election is customary), and taxed as the fund allocates income and gain to it. The character passes through — long-term capital gain on portfolio exits, ordinary income on interest and fees, qualified dividends on dividends. Section 1061 recharacterizes a carried interest holder's long-term gains as short-term unless the fund held the asset more than three years (the regulations exclude Section 1231 gain, Section 1256 gain, and qualified dividends, and the statute excepts the return on capital the principal invested alongside the carry); the rule has applied since 2018, and the 2025 law did not change it. A fund that exits a company after two and a half years delivers short-term gain to the carry and long-term gain to the limited partners.

The management fee

The management company — an LLC or S corporation owned by the principals — earns the fee (typically a percentage of committed or invested capital) and pays the salaries, rent, travel, and overhead. The fee is ordinary income; the principals' salaries are wages if the management company is an S corporation (guaranteed payments, subject to self-employment tax, if it is taxed as a partnership); profit beyond salaries is distributed. Management fee waivers — forgoing fee in exchange for additional carry — are scrutinized by the IRS (2015 proposed regulations under Section 707(a)(2)(A) would treat a waiver without significant entrepreneurial risk as a disguised fee) and must carry real entrepreneurial risk to be respected.

Deal costs: capitalize or deduct

| Cost | Treatment | |---|---| | Due diligence, legal, and advisory costs on a deal that closes | Capitalized into the investment's basis (by the fund) or into the acquired company's costs, depending on who bears them and the transaction structure | | Costs of deals that do not close (broken-deal costs) | Deductible by the party that bore them when the deal is abandoned — in full by the management company; at a fund that invests rather than trades, individual partners generally cannot use them (they are miscellaneous itemized deductions, which the 2025 law disallowed permanently) | | Costs of organizing the fund | Organizational costs: if the fund elects, up to $5,000 deducted in the first year (reduced dollar for dollar once they exceed $50,000) and the rest amortized over 180 months; syndication costs of selling interests to investors are capitalized and never deducted | | Ongoing fund administration, audit, tax preparation | Fund expenses, allocated to the partners; at a fund that invests rather than trades, they are investment expenses that individual partners cannot deduct, because the 2025 law made the suspension of miscellaneous itemized deductions permanent | | Management company overhead | Deductible by the management company |

Which entity bears a cost decides where it is deducted or capitalized, and the fund agreement's expense allocation governs.

The net investment income tax

Carry allocations of capital gain, dividends, and interest are net investment income — a fund that invests is not itself a trade or business, and gain on portfolio company stock is investment income whatever the principal's role — and bear the 3.8 percent tax once modified adjusted gross income exceeds $200,000 ($250,000 married filing jointly). Management fee income is not investment income, but the management company's distributions to a principal who materially participates in it are outside the tax, while a passive owner's share is inside it.

Self-employment tax on the general partner

Members of the general partner entity who actively manage the fund may be subject to self-employment tax on their shares of guaranteed payments and ordinary income; the "limited partner" exception no longer shelters state-law limited partners who in substance run the business. The Tax Court limited it to passive investors in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), and on September 17, 2026 the Second Circuit affirmed, holding that a limited partner must have limited liability and must not run, manage, or control the business. The Fifth Circuit, in a substitute opinion issued August 12, 2026 in K Alain, L.L.L.P. v. Commissioner (No. 24-60240, the former Sirius Solutions appeal), rejected the Tax Court's passive-investor test but held that a limited partner is one who plays no significant role in managing or running the business, and remanded; a similar case, Denham Capital Management, is pending in the First Circuit. Under either standard, principals who manage the fund should expect self-employment tax on their ordinary shares. Carry that is capital gain is outside self-employment tax regardless.

The K-1 in September

Funds issue K-1s after their portfolio companies' and administrators' work is done, often in late summer. Principals extend their personal returns, estimate the carry's income for the first and second quarter payments, and true up when the K-1 arrives. The annualized method and a reserve against expected realizations are the tools.

Worked example. A principal of a small growth fund holds a 20 percent carried interest through the general partner and a 40 percent interest in the management company. The fund exits two companies: one held four years ($3 million of gain allocated to the carry — long-term after the three-year test) and one held two years ($1.2 million allocated to the carry — recharacterized as short-term under Section 1061). The management company earns $2.4 million of fees, pays the principal a $400,000 salary, and distributes her share of the remainder. Broken-deal costs of $180,000 borne by the management company are deducted; $640,000 of diligence on the closed deals was capitalized into those investments. Her carry gains bear the net investment income tax; her K-1 arrives in September, and she paid first-half estimates on a reserve.

Official sources

The statute provides: “Except as provided in this paragraph or paragraph (4), the term “applicable partnership interest” means any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.” — Legal Information Institute, 26 U.S. Code § 1061 - Partnership interests held in connection with performance of services, https://www.law.cornell.edu/uscode/text/26/1061

The IRS explains, describing Rev. Proc. 93-27: “if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of the interest as a taxable event for the partner or the partnership.” — Internal Revenue Service, Rev. Proc. 2001-43, https://www.irs.gov/pub/irs-drop/rp-01-43.pdf

The IRS explains: “A 3.8 percent net investment income tax (NIIT) applies to individuals, estates, and trusts that have net investment income above applicable threshold amounts.” — Internal Revenue Service, Topic no. 559, Net investment income tax, https://www.irs.gov/taxtopics/tc559

Related guides

• Private Equity Entity and Estimated Taxes: The Fund, the General Partner, the Management Company, the Carry Vehicle, the Estimates Paid Before the K-1, and the Exit That Lands in One Quarter
• The 83(b) Election: Paying Tax Early on Restricted Stock
• Partnership Tax Basics: Form 1065, K-1s, and Basis
• The 3.8 Percent Net Investment Income Tax for Owners
• Qualified Small Business Stock After the 2025 Law

Next step

Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk tracks carry allocations against the three-year test, allocates deal costs between the fund and the management company, and builds estimates ahead of the K-1. See pricing or book a free fit call.