Who this is for
- Hedge fund, private equity and venture fund principals with carry on a K-1
- Individuals holding carry directly or through a GP partnership or S corporation
- Carry holders with invested capital, late statements, state moves or cross-border questions
Not covered here
- Tax on granting or vesting a profits interest and section 83(b) elections
- Full partnership returns, basis, self-employment tax or passive losses
- Detailed state sourcing, foreign tax computations or departure tax
What is the carried interest three-year rule, and did the One Big Beautiful Bill Act change it?
Section 1061 changes the tax character of certain carried interest gains from long-term to short-term. Qualifying gains generally need a holding period of more than 3 years to remain long-term under this rule; exactly three years is not enough (26 USC 1061).
The One Big Beautiful Bill Act did not amend Section 1061; the three-year rule still applies (26 USC 1061).
The adjustment remains a capital gain. Net short-term capital gain is taxed at ordinary income rates, so changing its character can increase tax; the result depends on your other gains, losses and taxable income (IRS: capital gains and losses).
Is my carry an applicable partnership interest?
A partnership interest received or held for substantial services in an investment business can be an applicable partnership interest, or API. The test includes related persons' services and interests held through another entity (26 USC 1061(c)).
The business must regularly raise or return capital and invest in or develop specified assets. Those assets include securities, commodities, investment or rental real estate, cash, derivatives and certain partnership interests. Hedge, private equity, venture and real estate funds can fit that test; the fund's label alone does not decide it.
Carry keeps its API character through a GP partnership and after you leave or retire (26 CFR 1.1061-2(a)). Carry held by a corporation, including a foreign corporation, is excluded. S corporations and passive foreign investment companies (PFICs) with a shareholder's qualified electing fund (QEF) election are outside that exception (26 CFR 1.1061-3(b)). The eligible shareholder makes the QEF election on Form 8621 with its signed return by the shareholder's return due date, including extensions, for the first effective year; see foreign funds (IRS: Form 8621 instructions).
A genuine gift without recognized gain is not the taxable transfer covered by Section 1061(d), but the recipient still holds an API. A gain-recognizing sale can trigger an additional adjustment if the buyer is your spouse (unless legally separated by court decree), child, grandchild or parent; someone who served the same investment business this year or in the preceding 3 calendar years; or a passthrough entity to the extent those people own it (26 CFR 1.1061-5).
Section 1061 applies even if you made an 83(b) election; grant, vesting and election questions belong in splitting ownership between LLC partners.
Whose holding period counts if the deal lasted two years but carry pays in year five?
For gain allocated from a fund's asset sale, the fund's holding period in the asset controls. How long you have owned the carry, or when cash reaches you, does not replace that period (26 CFR 1.1061-4(b)(8)).
A company held for two years can therefore produce carry gain subject to recharacterization even when your carry interest is five years old. A later payout does not lengthen the asset's holding period at sale.
If you sell the carry interest itself, your holding period in that interest generally matters. Certain sales require a lookthrough calculation using the fund's underlying assets, including transactions designed to avoid recharacterization (26 CFR 1.1061-4(b)(9)).
Is a hedge fund incentive allocation carried interest, and why might little change?
A hedge fund incentive allocation can be carried interest when the manager's profits interest meets the API test. Section 1061 changes eligible long-term capital gains; it does not make every incentive allocation short-term.
The fund's strategy and underlying income determine what can change (IRS: K-1 instructions, code AK):
| Income allocated to the carry holder | Effect of Section 1061 |
|---|---|
| Ordinary income, including interest, nonqualified dividends and Section 475(f) mark-to-market trading gains | Outside Section 1061 |
| Capital gain already short-term under ordinary holding-period rules | Already short-term; no conversion needed |
| Eligible long-term capital gain from assets held no more than three years | Enters the recharacterization calculation |
| Long-term gains and losses under Section 1256 (regulated futures and certain options) | Excluded from the calculation |
| Long-term gains and losses under Section 1231 (business property) | Excluded from the calculation |
| Qualified dividends and certain mixed-straddle gains and losses | Excluded from the calculation |
These exclusions come from 26 CFR 1.1061-4(b)(7). A fund trading positions within a year may already allocate short-term gains; a fund holding investments longer may have more eligible long-term gain (IRS: holding periods). Do not assume that most hedge fund gains need an adjustment.
Management fees, trader-versus-investor status, fee deductions and the management company's QBI treatment belong in a new hedge fund's first tax year.
Does my GP commitment or co-investment fall under the rule?
Returns on your invested capital can qualify for the capital-interest exclusion. Calling an allocation a GP commitment or co-investment does not establish the exclusion (26 CFR 1.1061-3(c)).
Carry gain retained in the fund, or distributed and reinvested, counts as new contributed capital; later returns can qualify under the same tests (26 CFR 1.1061-3(c)(3)(iii)).
The capital allocation and distribution rights must be reasonably consistent with those of similarly situated investors who neither provide nor have provided services in the relevant investment business. Those outside investors must not be, or have been, related to any API holder or current or former service provider in that business (26 CFR 1.1061-1(a)). Together, they must hold at least 5% of contributed capital when allocations are made, tested for the relevant class or investment.
If the GP invests capital in the fund, the qualifying capital return keeps its exclusion when properly allocated to the GP's capital partners under Sections 704(b) and 704(c). The GP need not have another qualifying outside-investor group (26 CFR 1.1061-3(c)(5)).
The partnership agreement and contemporaneous records must separate the capital return from carry and demonstrate the conditions. Loan-funded contributions need review: certain partnership or partner loans and guarantees prevent the allocation from qualifying, subject to a limited exception for qualifying personal recourse borrowing from another partner. Repayments count as contributed capital as paid, unless funded by another such loan (26 CFR 1.1061-3(c)(3)).
Where is carry on K-1 box 20 code AM and Section 1061 Worksheet A?
For Form 1065, the latest published partner instructions identify Section 1061 information with box 20 code AM. Worksheet A accompanies the K-1; code AM flags supporting information rather than a separate cash payment (IRS: K-1 instructions).
For an S corporation K-1, Publication 541 places the Section 1061 attachment at box 17 code ZZ; the FAQ's older code AD is out of date (IRS: Publication 541).
The IRS reporting FAQ still refers to the older box 20 code AH. In the latest published instructions, box 20 code AH means noncash charitable contributions. Use the instructions for the K-1's tax year and its attached statement, rather than treating AH as a permanent carry code.
The fund or GP entity prepares Worksheet A:
| Worksheet A line | What the entity reports |
|---|---|
| 1 | Net long-term capital gain or loss from the specified K-1 box; Form 1065 box 9a or Form 1120-S box 8a |
| 2 | Excluded gains and losses already included in line 1 |
| 3 | Qualifying capital-interest gains and losses already included in line 1 |
| 4 | Line 1 minus lines 2 and 3: the API One Year Distributive Share Amount |
| 5 | Line 4 gains and losses that fail the three-year holding-period test |
| 6 | Any applicable lookthrough adjustment |
| 7 | Line 4 minus lines 5 and 6: the API Three Year Distributive Share Amount |
If a fund allocates carry to a GP partnership, the GP must pass the required information through to its individual partners. Receiving only the fund's statement to the GP may leave your personal allocation unresolved (26 CFR 1.1061-6(b)).
How do I complete Worksheet B and the Form 8949 adjustment?
You complete Worksheet B using all your APIs together. Worksheet A is the entity's allocation calculation; Worksheet B determines your personal adjustment (IRS: Publication 541).
Use gains as positive amounts and losses as negative amounts. Follow the zero floors and skip instruction in Worksheet B:
| Worksheet B line | What to enter |
|---|---|
| 1 | Combine Worksheet A line 4 amounts from all APIs; include applicable separately supplied collectibles and unrecaptured Section 1250 amounts |
| 2 | Combine the disposition amounts from Table 1, line 4 |
| 3 | Add lines 1 and 2; if zero or less, enter zero and skip to line 8 |
| 4 | Combine Worksheet A line 7 amounts, including applicable separately supplied special gains |
| 5 | Combine Table 2, line 4 disposition amounts |
| 6 | Add lines 4 and 5; enter zero if the sum is zero or less |
| 7 | Subtract line 6 from line 3; enter zero if the result is zero or less |
| 8 | Enter the additional Section 1061(d) related-person transfer amount, if applicable |
| 9 | Add lines 7 and 8: the Form 8949 adjustment |
| 10 | (a) Total collectibles gain from all passthrough interests; (b) amount recharacterized; (c) amount entered in the 28% Rate Gain Worksheet (Schedule D, line 18) |
| 11 | (a) Total unrecaptured Section 1250 gain from all passthrough interests; (b) amount recharacterized; (c) amount entered in Schedule D's Unrecaptured Section 1250 Gain Worksheet |
For each line, (b) plus (c) must equal (a); totals include capital-interest gains (IRS: Worksheet B and reporting instructions). Collectibles include art and precious metals; unrecaptured Section 1250 gain generally reflects the depreciation portion of long-term real estate gain (Schedule D instructions).
Pending further guidance, the IRS requires a reasonable method to determine how much API collectibles gain or unrecaptured Section 1250 gain enters the recharacterization amount (IRS: Publication 541).
Compute Table 1 and Table 2 separately for each API. They cover relevant carry sales, distributions treated as interest-sale gains, and, for Table 1, sales of distributed API property. Ordinary annual fund allocations go through Worksheet A. Attach Worksheet B and Tables 1 and 2 to your return, as the IRS instructions require.
First report gains and losses as though Section 1061 did not apply. Then enter the paired transactions below on Form 8949, Part I box C and Part II box F, for this adjustment without a broker information return (Form 8949); both use Section 1061 Adjustment in column (a) (IRS reporting FAQ 3):
| Form 8949 entry | Proceeds, column (d) | Basis, column (e) | Result |
|---|---|---|---|
| Part I, line 1 | Worksheet B line 9 | Zero | Increases short-term capital gain |
| Part II, line 1 | Zero | Worksheet B line 9 | Decreases long-term capital gain by the same amount |
Keep the full K-1 net long-term gain or loss (Form 1065 box 9a or Form 1120-S box 8a) on Schedule D (Form 1040), line 12, and add the paired adjustments above. Do not replace it with the gain remaining after Section 1061 (IRS: partnership K-1 instructions; S corporation K-1 instructions).
What if Worksheet A is missing, late or looks wrong?
Request the Section 1061 statement from the fund or GP. In a tiered structure, a GP needing extra information must request it by the later of the 30th day after the relevant year closes or 14 days after an upper-tier entity's request. The fund generally supplies requested information by its K-1 due date; for a regular calendar-year domestic partnership, March 15 or September 15 with a timely Form 7004 extension. Late requests follow separate reporting rules (26 CFR 1.1061-6(b)(2)). Missing information can prevent you from excluding capital-interest or otherwise excluded gains and can force the three-year amount down unless you substantiate the missing amounts another way (26 CFR 1.1061-6(a)(2)).
If you cannot substantiate a missing three-year amount, the affected items fail the longer holding-period test. That can turn all the affected net long-term carry gain into short-term gain. For QEF income, the QEF must supply the information; independent substantiation is unavailable (26 CFR 1.1061-6(d)).
Ask for the one-year and three-year amounts, excluded gains, qualifying capital-interest allocations, and any special-gain detail. For an interest sale or related-person transfer, request the underlying information needed for that calculation too.
Reconcile Worksheet A line 1 to the K-1 and check whether lines 2 and 3 include only amounts already in line 1. Preserve the requests, replies, asset dates and allocation records. A blank statement does not prove a zero adjustment.
If Worksheet A or the K-1 looks wrong, request corrected information from the fund or GP; do not alter your K-1. For a partnership subject to the centralized audit rules, reporting an item inconsistently with its treatment requires Form 8082 with your return (IRS: K-1 instructions). Disagreement procedures and corrected K-1s or Forms 8986 received after filing belong in correcting a filed business return.
If my K-1 arrives in September, what do I pay by April 15?
For a calendar-year Form 1040 filer subject to the regular deadline, estimate and pay the remaining tax by April 15, 2027. A timely extension generally gives you until October 15 to file, but does not extend payment (26 USC 6072(a); IRS: filing extensions).
Ask each fund for an estimate letter separating carry, capital returns and short-term income. Combine it with other income, withholding and payments. If at least 90% of your final tax is paid by the regular deadline and the rest with your timely extended return, extension-period late-payment penalties generally do not apply. Interest still runs from the payment deadline. Otherwise, absent reasonable cause, the usual penalty is 0.5% of unpaid tax per month or part-month, up to 25% (Form 4868).
| When | Action |
|---|---|
| Before the regular April deadline | Request estimates, calculate the balance, pay and request an extension using Form 4868 or an eligible extension payment |
| When final fund statements arrive | Reconcile estimates to K-1s and Worksheets A; complete Worksheet B |
| By October 15 | File the return with the required worksheets and adjustments |
Quarterly estimated-tax penalties are a separate calculation; the safe harbors and uneven-income method are covered in estimated tax payments for owners.
Can New York or California still tax carry after I move to Florida or Texas?
New York or California may still tax income after a move if you remain a resident or the income has a source in that state. Neither state's general guidance establishes a universal answer for carry.
| Old state | What needs review |
|---|---|
| New York | Nonresident intangible income is generally excluded unless connected with a New York business; partnership source income and special accruals can change the answer. In the move year, choose direct accounting or day proration over each partnership's year separately (IT-203 instructions) |
| California | Residents are taxed on worldwide income; nonresidents on California-source income. Investment stock gains and business income have different sourcing rules. Part-year residents split resident and nonresident periods; the FTB partnership example prorates income by days (FTB Publication 1031) |
A move date, payout date or federal capital-gain label alone does not settle carry sourcing. Gather residency records, work locations, fund and GP agreements, and state K-1 schedules before an exit or move. Nonresident filings belong in business income tax in other states.
How is carried interest taxed if I live in Canada or mainland China?
Canada taxes residents' carry under Canadian law, computing partnership income as if the partnership were resident in Canada. Carry's Canadian character needs review; the US short-term label does not carry over (Income Tax Act, section 96; CRA: Capital Gains).
For a non-US citizen who is a US tax nonresident, carry capital gain generally faces US tax if effectively connected with a US business, from US real property, or US-source with at least 183 days of US presence that year. Treaty relief may apply; reclassification may change no US tax (IRS: Publication 519). Withholding, Form 1040-NR and foreign tax credits for Canadian residents belong in Canadian partners in US partnerships.
A US citizen in Canada remains subject to US tax on worldwide income; living there alone does not remove Section 1061 for qualifying carry (IRS: citizens abroad). Coordinate Canadian treatment and foreign tax credits through Americans living in Canada.
For mainland China, overseas-income reporting and credit questions belong in moving back to China and overseas income.
Example
All amounts are illustrative, in US dollars. A new fund's management company earns fees, while its GP partnership holds the carry. An individual GP partner has held that carry since the fund started.
Five years after the fund started, it sells a company it held for two years. The partner receives an allocation of $40,000 of eligible long-term carry gain and $10,000 of gain on invested capital. Assume the capital allocation satisfies the exclusion, there are no other APIs or relevant losses, and there is no interest sale or related-person transfer.
Worksheet A starts with $50,000 on line 1, removes $10,000 on line 3, and shows $40,000 on line 4. The two-year asset holding period puts $40,000 on line 5 and leaves zero on line 7.
Worksheet B shows $40,000 on lines 1 and 3, zero on lines 4 and 6, and $40,000 on lines 7 and 9. Form 8949 adds $40,000 of short-term gain and subtracts $40,000 of long-term gain. The $10,000 capital-interest gain remains long-term under these assumptions. Owning the carry for five years does not change the company's two-year holding period.
Different for you?
A direct carry allocation with complete statements is easier to reconcile than a carry exit, several funds, a move or two countries. We prepare principals' returns and carry adjustments, GP books, returns, K-1s and Worksheets A, and fund Form 1065 returns: see hedge fund tax and accounting. Bring K-1s, Worksheets A, estimate letters, capital accounts, agreements and transfer or residency records.
- Grant or vesting: Profits interests and ownership splits covers the grant and 83(b) questions.
- Other K-1 items, basis, undistributed income or self-employment tax: use how partnerships are taxed.
- Losses or passive status: use business losses.
- State PTET credits: use pass-through entity tax elections.
- Canadian foreign-property or affiliate forms: use foreign property and affiliate reporting.
- Leaving Canada with unrealized carry: use leaving Canada; an illiquid interest and a possible deferral belong in deferring departure tax when moving to the US.
- US nonresident business income: use the nonresident business-income return.
- Foreign fund interests or accounts: use US foreign-account and asset reporting.
- Carry sale, family transfer, missing statements or disputed allocations: bring the transaction and allocation records to hedge fund tax and accounting before deciding the reporting treatment.
Figures on this page
| Figure | Value | Source |
|---|---|---|
| Section 1061 long-term capital gain holding-period test Eligible API gains generally require a holding period of more than three years; exclusions and special disposition rules apply. | 3 years | 26 USC 1061(a), official Title 26 release through Public Law 119-120 Checked |
| General deadline for a QEF election Eligible shareholder elects using Form 8621 attached to a timely filed return; special retroactive-election rules may apply. | The shareholder's return due date, including extensions, for the first effective year | IRS: Form 8621 instructions, Part II Election A Checked |
| Related-person service lookback for Section 1061(d) Before the current calendar year; services must be in the relevant investment business. | 3 calendar years | 26 CFR 1.1061-5(e)(2) Checked |
| Unrelated non-service investors' minimum aggregate capital for the Section 1061 capital-interest allocation test Unrelated Non-Service Partners must possess at least this share of aggregate contributed capital when allocations are made; apply the test to the relevant class or investment where applicable. | 5% | 26 CFR 1.1061-3(c)(3)(iv) Checked |
| Maximum tax rate on collectibles gain Long-term gain on collectibles such as art, antiques, gems, stamps, coins and bullion held more than one year; set by statute, not indexed. | 28% | IRS: Publication 550 Checked |
| Section 1061 tiered entity information-request deadline after year-end Later of this day after the relevant taxable year closes or 14 days after an upper-tier passthrough entity request. | 30th day | 26 CFR 1.1061-6(b)(2)(iii)(A) Checked |
| Section 1061 request window after an upper-tier entity request Alternative later deadline for passthrough entity requests; individual owner requests do not trigger this extension. | 14 days | 26 CFR 1.1061-6(b)(2)(iii)(A) Checked |
| Regular calendar-year domestic partnership K-1 furnishing deadline Following the calendar tax year; weekends, legal holidays and disaster relief can alter the date. The extended date requires a timely extension. | March 15 | 26 USC 6031(b) and 6072(b) Checked |
| Calendar-year domestic partnership K-1 furnishing deadline with a timely automatic extension Following the calendar tax year; weekends, legal holidays and disaster relief can alter the date. The extended date requires a timely extension. | September 15 | IRS: Form 7004 instructions and 26 USC 6031(b) Checked |
| Calendar-year 2026 US individual return filing deadline Section 6072(a) sets April 15 after the close of the calendar year; this date is a weekday | April 15, 2027 Tax year 2026 | 26 USC 6072(a) Checked |
| Regular calendar-year individual filing deadline with a timely automatic extension Following the tax year; weekend, holiday, overseas and disaster rules can alter the applicable deadline. | October 15 | IRS: Get an extension to file your tax return Checked |
| Individual extension-period late-payment reasonable-cause payment threshold Pay at least this share of total final tax by the regular due date and the remaining balance with the timely extended return; interest still applies. | 90% | IRS: Form 4868 instructions Checked |
| General monthly failure-to-pay penalty rate Of unpaid tax for each month or part month the tax remains unpaid; special rates can apply in some cases | 0.5% | IRS: Failure to pay penalty Checked |
| General maximum failure-to-pay penalty rate Maximum percentage of unpaid tax | 25% | IRS: Failure to pay penalty Checked |
| Annual US presence threshold for nonresident US-source capital gains Actual presence during the tax year for non-effectively-connected US-source capital gains; separate from the substantial-presence residency test and subject to treaty relief. | 183 days | IRS: Publication 519, Sales or Exchanges of Capital Assets Checked |
Primary sources
- US Code: 26 USC 1061
- IRS: Section 1061 reporting guidance FAQs
- IRS: Partner's Instructions for Schedule K-1 (Form 1065)
- IRS: Publication 541, Partnerships
- IRS: Section 1061 Worksheet A
- IRS: Section 1061 Worksheet B
- IRS: Section 1061 Table 1
- IRS: Section 1061 Table 2
- eCFR: 26 CFR 1.1061-2, API rules
- eCFR: 26 CFR 1.1061-3, exceptions and capital interests
- eCFR: 26 CFR 1.1061-4, computations and holding periods
- eCFR: 26 CFR 1.1061-5, related-person transfers
- eCFR: 26 CFR 1.1061-6, reporting and missing information
- IRS: Topic 409, Capital gains and losses
- IRS: Get an extension to file your tax return
- New York: Instructions for Form IT-203
- California FTB: Publication 1031, Guidelines for Determining Resident Status
- Justice Laws: Income Tax Act, section 96
- CRA: Capital Gains guide T4037
- eCFR: 26 CFR 1.1061-1, definitions
- IRS: Instructions for Schedule D (Form 1040)
- IRS: US citizens and resident aliens abroad
- US Code: 26 USC 6072
- IRS: Publication 519, US Tax Guide for Aliens
- IRS: Form 8949
- IRS: Form 4868
- IRS: S corporation K-1 instructions
- IRS: Form 8621 instructions
- IRS: Form 7004 instructions
About this guide
Published by Cloud Accounting under standing professional approval. This version has no separately recorded personal review. It explains general rules for the tax year shown. It is not advice for your situation.
Changes
- : First published.