Vesting Rights and The Taxation of Carried Interest

How do fund managers internally divide carried interest? What are the tax implications of carried interest?

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There’s a decent chance someone will call me a dummy for something in this post—and fair enough. I learned a few things while writing it and remembered a few more along the way. As always, please flag anything that’s confusing or just flat-out wrong. We’re all figuring it out as we go.

A few weeks back, we explored how capital flows back to investors (or “LPs”) in a private fund structured as a limited partnership.

Today, we shift the lens inward.

Rather than focus on how profits are shared between a fund manager and its investors, we’ll examine how the GP’s harvest of carried interest cascades through and among the hierarchy of investment professionals who comprise its ecosystem.

And I mean, stuff gets complicated.

Sometimes firms take on minority investors or new business lines.

So over time, carry splits change.

People are promoted. Others are kicked out. New stars emerge.

Always politics, innit bruv!!

(Sorry, I worked in the City of London for a few days, and I feel I’ve earned the slang privileges.)

We’ll also navigate the corridors of carried interest’s tax implications—though with humility. I’m not a tax attorney. What follows distills the quintessential knowledge a funds lawyer gains by proximity, with federal income and partnership tax experts and state and local specialists (also known as “SALT” attorneys).

To comprehend carried interest with clarity, one must contemplate the profound distinction between two deceptively simple concepts: capital interest and profits interest.

A capital interest bestows upon its holder a slice of the pie as it stands today—value that exists, assets that could be distributed if the fund liquidated at that moment. A profits interest, by contrast, is a bet on tomorrow. It entitles the holder only to the upside—no present value, no cash if the music stops too soon.

LPs, having contributed actual capital, receive capital interests in return—stakes tethered to both current assets and future valuation. Fund managers (or “GPs”), conversely, typically receive profits interests as remuneration. These reflect not money contributed, but value created, performance compensation dressed in equity’s clothing.

And therein lies the tax wrinkle. Under Section 1061 of the Internal Revenue Code—the comprehensive body of federal tax laws that governs all aspects of taxation in the United States—GPs must hold profits interests for at least three years to secure the coveted long-term capital gains treatment. LPs face no such temporal constraint, their exemption flowing naturally from having genuine capital at risk rather than services rendered. Theirs is ownership; the GP’s is reward.

Let us proceed.

Vesting

At the outset, a carry recipient may be granted a share of the GP’s economic interest, a future slice of the profits, but that grant is rarely unconditional. Ownership accrues only when it vests. Vesting binds long-term incentives to time, to performance, or to both.

Vesting serves as both compensation policy and institutional memory. It tempers entitlement, rewards endurance, and ensures that the right to share in carried interest is earned—not merely assigned.

Deal-by-deal vesting is common in firms with clearly delineated investment teams. Here, the vesting clock starts when a specific transaction closes. Rights typically vest annually (e.g., 20% per year over five years), with unvested portions potentially accelerating upon the sale of a fund’s asset. This model allows firms to match rewards precisely to performance, deal by deal.

Fund-level vesting, by contrast, begins at the fund’s first closing and proceeds over time, independent of any single investment’s outcome. This approach encourages collective responsibility and retention, especially where teams are integrated, and attribution is diffuse.

A hybrid approach combines both philosophies. Vesting may track fund-level timelines, but success can still accelerate rights, particularly when a strong early exit demands recognition. It’s part design, part morale management.

But vesting isn’t only about staying. It’s also about leaving.

In most arrangements, if a recipient departs voluntarily or is terminated without cause, unvested carry is forfeited. Vested carry may be retained, though often subject to strict transfer restrictions and clawback provisions. In the case of a termination for cause (sometimes defined to include fraud, willful misconduct, or breach of restrictive covenants) both vested and unvested carry may be extinguished entirely.

Between the extremes, one finds tailored provisions: partial vesting in cases of death, disability, or departure for “good reason.” These scenarios reflect a firm’s risk tolerance, its cultural instincts, and, often, the personalities at the table.

To avoid long-term entrenchment and preserve optionality, many funds include buyback rights. These provisions allow the GP to repurchase vested carry at fair market value, a negotiated discount, or according to a pre-agreed formula. Buybacks are often subject to valuation floors or consent rights to protect senior holders—and to prevent what Lewis Carroll might have called “frumious” disputes once the carry becomes real.

Taxation of Carry

Just to be clear again—I’m not a tax attorney (definitely not qualified for that). Also, this discussion is from a US perspective, so take it with a second grain of salt.

Recall that the GP entity (legally separate from the fund) is itself a partnership. The profits interest it grants to investment professionals is a specific legal construct, one that confers no claim on existing assets, only rights to future appreciation. I guess you could think of it like being given the right to share in a farm’s future harvests without owning any of the land itself. You’re entitled only to a portion of crops grown after you started working on the land.

This fundamental distinction shapes the entire economic landscape of private capital. LPs contribute actual money and receive capital interests—claims on both current assets and future gains. If the fund were liquidated immediately after formation, LPs would receive their proportional share of assets. Their capital is genuinely at risk.

The GP, by contrast, contributes expertise and puts in labor to work the capital. It typically receives a modest capital interest alongside its carried interest, which represents compensation for management. This carried interest is then subdivided among the firm’s professionals through various structures, such as carry vehicles or tailored partnership arrangements.

The tax treatment follows this economic reality. When properly structured, a profits interest incurs no tax upon grant or vesting. It has no present value. Taxation occurs only when the fund realizes gains and shares them with partners.

Here, we must distinguish two crucial concepts:

1. Allocation refers to the accounting assignment of profits and losses to partners for tax purposes. When a fund sells a portfolio company at a profit, those gains are “allocated” to partners according to the partnership agreement—typically 80% to LPs and 20% to the GP as carried interest (what we covered a few weeks ago). This allocation happens on paper and determines each partner’s tax liability, regardless of whether any cash changes hands.

2. Distribution refers to the actual payment of cash or securities to partners. Distributions often lag behind allocations, sometimes by years. A fund might allocate profits when an investment is sold, but hold back the actual cash distribution until certain conditions are met—like clearing escrow periods or reserving for potential liabilities.

When profits are allocated, the recipient inherits the character of the fund’s income. When a fund generates long-term capital gains from selling portfolio companies, the carried interest holder receives the same tax treatment.

Section 1061 of the Internal Revenue Code changed this landscape in 2017. For investments made after that date, carried interest earned through investment services (now labeled an “Applicable Partnership Interest” or API) requires a three-year holding period to qualify for long-term capital gains treatment, rather than one year.

Miss that three-year window, and carried interest is taxed as short-term capital gain at higher ordinary income rates. Only gains attributable to actual capital contributions (such as those made by LPs) escape this requirement.

Some fund managers have attempted to navigate around these constraints through mechanisms like carry waivers—agreements to forgo carry from investments held less than three years, hoping to recapture those economics from longer-held investments. The IRS views such arrangements skeptically, particularly when they lack economic substance beyond tax avoidance.

Even when long-term treatment applies, the gap between allocation and distribution creates complications. Because partnerships are pass-through entities, partners are taxed when income is allocated, not when cash is distributed. This creates “phantom income”—taxable earnings without corresponding cash flow.

A practical example: a fund sells a portfolio company after three years, generating $100 million in gains. The partnership agreement allocates $20 million to the GP as carried interest. A professional with a 5% share of the GP receives a tax form showing $1 million in allocated gains—and a tax bill to match—even if those proceeds remain in escrow or subject to future clawback.

To address this timing mismatch, most funds make periodic tax distributions—payments specifically designed to cover partners’ tax liabilities on allocated but undistributed income. These payments are advances against future carried interest distributions and may themselves be subject to clawback.

The clawback mechanism presents a final complication. If a fund underperforms in later years (assuming what we call a “deal-by-deal” structure that returns money as investments are sold, rather than at the end of a fund’s life), the GP may need to return money to LPs. But taxes on earlier allocations have already been paid. Generally speaking, unless the clawback occurs in the same tax year those tax dollars are irrecoverable. For protection, many fund agreements require personal guarantees or escrow arrangements from the GP and its professionals.

Alright, that was, as with other posts, a lot. Hit me with questions whenever!