A PE fund manager holds carried interest in a fund that sells a portfolio company after a 2.5-year hold. Does the gain qualify for long-term capital treatment?
No, the gain does not qualify for long-term capital treatment under the standard rules. Although the portfolio company was held for 2.5 years (which exceeds the general 1-year holding period for long-term capital gain treatment), carried interest held by a fund manager is subject to special rules under 26 U.S.C. § 1061. This provision applies to "applicable partnership interests" held in connection with the performance of services.
Under § 1061, the holding period requirement is extended from 1 year to 3 years. Specifically, any gain that would otherwise qualify as long-term capital gain is recharacterized as short-term capital gain to the extent it does not meet the 3-year holding period. Since the portfolio company was held for only 2.5 years, the gain falls short of this threshold and will be treated as short-term capital gain, taxed at ordinary income rates.
Key takeaway: For carried interest, the fund must hold the underlying asset for more than 3 years to achieve long-term capital gain treatment, not just the standard 1 year.