QSBS and Carried Interest: Qualified Small Business Stock for Fund Managers

The interaction between Qualified Small Business Stock (QSBS) benefits and carried interest (profits interests) in partnerships presents one of the most complex and uncertain areas in QSBS taxation. While Section 1202(g) provides rules for QSBS held through partnerships, the regulations under Section 1045 create potential limitations for partners holding only profits interests (carried interest) without capital interests.

This page analyzes the legal framework, regulatory requirements, and planning considerations for carried interest holders seeking QSBS benefits.

Understanding Carried Interest (Profits Interest)

A carried interest, also known as a profits interest, is a partnership interest that entitles the holder to a share of the partnership's future profits but does not require an initial capital contribution or provides the holder with only a minimal capital interest in the partnership.

Key Characteristics:

• Represents a share of partnership profits and losses
• Typically granted to fund managers or general partners
• May have zero or minimal initial capital account balance
• Often subject to vesting or forfeiture provisions

Section 1202(g): Pass-Through Entity Treatment

Section 1202(g) allows QSBS benefits to flow through to partners when QSBS is held by a partnership. The statute provides:

Requirements for Pass-Through Treatment

Under Section 1202(g)(2), gain from the sale of QSBS by a partnership qualifies for exclusion at the partner level if:

1. Entity-Level Qualification: The stock is qualified small business stock in the hands of the partnership (determined by treating the partnership as an individual) [IRC §1202(g)(2)(A)]

2. Holding Period: The partnership held the stock for at least 3 years (or more than 5 years for stock acquired on or before the applicable date) [IRC §1202(g)(2)(A)]

3. Partner's Interest Requirement: The gain is includible in the partner's gross income "by reason of the holding of an interest in such entity which was held by the taxpayer on the date on which such pass-thru entity acquired such stock and at all times thereafter before the disposition of such stock by such pass-thru entity" [IRC §1202(g)(2)(B)]

Key Language: "An Interest"

Critically, Section 1202(g)(2)(B) refers to "an interest" in the partnership, not specifically a "capital interest." This broader language suggests that any partnership interest—including a profits interest—should satisfy the requirement.

Statutory Text: The statute states the partner must hold "an interest" in the entity continuously from acquisition through disposition, without limiting this to capital interests.

Section 1045: Partnership Rollover Regulations

Section 1045 allows taxpayers to defer gain from the sale of QSBS by rolling proceeds into replacement QSBS within 60 days. Section 1045(b)(5) provides that "rules similar to" Section 1202(g) apply, suggesting parallel treatment.

However, Regulation 1.1045-1(d) imposes a specific limitation for partnership rollovers:

Capital Interest Limitation

Regulation 1.1045-1(d)(1) limits the amount of gain that an eligible partner can defer through a Section 1045 rollover to the partner's "smallest percentage interest in partnership capital" during the holding period.

Regulation Text: "The amount of gain that an eligible partner does not recognize under paragraphs (b)(1) and (c)(1) of this section cannot exceed the nonrecognition limitation. Except as otherwise provided in paragraph (d)(2) of this section, the nonrecognition limitation is equal to the product of—(i) The partnership's realized gain from the sale of the QSB stock... and (ii) The eligible partner's smallest percentage interest in partnership capital as determined in paragraph (d)(2) of this section." [Reg. 1.1045-1(d)(1)]

The Carried Interest Problem

For partners holding only profits interests (carried interest) with zero or minimal capital interests:

• Smallest percentage interest in partnership capital: This would be effectively zero (or very small)
• Nonrecognition limitation: The product of partnership gain × 0% = zero

Result: Partners with only profits interests cannot defer gain through Section 1045 rollovers, even if the partnership makes the rollover election.

Does the Section 1045 Limitation Apply to Section 1202?

This is the central question creating uncertainty:

Arguments That It Does NOT Apply

1. Section-Specific Regulations: Regulation 1.1045-1 is specific to Section 1045 rollovers and does not explicitly limit Section 1202 exclusions

2. Different Statutory Language: Section 1202(g) uses "an interest" while Reg. 1.1045-1(d) specifically references "partnership capital"

3. Policy Distinction: The limitation in Section 1045 may reflect concerns about deferral mechanics that don't apply to the Section 1202 exclusion

4. Regulatory Scope: Section 1045(b)(5) states "rules similar to" Section 1202(g) apply—this suggests Section 1202(g) is the primary rule, with Section 1045 incorporating similar mechanics, not vice versa

Arguments That It Might Apply

1. IRS Policy View: The Section 1045 regulation may reflect the IRS's view that capital interests are required for partnership-level QSBS benefits

2. Cross-Reference: Section 1045(b)(5) makes Section 1202(g) rules apply to Section 1045, suggesting policy alignment

3. Regulatory Guidance: The existence of the capital interest limitation, even if only in Section 1045 regulations, signals potential IRS interpretation

Current State of Authority

There is no direct authority addressing whether the Section 1045 capital interest limitation applies to Section 1202 exclusions. This creates significant uncertainty for carried interest holders.

Planning Considerations

Given the uncertainty, carried interest holders should consider:

1. Document the Legal Position

• Section 1202(g) uses "an interest," not "capital interest"
• Section 1045 regulations are section-specific
• No direct authority extends the capital interest limitation to Section 1202

2. Maintain Appropriate Documentation

• Partnership agreements showing interest held continuously
• Documentation of partnership's QSBS acquisition
• Records of partnership's QSBS holding period

3. Structure Considerations

If structuring new arrangements, consider:

• Whether partners can receive some capital interest (even minimal)
• Whether carried interest can be structured to include capital components
• Tax vs. economic trade-offs of different structures

4. Separate Analysis for Section 1202 vs. Section 1045

• Section 1202 Exclusion: Arguably available to profits interest holders (based on statutory language)
• Section 1045 Rollover: Clearly limited by capital interest requirement (per regulations)

5. Professional Advice

Given the uncertainty and significant tax dollars at stake, carried interest holders should:

• Consult with experienced tax counsel
• Consider the audit risk of claiming Section 1202 benefits
• Evaluate whether to seek a private letter ruling (though PLRs are fact-specific and not precedential)

Potential IRS Challenges

If the IRS were to challenge a carried interest holder's Section 1202 exclusion, potential arguments might include:

1. Analogy to Section 1045: The Section 1045 capital interest limitation reflects policy requiring capital investment

2. Legislative Intent: Congress may have intended QSBS benefits for investors making capital contributions

3. Regulatory Interpretation: The Section 1045 regulation may signal broader IRS interpretation

However, these arguments would need to overcome:

• The plain language of Section 1202(g) referring to "an interest"
• The section-specific nature of the Section 1045 regulation
• The absence of similar language in Section 1202 regulations

Comparison Table

| Aspect | Section 1202 Exclusion | Section 1045 Rollover | |--------|----------------------|---------------------| | Statutory Language | "An interest" in the entity | Uses Section 1202(g) rules | | Regulatory Limitation | None specified | Capital interest required [Reg. 1.1045-1(d)] | | Carried Interest Eligibility | Uncertain - statutory language supports, but no direct authority | Clear limitation - capital interest required | | Planning Risk | Medium-High (uncertainty) | High (regulation clearly limits) |

Key Takeaways

1. Statutory Uncertainty: Section 1202(g) uses broad "an interest" language, but Section 1045 regulations suggest capital interest requirement

2. Section 1045 is Clear: Carried interest holders cannot use Section 1045 rollovers due to capital interest limitation

3. Section 1202 is Unclear: No direct authority addresses whether capital interest limitation applies to Section 1202 exclusions

4. Significant Risk: Claiming Section 1202 benefits with only profits interest involves uncertainty and potential audit risk

5. Professional Guidance Essential: This area requires careful analysis and tax professional consultation

6. Documentation Critical: Maintain thorough records regardless of position taken

Sources and Citations

• IRC Section 1202(g): Pass-through entity treatment provisions
• IRC Section 1045(b)(5): Cross-reference to Section 1202(g) rules
• Reg. 1.1045-1(d): Capital interest limitation for partnership rollovers
• IRC Section 1045(b)(1): Definition of qualified small business stock (cross-references Section 1202(c))

Verification Date: January 2025

Note: This analysis reflects the current state of law and regulations as of January 2025. This area involves significant uncertainty and evolving interpretation. This information should not be construed as legal or tax advice. Consult with qualified tax counsel regarding specific situations. The absence of direct authority creates risk in relying on any particular interpretation.