What Is a Carry Waiver?

Since the enactment of Section 1061 as part of the Tax Cuts and Jobs Act of 2017 (TCJA), carry waivers have become an increasingly common tool for investment funds seeking to manage the timing and character of the income allocated to their general partners (GP). A carry waiver is a transaction in which a carried interest holder relinquishes its right to receive a current carried interest allocation in exchange for the opportunity to participate in future allocations.

Consider, for example, a fund selling an investment that has been held for less than three years. Under Sec. 1061 of the Internal Revenue Code, the gain is recharacterized as short-term capital gain in the hands of the partners who hold an applicable partnership interest, such as a GP's carried interest. The recharacterization increases the effective tax rate of the GP individuals, wiping out one of the key benefits of a carried interest.

To avoid this outcome, the GP may choose to waive its current carry allocation in exchange for the opportunity to receive additional carry from a future transaction involving an asset with a more favorable holding period. If such a transaction materializes, the result is advantageous to both the GP (lower effective tax rate) and the Limited Partner (accelerated cash flow from the waiver transaction).  However, if the fund's remaining investments do not generate sufficient gain, the GP may never recover the waived carry. In addition, the GP must take on significant entrepreneurial risk, or the waiver will not be respected under IRS regulations.

What Is Qualified Small Business Stock?

Qualified Small Business Stock (QSBS) is stock of a corporation that satisfies the requirements of Sec. 1202. When those requirements are met, a noncorporate taxpayer may exclude all or part of the gain on a later sale of the stock, making QSBS one of the most valuable tax benefits available to early-stage investors. To qualify, the stock generally must be acquired at original issuance, the issuer must be a domestic C corporation engaged in an active qualified trade or business, and the corporation must have been a small business, measured by its gross assets, when the stock was issued. Stock in foreign corporations, in entities taxed as partnerships, or acquired on the secondary market does not qualify.

The exclusion is claimed at the level of the noncorporate taxpayer, not the fund. A venture fund organized as a partnership cannot itself exclude QSBS gain. The gain instead flows through, and each eligible partner determines its own exclusion. The benefit therefore matters most to a fund's taxable investors and is of little value to its tax-exempt or corporate investors.

Most importantly for carry waiver analysis, the exclusion is only available for assets that meet the required holding period before a taxable event. The One Big Beautiful Bill (OBBBA), signed into law on July 4, 2025, changed that holding period, creating the following QSBS exclusion classes:

• For stock purchased before July 4, 2025:
• Held less than five years: 0% exclusion
• Held at least five years: 100% exclusion
• For stock purchased on or after July 4, 2025:
• Held less than three years: 0% exclusion
• Held at least three years but less than four years: 50% exclusion
• Held at least four years but less than five years: 75% exclusion
• Held at least five years: 100% exclusion

How Has the OBBBA Changed Carry Waiver Analysis for Funds with QSBS?

The QSBS holding period tiers created by the OBBBA provide venture capital funds with greater flexibility in managing exits of QSBS-eligible investments. However, they also complicate the carry waiver analysis for venture capital funds holding substantial QSBS. The difficulty lies in how a waived carry allocation is ultimately paid back.

A GP recoups a waived allocation, if at all, out of carry on the fund's future gains. In practice, an LP will generally not permit a GP to waive carry on one class of gain and later make itself whole out of a more tax-favored class. In particular, a GP that waives carry on fully taxable long-term capital gain cannot expect the LPs to allow carry recovery out of excludable QSBS gain.

Certain corporate or tax-exempt LPs may be indifferent to this difference in character. But even then, IRS may question whether a special allocation of taxable gain to one partner, recouped by an allocation of excludable gain to another, has substantial economic effect under the Sec. 704(b) regulations, or whether it is merely a device to reduce the partners' aggregate tax liability.

For funds holding QSBS, a carry waiver becomes a matter of timing. Before the OBBBA, a fund could recoup waived carry by selling stock held between three and five years: such gain had already cleared the Sec. 1061 three-year holding period, so it was long-term, but it was not yet QSBS, so it carried no exclusion. That provided a clean source of fully taxable long-term gain with which to make the GP whole.

The OBBBA collapses that window. Because the exclusion now begins at a three-year holding period, stock becomes QSBS the moment it clears the Sec. 1061 three-year hurdle. There is no longer any interval in which a position is old enough to generate long-term capital gain for repayment, yet too young to carry QSBS character. For a fund holding primarily QSBS, the non-QSBS long-term gain that a carry waiver depends on to repay the GP has largely disappeared.

What Should General Partners Consider Before Waiving Carry?

Under the new OBBBA rules, venture capital funds must evaluate the entire portfolio before waiving carry on a single asset with unfavorable tax attributes.

First, individual investments must be analyzed for QSBS eligibility. In addition to the baseline requirements discussed earlier in this article, the GP should monitor subsequent activity by the portfolio company. Is the company still engaged in a qualified trade or business? Has the company engaged in significant stock redemptions? Has the company been part of a merger, acquisition, or otherwise changed corporate form?

Next, the fund’s portfolio must be analyzed. If all QSBS-eligible investments qualified for gain exclusion when sold, would there be enough gain from remaining investments to satisfy the carry waiver?  How are these non-QSBS investments performing, and what is the liquidity outlook?

When Does a Carry Waiver Need to Be Made?

Once the fund determines a carry waiver is prudent and receives LP authorization, a waiver should generally be made before the income or gain being waived is earned. In the sale of a portfolio company, the waiver should be completed before legal title passes.

Most importantly, the timing of the waiver and subsequent recoupment must support entrepreneurial risk. While it’s possible to show the fund bore risk when recoupment happens in the same calendar year, a waiver is more defensible if recoupment occurs in a year subsequent to the carry waiver.

The Takeaway

Carry waivers are a recognized fund-planning technique, but they are not expressly sanctioned by final Sec. 1061 or the final Sec. 704 regulations. Treasury and IRS have acknowledged these arrangements and cautioned that they may be challenged under existing tax doctrines. GPs should ensure that the language of the carry waiver, the recoupment of gain, and the relative timing of the transactions support a position that significant entrepreneurial risk was undertaken by the GP. Further, GPs should analyze when QSBS-eligible stock in the fund’s portfolio will create a challenge in the carry recoupment stage, especially considering the reduced QSBS holding period following the enactment of the OBBBA.