What Is Carried Interest?
Carried interest is often the subject of political controversy because many believe it represents income that receives preferential treatment under the U.S. Tax Code. Politicians from both parties often view carried interest as a tax loophole that overwhelmingly benefits wealthy investors. In fact, during the 2016 presidential campaign, both former-President Donald Trump and Hillary Clinton said they wanted to close the carried interest loophole.
By itself, carried interest is not that controversial. It simply represents the share of any profits that the general partners who set up and manage private equity and hedge funds are paid, whether or not they actually contributed their own money to the fund. This compensation is usually calculated as a small management fee—usually 2% of the total funds—plus as much as 20% of any profits earned. Since a general partner can be managing investments of $100 million or more, the carried interest they receive can often run into the millions of dollars.
It is called “carried interest" because the general partner's interest in the profits earned by the private equity or hedge fund is generally carried over from year to year until a cash payment is made. In other words, the partner's compensation remains invested in the fund until he or she cashes out.
Carried Interest Not Taxed as Income
To fully understand the carried interest controversy, you must first know the difference between how long-term capital gains and ordinary income are taxed. Ordinary income is generally taxed at a higher rate than long-term capital gains—significantly higher rates in the highest tax brackets. For example, if you earn a $1 million return on long-term investments in 2020 it will be taxed at the maximum rate for long-term capital gains, which is 20%. If that same amount was treated as income, your marginal income tax rate would be 37%.
The controversy surrounding carried interest stems from the fact the Tax Code treats it as a capital gain, not income earned by the general partner for managing the fund. As a general rule, long-term capital gains are the profits you make from investments in things like property, stock, or a business that you have owned for more than 12 months.
The lower tax rate for long-term capital gains is part of the U.S. government's efforts to encourage investment in the economy. Short-term capital gains are the profits from selling property you have owned for less than 12 months, which is taxed as ordinary income.
Since in many cases general partners invest very little of their own money in the private equity or hedge fund, most critics of how carried interest is taxed argue that the partners are not really receiving a capital gain. They claim that the general partners are receiving a tax break on payments that should be treated as ordinary income. Supporters of the current tax treatment for carried interest claim general partners should be treated more like entrepreneurs who start their own businesses.
The 2017 Tax Reform Increased the Carry Period
One of the reasons that some of the controversy surrounding carried interest has died down in recent years was the passage of the 2017 Tax Cuts and Jobs Act (TCJA). The Act increased the amount of time a general partner needed to hold their interest.
Prior to the enactment of the TCJA, a general partner only needed to hold carried interest for one year and it would be taxed as a capital gain when it was converted into cash. The TCJA increased the carry period to three years. If the general partner converts his or her carried interest into cash before the carry period has expired it is taxed as ordinary income.