What Is Carried Interest?

Carried interest is often controversial because many believe it represents income that receives preferential treatment under the U.S. tax law. Politicians from both parties often view carried interest as a tax loophole that overwhelmingly benefits wealthy investors. In fact, both former President Donald Trump and President Joe Biden have said they wanted to close the carried interest loophole.

Efforts to eliminate the preferential treatment of carried interest are ongoing in Washington, D.C. Bills that end the special treatment of carried interest in the U.S. tax system are regularly introduced by Democrats and Republicans in Congress. For example, early drafts of the 2022 Inflation Reduction Act contained provisions to end the lower taxation of carried interest that were eventually removed in the bill that passed the Senate.

What Is Carried Interest?

By itself, carried interest is not that contentious. It simply represents the share of any profits the general partners who set up and manage private equity funds and hedge funds are paid. They receive the payment regardless of whether they actually contributed their own money to the fund. Much of the investment capital for the funds comes from limited partners who have little say in how they are managed.

Fund managers' 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 they cash out.

Carried Interest Not Taxed as Income

To fully understand the carried interest controversy, you must first know how long-term capital gains and ordinary income are taxed. In general, ordinary income tax rates are higher than long-term capital gains tax rates and are taxed at significantly higher rates in the highest tax brackets. For example, if you earn a $1 million return on long-term investments in 2023, it will be taxed at the top rate for long-term capital gains, which is 20%. Your marginal income tax rate on that same income would be 37%.

The debate surrounding carried interest stems from the fact the federal income 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 a taxpayer makes from investments held for more than 12 months. Generally, these are the profits from the sale of things like property, stock, or a business.

The lower tax rate for long-term capital gains is part of the U.S. government's efforts to encourage economic investment. Short-term capital gains are the profits from selling property you have owned for less than 12 months and are 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 argue the partners don't really have a capital gain. They claim that the general partners receive a tax break on payments that should be treated as ordinary income. Supporters of the current tax treatment for carried interest feel 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 recently was the passage of the 2017 Tax Cuts and Jobs Act (TCJA). The act increased the time a general partner needed to hold their interest before selling.

Before the enactment of the TCJA, a general partner only needed to hold carried interest to have it treated when they cashed out. The TCJA implemented a three-year holding period. If the general partner converts their carried interest into cash before the carry period expires, it is taxed as ordinary income.

Have More Questions About Carried Interest?

As with most things related to hedge funds, carried interest is a complex topic that raises questions best answered by a local tax attorney. They understand tax laws and IRS rules that apply to carried interest. A tax lawyer can ensure that you take the steps necessary to take advantage of the carried interest provisions in the tax code.