What Is Carried Interest?

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DEFINITION

Carried interest is a share of profits earned when a private equity fund sells a business. Carry only occurs when selling an acquisition results in a profit that exceeds a certain threshold referred to as the "hurdle rate."

What Is Carried Interest?

Carry makes up at least a portion of the compensation paid to a general partner of a private investment or private equity fund. It is compensation for services performed in ensuring that the limited partners achieve a return on their own investments.

According to the Tax Policy Center, "carried interest, income flowing to the general partner of a private investment fund, often is treated as capital gains for the purposes of taxation. Some view this tax preference as an unfair, market-distorting loophole. Others argue that it is consistent with the tax treatment of other entrepreneurial income."

A general partner manages the fund's investments. Carried interest is paid regardless of whether the general partner personally invested anything toward the purchase of the company that generated the profit.

In a typical scenario, about 80% of carried interest eventually trickles down to the fund's limited partners, those who initially invested capital. The general partner receives the other 20%, as well as compensation in the form of an annual management fee—a percentage of the fund's assets.

  • Alternate name: Carry

How Tax on Carried Interest Works

Carried interest has historically been taxed as capital gains, just like income that might be derived from other types of investments (like stocks). It represents capital gains to the private equity fund itself, so it's not treated as ordinary income to the general partner. This generally means it's taxed at a lower rate.

For those in the top income brackets, carried interest is typically subject to the 20% capital gains tax rate, plus the 3.8% net investment income tax, for a total tax burden of 23.8%. Contrast this with the highest tax bracket for ordinary income in any given year, and that's a big tax break.

How Does a Private Equity Fund Work?

Private equity funds raise capital from investors and often use that money to buy companies that are struggling and badly need capital. A private equity fund may buy the business and put it on its feet again through revisions to operations, structure, or both. The fund makes the company profitable, and then it sells it again. This sale is made either privately or through a public offering. Profits from the sale are passed on to the fund's general and limited partners.

The "private" part of the term relates to who these equity fund investors are. Private equity funds do not accept or solicit capital from the general public or retail investors—only from private investors.

Reporting requirements are less exacting, so these funds can do what they do without revealing their target companies and their goals to competing investment funds and to the market, which could skew profits.

The Investment Company Act of 1940 set the terms for investment companies. These private funds qualify for special tax treatment under the 3C1 and 3C7 exemptions of the Act, both of which limit the number of qualified investors they can have.

In some cases, families form their own private equity funds, and these can operate entirely on family wealth. Some hedge funds can be private equity funds, but the two terms are not synonymous. Hedge funds tend to focus on a wide variety of short-term investments, whereas private equity funds invest in businesses with long-term goals in mind.

Ordinary Income vs. Capital Gains

Ordinary Income  Capital Gains 
Taxed at individual tax bracket rates ranging from 10% to 37% Taxed at long-term capital gains rates of 0%, 15%, or 20%
Taxed at a rate of 24% at an annual income of $100,000 Taxed at a rate of 15% on gains of $100,000
Can be reduced by tax deductions Can only be reduced by capital losses

Ordinary income is taxed according to tax brackets, and it includes sources like wages, salaries, self-employment income, and even some unearned income like interest. Ordinary income also includes "any gain from the sale or exchange of property which is neither a capital asset nor property described in Section 1231(b)" of the Internal Revenue Code, according to the Legal Information Institute.

Capital gains, on the other hand, are "the difference between the basis and the amount the seller gets when they sell an asset," according to the IRS. The basis is usually what the seller paid for the asset. Long-term capital gains tax rates are 0%, 15%, or 20%, depending on overall income. Short-term gains (for assets held for a year or less) are taxed at ordinary income brackets.

Proponents of the capital gains carry loophole take the position that, were this income to be taxed at regular rates, it would deter investors from participating in these types of funds. This could potentially have a negative impact on the economy and could virtually cripple the concept of these funds.

Opponents argue that carry should be taxed the same way as income is taxed for regular wage-earners. Investment bankers pay ordinary income tax rates on their earnings, so why shouldn't these participants in private equity funds do so, as well?

Do I Need To Pay Income Tax on Carried Interest?

Some changes came about when the Tax Cuts and Jobs Act (TCJA) went into effect in 2018, so you might have to pay ordinary income tax rates on carry under some circumstances. The TCJA extended the time that investment funds need to hold investments to qualify for long-term capital gains—at least three years instead of just one.

Many private equity funds scurried to reorganize themselves as S corporations as a result. The Treasury Department then said in March 2018 that it would not allow private equity funds to operate and file taxes as S corporations. These businesses are not taxed at the corporate rate. Profits trickle down to their shareholders for taxation purposes.

Key Takeaways

  • Carried interest is paid to a general partner of a private equity fund when the fund sells a business for a profit.
  • Carried interest has historically been taxed at long-term capital gains tax rates, which can be significantly less than ordinary income tax rates.
  • The Tax Cuts and Jobs Act implemented rules that prohibit taxation at more favorable capital gains rates unless a fund holds the business for at least three years.

Frequently Asked Questions (FAQs)

Who gets carried interest?

The general partners of private equity firms and hedge funds are compensated in part with carried interest, which comes from their firms' profits.

Why is it called "carried interest"?

The people who have shares in the profits of a private equity firm or hedge fund can reinvest the funds, and so they can carry over from one year to the next, until they are cashed out.

Article Sources

  1. Tax Policy Center. "What Is Carried Interest, and Should It Be Taxed as Capital Gain?" Accessed Dec. 17, 2021.

  2. Tax Foundation. "2022 Tax Brackets." Accessed Dec. 17, 2021.

  3. Office of Investor Education and Advocacy. "Private Equity Funds." Accessed Dec. 17, 2021.

  4. Government Publishing Office. "Investment Company Act of 1940," Page 20. Accessed Dec. 17, 2021.

  5. Legal Information Institute. "26 U.S. Code § 64. Ordinary Income Defined." Accessed Dec. 17, 2021.

  6. Internal Revenue Service. "Capital Gains and Losses—10 Helpful Facts to Know." Accessed Dec. 17, 2021.

  7. Department of the Treasury. "Treasury, IRS Issue Guidance on Carried Interest." Accessed Dec. 17, 2021.

  8. Tax Policy Center. "Effects of the Tax Cuts and Jobs Act: A Preliminary Analysis," Page 19. Accessed Dec. 17, 2021.