Private equity firms and hedge funds benefit from several controversial provisions in the current U.S. tax code. Critics refer to these special tax breaks as loopholes, while defenders justify them as a fair means of rewarding risk.
Here is how private equity and hedge funds are taxed.
- Private equity and hedge funds are generally structured as pass-through entities, allowing them to pass their entire tax obligation along to their investors or limited partners.
- Investors report their share of the fund’s income (or losses) on their individual tax returns.
- Fund managers, also known as general partners, receive most of their income in the form of carried interest, which is taxed at lower capital gains rates rather than as compensation.
- These practices have been widely criticized as favoring wealthy investors, but efforts to repeal them have failed so far.
What Are Private Equity and Hedge Funds?
Private equity firms pool investor capital, typically using it to buy existing businesses and take over their management. By cutting costs and other means, they attempt to increase the value of those companies so that they can later sell them at a substantial profit. Private equity firms are run by a general partner, while the investors are limited partners.
Hedge funds also pool capital from a group of investors, using it for a range of purposes, with the goal of generating especially high returns. Comparing them with mutual funds, a more familiar investment, the U.S. Securities and Exchange Commission (SEC) notes that hedge funds often use riskier investment strategies, such as leverage, and are not subject to the same disclosure safeguards. Like private equity funds, hedge funds are run by a general partner, and the investors are limited partners.
Both private equity and hedge funds cater to large institutional investors and wealthy individuals, who can presumably afford to take on the added risks. By law, institutions and individuals generally must be accredited investors to invest in them.
How Private Equity and Hedge Funds Are Taxed
As partnerships, private equity funds and hedge funds generally qualify as flow-through entities (also known as pass-through entities). This means that rather than being subject to taxation themselves (as corporations are), they pass their entire tax liability onto their investors, escaping double taxation. Limited partners will receive a Schedule K-1 from the fund each year. It breaks down their share of the fund’s profits or losses, which they must then report on their individual tax returns.
Because limited partners are considered passive investors instead of active owners, they are exempt from paying self-employment tax for Social Security and Medicare. By contrast, income from some other types of pass-through entities, such as sole proprietorships, is subject to the tax. In 2022, for example, the exemption avoids 15.3% in taxes on the first $147,000 ($160,200 in 2023) in income, a potential benefit of $22,491 ($24,510.60 in 2023).
General partners are taxed differently and often more favorably. They typically earn a 2% annual management fee plus 20% of any profits that the fund produces if it meets certain targets. Through a special provision in the law, that 20% is treated not as regular compensation but as carried interest, entitling it to preferential capital gains tax treatment.
For example, the highest tax rate on long-term capital gains is 20%, while the highest tax rate on ordinary income is 37%. Since the passage of the Tax Cuts and Jobs Act in 2017, the investment must be held for at least three years to qualify for capital gains treatment. In addition, because it isn’t classified as earned income, carried interest is not subject to self-employment tax.
The 2% management fee, on the other hand, is usually taxed as ordinary income; however, some general partners have also found a way around that by using a tactic called a management fee waiver. By forgoing their fee in return for a greater share of the partnership’s profits, they can transform it into a capital gain and pay tax at the lower rate.
The increase in government revenues over a decade that would be generated by taxing carried interest at the same rate as ordinary income, according to an estimate by the nonpartisan Joint Committee on Taxation.
Critics and Defenders of Carried Interest
Carried interest is often criticized as an egregious tax break for the already rich. Both Donald Trump, as a presidential candidate in 2016, and Joe Biden, as a newly elected president in 2021, promised to do away with it.
The Ending the Carried Interest Loophole Act was introduced in the Senate in August 2021, but it remains in committee. Sen. Sheldon Whitehouse (D-R.I.), a sponsor of the bill, maintained that “Americans have had enough of hedge fund tycoons using this special carve-out to pay lower tax rates than their drivers. We need to rebuild our tax code to guard against the ultra-rich and corporations scheming to avoid paying their fair share.”
Meanwhile, the defenders of carried interest maintain that eliminating it would be counterproductive. The U.S. Chamber of Commerce, for example, has said that such a law would “restrict access to capital, harming job creation and innovation,” among other dire predictions.
What Is the Difference Between Private Equity and a Hedge Fund?
The primary difference between private equity and hedge funds is in their investments. Private equity generally invests in individual companies, while hedge funds invest in various types of financial securities. Because of this difference, private equity tends to have a longer time horizon and may take years to realize a profit.
Can Anyone Invest in Private Equity or a Hedge Fund?
To participate in a private equity offering or a hedge fund, individuals must qualify as accredited investors under federal securities laws. According to the U.S. Securities and Exchange Commission (SEC), that means having at least one of the following:
- An earned income of more than $200,000 ($300,000 with a spouse or spousal equivalent) in each of the two previous years, with a similar expectation for the current year
- A net worth of more than $1 million (alone or with a spouse or spousal equivalent), not including a principal residence
- A Series 7, 65, or 82 securities license in good standing
In addition, the funds have their own minimum investment requirements, such as $100,000, $500,000, or $1 million.
Can You Invest in Hedge Funds Through a Mutual Fund?
Yes. There is a subcategory of mutual funds known as funds of hedge funds. These funds typically invest in multiple hedge funds and are available to individual investors who may not meet the income or asset requirements for investing in a hedge fund directly.
The Bottom Line
Private equity and hedge funds enjoy several advantages under current U.S. law that allow them to pay less tax on their income than they would without them. While widely criticized, these laws remain on the books.