Table of Contents
Table of Contents

Carried Interest Explained: Who It Benefits and How It Works

Carried Interest

Investopedia / Joules Garcia

What Is Carried Interest?

Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. Carried interest is due to general partners based on their role rather than an initial investment in the fund. As a performance fee, carried interest aligns the general partner's compensation with the fund's returns. Carried interest is often only paid if the fund achieves a minimum return known as the hurdle rate. Carried interest typically qualifies for treatment as a long-term capital gain taxed at a lower rate than ordinary income.

Key Takeaways

  • Carried interest is a share of profits from a private equity, venture capital, or hedge fund paid as incentive compensation to the fund's general partner.
  • Carried interest typically is only paid if a fund achieves a specified minimum return.
  • In most cases, carried interest is considered a return on investment and taxed as a capital gain rather than ordinary income, usually at a lower rate. 
  • Because carried interest is typically distributed after a period of years, it defers taxes in the manner of an unrealized capital gain.

What is Carried Interest?

How Carried Interest Works

Carried interest serves as the primary source of compensation for the general partner, typically amounting to 20% of a fund's returns. The general partner passes its gains through to the fund's managers.

Many general partners also charge a 2% annual management fee. Unlike the management fee, carried interest is only earned if a fund achieves a pre-agreed minimum return.

Carried interest can also be forfeited if the fund underperforms. For example, if fund targeted a 10% annual return but only returned 7% for a period of time, investors known as limited partners may be entitled under the terms of their investment agreement to "claw back" a portion of the carry paid to the general partner to cover the shortfall when the fund closes. Although the clawback provision is not an industry standard, it has been used to argue that carried interest should not be taxed as ordinary income.

The carried interest portion of a general partner's compensation typically vests over a number of years. 

Carried interest has long been a controversial political issue, criticized as a “loophole” that allows private-equity managers to secure a reduced tax rate.

Taxation of Carried Interest

Carried interest on investments held longer than three years is subject to a long-term capital gains tax with a top rate of 20%, compared with the 37% top rate on ordinary income.

Critics argue taxing carried interest as long-term capital gains allows some of the richest Americans to unfairly defer and lower taxes on the bulk of their income.

Defenders of the status quo contend the tax code's treatment of carried interest is comparable to its handling of "sweat equity" business investments.

The minimum holding period on an investment required to qualify associated carried interest for treatment as a long-term capital gain was increased from one year to three by the 2017 Tax Cuts and Jobs Act. The Internal Revenue Service (IRS) issued complex rules related to the provision in 2021.

Private-equity and venture-capital fund holding periods typically range from five to seven years, however. Some in Congress have proposed requiring the annual reporting of imputed carried interest for immediate taxation as ordinary income.

Article Sources
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  1. Internal Revenue Service. "IRS Plans to Issue Regulations Clarifying Limitations on Carried Interest."

  2. Congressional Research Service. "Taxation of Carried Interest," Page 3-4.

  3. University of Utah, SJ Quinney College of Law. "Carried Interest and Beyond: The Nature of Private Equity Investment and Its International Tax Implications," Page 423.

  4. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

  5. U.S. Senate Finance Committee. "Ending the Carried Interest Loophole Act."

  6. The Hill. "It's Time for Congress to Close the Carried Interest Loophole."

  7. Internal Revenue Service. "Tax Cuts and Jobs Act: A Comparison for Large Businesses and International Taxpayers."

  8. Internal Revenue Service. "Section 1061 Reporting Guidance FAQs."

  9. U.S. Congress. "S.2617 - Ending the Carried Interest Loophole Act."