Carried Interest – History & Controversy

Carried Interest: The Investment Industry Loophole That Won’t Die

Carried interest or “carry” is one of the most enduring controversies in the U.S. tax code. It allows private equity, hedge fund, venture capital, and real estate fund managers to pay a significantly lower tax rate on a substantial portion of their income than typical wage earners, despite the fact that this income functions essentially as performance-based compensation. While reform proposals have circulated for decades, none have succeeded. Why does this provision persist? And how much additional revenue could it generate?

What Is Carried Interest?

Carried interest is the share of profits that investment fund managers receive from their funds’ returns, typically amounting to 20% of the fund’s net profits above a specified threshold. It is designed as a performance incentive and is paid in addition to a fixed management fee, usually around 2% of assets under management (AUM) [1]. Crucially, carried interest is not compensation for capital invested, but rather for services rendered —choosing investments, managing risk, and executing deals. Despite this, the income is often taxed at long-term capital gains rates.

The Historical Basis: Sweat Equity

The roots of carried interest lie in early 20th-century oil and gas partnerships. General partners received a share of the profits “carried interest” for contributing expertise and labor rather than capital. This treatment later spread to real estate and private equity, where it was viewed as a form of “sweat equity” [2]. The U.S. tax code under Subchapter K (1954) reinforced this idea: partners in a partnership are taxed according to the character of the income earned by the partnership. So, if the fund earns long-term capital gains, the General Partner’s (GPs) carried interest is also taxed as capital gains [3].

While it makes sense for a passive investor to receive capital gains treatment, applying the same to GPs who contributed no capital but are actively compensated for performance is where the controversy begins.

Investment Funds: Business Model and Revenue Structure

Funds like hedge funds, private equity, and venture capital operate as pooled investment vehicles. Their compensation structure is typically known as “2 and 20”:

• 2% management fee on Assets Under Management (AUM, paid annually)
• 20% performance fee on profits earned beyond a hurdle rate [4]

The management fee provides stable income, while carried interest represents the bulk of the long-term upside. Here’s a breakdown of estimated annual carried interest income by sector in the U.S. (2024):

This $98 billion represents income largely taxed at capital gains rates, despite functioning as labor-based compensation.

Capital Gains vs. Ordinary Income vs. Carried Interest

From an economic perspective, carried interest behaves like ordinary labor income: it’s earned by providing a service (investment management), not by risking capital. Yet, under current law, it receives the same tax treatment as capital gains.

In practice, carried interest is taxed at a flat 20% (plus 3.8% NIIT for high earners – the Net Investment Income Tax, see NIIT definition), the same as long-term capital gains, so long as the underlying investment is held >3 years (a provision added by the 2017 Tax Cuts and Jobs Act) [8]. Unlike genuine capital gains, which are typically generated from capital that was originally earned as income and thus already taxed once, carried interest often represents compensation for services and receives favorable capital gains treatment without prior income taxation. This has led critics to argue that capital gains may be doubly taxed, while carry is taxed just once—and at the preferential rate.

Capital Gains Tax Bracket vs. Carry

Here is a breakdown of capital gains tax brackets for 2024:

Since fund managers receiving carry usually earn far above these thresholds, virtually all carried interest is taxed at the top capital gains rate of 20%, plus the 3.8% NIIT surtax.

Legal Challenges and Political Inertia

Although tax authorities have long been aware of the mismatch, the IRS has not reclassified carry as ordinary income, likely because of how entrenched it is in partnership tax law (Subchapter K). Carried interest has also withstood numerous legislative challenges:

• 2007-2008: Bipartisan proposals led by Rep. Sander Levin (H.R. 2834, 110th Cong.) and Sen. Chuck Grassley aimed to reclassify carried interest as ordinary income, but did not advance into law. Levin’s proposal passed the House as part of H.R. 3996 in November 2007 and again in 2008 as part of H.R. 6275, but both efforts stalled in the Senate [12]
• Obama-era budgets called for reform repeatedly [9]
• Trump’s TCJA (2017) only tightened the holding period requirement to 3 years
• Biden and Sen. Ron Wyden have proposed closing the loophole, but efforts remain stalled due to intense lobbying by financial firms [10]

How Much Revenue Is At Stake?

Including all asset classes, the U.S. investment management sector extracts an estimated $98 billion/year in carried interest. With a 17% tax delta between capital gains and ordinary income rates (37% – 20%), the maximum additional federal revenue from reclassifying carry would be around $16.7 billion/year [11]. Actual revenues are likely to be less than estimate.

Given the $6.4 trillion federal budget in FY2024, this amounts to ~0.25% of total outlays. While $16 billion is a lot of money, given the energy and controversy behind it, it does little to improve the Federal Revenue. In terms of budget impact – we rate this more of a political talking point than a transformative reform.

Conclusion

The carried interest loophole remains due to a combination of legal precedence, institutional inertia, and powerful lobbying. While economically it has been widely criticized by both Republicans and Democrats, its closure would raise relatively modest revenue. It may also be seen as a question of fairness in that it is given preferential rate treatment versus ordinary income earners and is only available to a small highly compensated group. Nonetheless, for many reform advocates, it remains a glaring example of tax code inequity: a compensation scheme masquerading as investment income, allowing some of the wealthiest Americans to pay lower tax rates than ordinary income earners.

Citations

[1] Preqin Alternative Assets Report (2023)
[2] Fleischer, Victor. “Two and Twenty: Taxing Partnership Profits in Private Equity Funds.” NYU Law Review, 2008.
[3] Internal Revenue Code, Subchapter K, §702(b); Rev. Proc. 93-27
[4] Hedge Fund Research (HFR) Industry Report, 2024
[5] LCH Investments Hedge Fund Report, Jan 2024
[6] McKinsey Global Private Markets Review, 2024; Bain Global PE Report, 2024
[7] AICPA Private Capital Markets Update, 2024
[8] Tax Cuts and Jobs Act, Pub. L. 115–97, Sec. 1061
[9] Congressional Budget Office: Budget Options Report (2016)
[10] U.S. Senate Finance Committee, “Ending the Carried Interest Loophole Act,” 2022
[11] Tax Project estimate using $98B x (37% – 20%)
[12] The Venture Alley: “Carried Interest Tax Legislation Won’t Go Away,” Jan 2012, https://www.theventurealley.com/2012/01/carried-interest-tax-legislation-wont-go-away/