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What is Carried Interest?

What is Carried Interest?

October 2023

Carried interest, often abbreviated as “carry,” is a financial arrangement commonly used in the private equity and venture capital industries, as well as in some hedge funds and real estate investments. It represents a share of the profits that investment professionals, such as fund managers or general partners, receive as compensation for managing and investing other people’s money.

The term “carried interest” derives from the idea that the investment manager “carries” or participates in the profits of the investments they manage. Carried interest is typically structured as a percentage of the fund’s profits, usually after a certain minimum rate of return, known as the “hurdle rate,” has been achieved. The specific terms can vary but often involve a 20% share of the profits after the hurdle rate has been met.

Here’s a simplified example of how carried interest works:

  1. A private equity or venture capital fund is established, and investors (limited partners) contribute capital to the fund.
  2. The general partners (investment professionals) manage and invest this capital in various businesses or assets, seeking to generate a return on investment.
  3. The fund’s performance is tracked, and if it surpasses the hurdle rate, the general partners are entitled to a share of the profits, typically 20%.
  4. If the fund generates substantial profits, the general partners receive 20% of the returns as carried interest, while the remaining 80% goes to the limited partners.

Carried interest serves as an incentive for fund managers to maximize the fund’s profitability, as they only benefit when the fund performs well. However, it has also been a subject of debate and controversy because it’s typically taxed at a lower rate than ordinary income in some jurisdictions, including the United States. Critics argue that this preferential tax treatment allows fund managers to pay lower taxes on their earnings. Efforts to change the tax treatment of carried interest have been made in various jurisdictions, with varying degrees of success.

How is Carried Interest Taxed? Capital Gains Rates.

In the United States, carried interest has historically been taxed at capital gains rates, which are generally lower than ordinary income tax rates. This preferential tax treatment has been a subject of controversy and debate. Here is how the taxation of carried interest is calculated per the US Internal Revenue Code.

  1. Capital Gains Treatment: Carried interest income is typically treated as a long-term capital gain when fund managers receive their share of the profits. Long-term capital gains are subject to a lower tax rate than ordinary income and are currently at 0%, 15%, and 20%.
  2. Holding Period Requirement: To qualify for the capital gains tax treatment, fund managers often need to meet certain holding period requirements, typically one year. This means they must hold the investment for at least one year to receive the lower tax rate.
  3. Section 1061 (Tax Cuts and Jobs Act): In 2017, the Tax Cuts and Jobs Act introduced Section 1061, which aimed to address the preferential tax treatment of carried interest. It extended the holding period requirement to three years for certain types of investments. If the holding period is not met, the income could be treated as short-term capital gains, which are taxed at higher rates.
  4. State Taxes: The taxation of carried interest at the state level can vary. Some states may treat it as capital gains, while others may follow federal tax rules or have their own rules for taxing carried interest.

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