Carried Interest
What Is Carried Interest?
The carried interest tax loophole is an income tax avoidance scheme that allows private equity, hedge funds, and any entity or person who manages investments for others to substantially lower the amount they pay in taxes.
The carried interest loophole allows private equity firms to claim large parts of their compensation for services as investment gains, which allows them to pay lower tax rates than middle class taxpayers pay on their wages and other compensation.
The loophole exacerbates income and wealth inequality and treating carried interest income as ordinary compensation income could raise between $1.4 billion and $18 billion annually.
A significant majority of voters across parties support legislation that would close this loophole.
“Carried interest” Disguises Compensation Income As Capital Gains, Lowering The Tax Rate.
Carried interest is effectively a payment for investment services that is taken out of the profits of the money managed for investors. Private equity firms use pooled money from large institutional investors like pension funds to purchase companies or financial stakes in companies.
The investors pay the private equity firms carried interest out of their investment profits. Under current tax law, the carried interest income is taxed at the preferential rates granted to investment income, even though the income represents compensation for services.
In all other contexts, compensation income is taxed as ordinary income. The carried interest tax loophole is tax alchemy that magically turns ordinary compensation income into preferentially taxed investment income.
The term “carried interest” can be traced back to the 16th century, when trans-oceanic ship captains would frequently take a 20 percent “interest” of whatever profits were realized from the cargo they “carried” (largely extractive profits from the colonies).
Today, this carried interest is captured by extractive Wall Street private investment houses including private equity funds, hedge funds, and venture capital funds, which are organized as partnerships.
Private fund managers typically charge investors two main fees for providing investment management services. One is an annual management fee of 2 percent of investment capital, while the other is a carried interest of approximately 20 percent of the fund’s investment returns.
Private equity firms generally charge carried interest fees only to the extent the investment returns exceed a “performance hurdle” (usually a rate of return of 6 to 8 percent), while venture capital funds and hedge funds generally do not impose such a hurdle.
Carried Interest Is Taxed At A Lower Rate Than Ordinary Income
Under current tax law, the carried interest paid to fund managers is taxed as if it were a profit from a long-term investment rather than what it is: compensation for performing services (managing other people’s money).
This distinction allows the general partners to almost halve their tax bill by paying the 20 percent long-term capital gains rate instead of the ordinary income tax rate of 37 percent that would likely apply to these top earners.
This 20 percent long-term capital gain rate is lower than the marginal tax rate applied to most families — in 2021, single filers would pay a marginal tax rate of 22 percent of their taxable income if they earn over $40,525 ($81,051 for married couples filing jointly).
This means that private equity managers pay a lower marginal tax rate on the carried interest income than the average worker.
All that being said, if you manage investments for a firm or as a private office, taking advantage of the carried interest loophole will significantly reduce what you pay in taxes.