Understanding Carried Interest: Current Tax Treatment and Potential Reforms
- yunseo sung
- Mar 5
- 3 min read
Updated: Mar 6
Yunseo Sung (US CPA & Korean CTA)
Carried interest has long been a controversial topic in the world of investment management and tax policy. At the heart of the debate is whether the profits that fund managers earn through carried interest should be taxed at lower capital gains rates—like long-term investments—or at higher ordinary income rates, like regular wages. This debate reflects a broader discussion about tax fairness and whether fund managers receive an unfair tax advantage compared to salaried workers.
What Is Carried Interest?
Carried interest is a share of a private investment fund's profits allocated to general partners or fund managers as compensation for their management services. Typically set at 20% of the fund's profits, this incentive aligns the interests of the managers with those of the investors, motivating managers to maximize returns.
From a tax perspective, carried interest is treated as a share of the fund’s capital gains, which is why it currently qualifies for lower capital gains tax rates instead of higher income tax rates.
Why Is Carried Interest Controversial?
Supporters of the current treatment argue that carried interest appropriately reflects the long-term nature of private equity investments. They say the profits fund managers earn are tied to the fund's performance, just like an investor’s gains, so it makes sense to tax them at capital gains rates.
Critics, however, argue that carried interest is essentially compensation for services—similar to a performance bonus—and should therefore be taxed like wages or salary at ordinary income rates. They claim this preferential treatment gives wealthy fund managers an unfair tax advantage over ordinary workers.
Current Tax Treatment of Carried Interest
Under existing U.S. tax law, carried interest is generally taxed as long-term capital gains rather than ordinary income. This allows fund managers to benefit from a top federal tax rate of 23.8% (including the 3.8% net investment income tax), which is significantly lower than the top ordinary income tax rate of 37%.
The Three-Year Holding Period Rule
The Tax Cuts and Jobs Act of 2017 introduced a special rule for carried interest. To qualify for long-term capital gains treatment, the underlying assets must be held for at least three years. If the holding period is less than three years, the carried interest is taxed at ordinary income rates.
This rule was intended to prevent short-term trading activity from benefiting from the lower capital gains rates.
Proposed Changes to Carried Interest Taxation
Over the years, there have been multiple legislative efforts to change the tax treatment of carried interest. Most recently, in February 2025, President Donald Trump met with Republican lawmakers to discuss eliminating the preferential tax treatment of carried interest as part of a broader tax reform package aimed at benefiting middle-class Americans.
At the same time, Democratic lawmakers introduced new legislation seeking to tax carried interest entirely as ordinary income, removing the option for capital gains treatment regardless of the holding period.
If these proposals pass, fund managers would face a top federal tax rate of up to 37% on carried interest, nearly doubling the current rate applied to these profits.
Potential Impact on Private Equity and Fund Managers
If carried interest is reclassified as ordinary income, the tax burden on fund managers could increase substantially. This would directly impact:
The after-tax earnings of fund managers.
The structuring of future compensation packages.
The timing of asset sales and distributions within private equity and hedge funds.
Fund managers and investors would need to work closely with tax advisors to reassess the economics of fund structures and potentially shift compensation strategies to mitigate the impact of higher taxes.
Key Takeaways
Carried interest is a key compensation mechanism for fund managers, but its favorable tax treatment has sparked decades of debate.
Current tax law allows carried interest to qualify for long-term capital gains rates, but only if assets are held for at least three years.
If proposed reforms are enacted, carried interest could be taxed entirely as ordinary income, dramatically increasing the tax liability of fund managers.
Fund managers and investors should closely monitor ongoing legislative developments and work with cross-border tax advisors to assess potential impacts on their compensation and fund structures.
Final Thoughts
The taxation of carried interest is at the center of a broader debate about how to tax investment income versus compensation for services. As tax policy continues to evolve, private equity professionals should stay informed and work proactively with tax professionals to navigate these changes and optimize their tax positions.
Disclaimer: This article is for informational purposes only and does not constitute tax or legal advice. Please consult a qualified tax advisor for guidance tailored to your situation.
Let me know if you’d like me to help with a title or meta description for this post!
