Carried Interest Explained: Who It Benefits and How It Works

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.

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 the 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. 

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.

The Bottom Line

Carried interest is a performance fee due to partners of certain investment firms: private equity firms, venture capital firms, and hedge funds. The performance fee corresponds to a partner's role as opposed to their investment in the fund. Carried interest is paid from profits and generally taxed as capital gains, which come with lower taxes than ordinary income.