Carried interest and the tax loophole: Here’s how it works

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A walk through the carried interest tax loophole.

© Dusan Petkovic/stock.adobe.com; Photo illustration Encyclopædia Britannica, Inc

When it comes to controversial tax topics, carried interest and the carried interest tax loophole carry some baggage, and then some. As a concept, carried interest dates back centuries, but it’s only in the past three decades or so that it has earned its “loophole” tag in the U.S., as its use helped fuel explosive growth in alternative investments such as private equity, hedge funds, and venture capital funds.

Proponents say carried interest encourages risk-taking and entrepreneurship, while critics dismiss it as a tax dodge for the wealthy. Still others view it as more of a political punching bag than a source of revenue. But it’s also widely misunderstood, and for any investor considering alternative investments, it’s crucial to understand carried interest—how it works and how it’s taxed.

Carried interest is a form of compensation paid to investment fund managers when the profits of private equity or venture capital funds are realized. It’s often structured as a performance fee, with the idea of motivating the manager to generate higher returns for the fund’s investors. Carried interest (or simply “carry”) refers to the share of profits fund managers receive for their performance. Typically set at 20% of a fund’s profits, carried interest serves as the primary incentive mechanism aligning the interests of fund managers (general partners, known as GPs) with those of their investors (limited partners, or LPs).

Carried interest should not be confused with management fees, which are paid to cover the ongoing costs of managing the fund. Management fees are paid regardless of performance—even if the fund loses money—whereas carried interest is only earned when investments generate returns above a predetermined threshold.

Most private investment funds follow what’s known as the “two and twenty” fee structure:

This structure means that for every $100 of profit above the hurdle rate, $20 goes to the fund managers as carried interest, while $80 goes to the investors. The management fee covers operational expenses (similar to the management fee charged by a mutual fund), while carried interest rewards performance.

One of the unique characteristics of carried interest is that in the U.S. it’s taxed as a capital gain rather than ordinary income. If the underlying investments are held by the fund for longer than a year, the carried interest can qualify for the long-term capital gains tax rate, which is typically lower than the rates applied to regular income.

This tax provision—seen by critics as a loophole—has roots in older tax principles, but became widely used and controversial in the late 20th century. Under the provision, investment fund managers pay taxes on their compensation (carried interest) at the lower capital gains tax rate, instead of the higher ordinary income tax rate, if the investment is held for three years or longer. As of the 2025 tax year, the capital gains tax rate tops out at 20%, while the marginal tax rate for ordinary income can be as high as 37%.

Under the loophole, investment manager compensation is considered part of the fund’s investment profits, which are taxed as capital gains. Critics argue this loophole allows fund managers, who can earn substantial amounts of carried interest, to pay a lower rate of tax on their income compared to ordinary taxpayers. As a result, carried interest has faced significant scrutiny from Congress and others.

Over the past two decades, lawmakers have introduced various proposals to increase the tax burden on carried interest. For example, the Tax Cuts and Jobs Act of 2017 increased the holding period requirement to three years to generate long-term capital gains treatment on carried interest.

Bipartisan proposals to change the tax treatment have surfaced repeatedly over the years, but substantial reform has proven elusive—highlighting how carried interest serves as both a policy target and a political symbol.

Critics’ perspective on carried interest tax treatment could be summed up in these points, according to Carey Heyman, a managing principal at auditor and tax consultant CliftonLarsonAllen LLP:

Supporters offer these points in defense of how carried interest is taxed:

For anyone investing in alternatives, carried interest is more than an abstract concept. Carried interest directly affects investment returns and shapes the behavior of those managing your capital. By understanding carried interest structures, you can better evaluate investment opportunities, negotiate more favorable terms, and set realistic expectations about potential returns.

Moreover, amid shifting regulatory environments, carried interest remains at the center of policy debates that could reshape the economics of private investing. Savvy investors who understand these mechanisms may be better positioned to adapt to any changes in the investment landscape and make informed decisions about where to allocate their capital.