If you were paying close attention to the presidential race, you may have heard someone say something about carried interest. Or maybe you have finance friends who’ve mentioned this term in passing. Either way, if you’re not sure what carried interest is, we’re here to help. We’ll explain what this term means and how it’s related to a controversial tax loophole.
Check out our investment calculator.
What Is Carried Interest?
Carried interest (or carry) is the portion of profits that general partners earn for managing certain kinds of funds, like venture capital funds and hedge funds. Fund managers can make money from the management fees investors pay. But most of their income (usually 20% to 25%) tends to come from carried interest.
Because carried interest comes from a percentage of an investor’s net profits, fund managers usually want the funds they manage to perform well. If a fund underperforms, a general partner won’t receive much compensation.
How Does Carried Interest Work?
Not all fund managers receive carried interest. In fact, general partners can’t earn carried interest unless a fund’s profits surpass a certain threshold called a hurdle rate. Even if a general partner receives carried interest, it can be confiscated (through a clawback) if a fund doesn’t earn expected returns.
Limited partners who manage certain investment funds are subject to different rules. These fund managers are individuals who’ve invested some of their own money in a fund. If an investment fund flops, someone in a limited partnership (meaning that he or she is not personally responsible for business losses or debts) could still receive a portion of the fund’s profits.
Carried interest is usually vested over a certain period. That means that fund managers receive their earnings after a designated time frame.
The Controversy Surrounding Carried Interest
Carried interest is a controversial topic because these earnings are considered capital gains for tax purposes. Compared to ordinary income, capital gains can be taxed at lower rates, especially if they’re long-term capital gains. That’s one tax loophole that critics say wealthy fund managers tend to exploit. Some opponents of the loophole also say that making carried interest subject to ordinary income tax would generate much-needed revenue.
On the other hand, private equity firms argue that if carried interest was taxed at higher rates, fund managers would be less inclined to go the extra mile and take the risks needed for their funds to reach full profit potential. Others offer middle-ground solutions, suggesting that carried interest should only be applied when fund managers include their own personal funds in initial investments.
Related Article: 4 Ways to Minimize Capital Gains Taxes on Investments
For decades, politicians and advocates for middle-class families have lobbied to change the guidelines surrounding the tax treatment of carried interest. But the practice of using carry to reward fund managers remains in place. Proponents of the tax loophole argue that carried interest is a form of compensation that should be taxed at lower rates, simply because general partners put a lot of time and effort into developing profitable fund management strategies.
Photo credit: ©iStock.com/piranka, ©iStock.com/AntonioGuillem, ©iStock.com/bowdenimages