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Carried interest

Carried interest is the share of profits allocated to general partners managing investment funds, such as private equity, venture capital, or hedge funds, as performance-based compensation, typically comprising 20% of net profits after limited partners recover their capital contributions and often a preferred return or hurdle rate.^[1]^[2] This arrangement aligns the interests of fund managers with investors by tying compensation to successful outcomes, reflecting the managers' role in sourcing, selecting, and overseeing investments without providing the bulk of the fund's capital.^[3] Under U.S. partnership tax rules, carried interest is treated as a distributive share of partnership income rather than a fee for services, enabling taxation at preferential long-term capital gains rates—currently up to 20% plus a 3.8% net investment income tax—provided the underlying assets are held for more than three years as mandated by Section 1061 of the Internal Revenue Code.^[4]^[5] The concept traces its modern roots to early 20th-century oil and gas partnerships, where general partners received profit shares for exploratory risks, evolving into standard practice for alternative investment vehicles that deploy capital into illiquid, high-risk assets.^[6] This tax treatment incentivizes managers to commit time, expertise, and often personal capital to long-term value creation, fostering economic growth through business formation and expansion, though empirical evidence on its net impact remains debated amid broader capital gains policy effects.^[3]^[7] Carried interest has faced persistent scrutiny, with critics contending it functions as deferred compensation for asset management services and should incur ordinary income tax rates up to 37%, potentially generating revenue while addressing perceived inequities in the tax code.^[8]^[9] Proponents counter that recharacterizing it as ordinary income would distort partnership taxation principles, discourage risk-taking in entrepreneurial investments, and overlook the substantial uncompensated labor and failure risks borne by managers, as funds often underperform benchmarks and many dissolve without profits.^[10]^[11] Legislative attempts to alter its treatment, including proposals in the 2017 Tax Cuts and Jobs Act and subsequent budgets, have largely preserved the structure with the three-year holding requirement, reflecting tensions between equity concerns and efficiency incentives in capital allocation.^[12]^[8]

Definition and Structure

Core Concept and Components

Carried interest is a performance-based compensation mechanism in investment partnerships, entitling the general partner (GP) to a share of the fund's profits after limited partners (LPs) recover their capital contributions plus a minimum return. This structure aligns GP incentives with long-term value creation in alternative investments like private equity, hedge funds, and venture capital, where GPs typically contribute nominal capital but manage portfolio investments. Standard carried interest rates range from 20% of qualifying profits, separate from the 1-2% annual management fee covering operational costs.^[13]^[1]^[14] Central components include the distribution waterfall, which sequences profit allocations. Initially, LPs receive return of capital. A hurdle rate, often 8% compounded annually, follows to provide preferred returns before GP participation. A catch-up phase then allocates distributions disproportionately to the GP—typically 100% until it reaches its full share of cumulative profits—ensuring equitable alignment post-hurdle. Subsequent profits split per the carry ratio, such as 80/20 favoring LPs.^[15]^[1]^[16] Risk-sharing features mitigate GP over-distribution, including clawback provisions requiring repayment if early successes exceed final fund performance, common in deal-by-deal (American) waterfalls versus fund-level (European) assessments. Vesting over fund life, often 4-6 years with cliffs, and minimum holding periods tie distributions to sustained performance. Under U.S. tax rules, qualifying carried interest receives long-term capital gains treatment at a 20% rate plus 3.8% net investment income tax, contingent on a three-year asset holding period per IRC Section 1061 enacted in 2017.^[17]^[18]^[19]

Standard Terms and Variations

The standard structure for carried interest in private equity funds allocates 20% of the fund's profits to the general partner (GP) after limited partners (LPs) receive their initial capital contributions plus a preferred return, often termed a hurdle rate of around 8% annually.^[1]^[20] This is commonly paired with a 2% annual management fee on committed capital, forming the "2 and 20" model that aligns GP incentives with long-term performance.^[13] Distributions follow a waterfall sequence: first, return of LP capital; second, the hurdle payment; third, a catch-up phase allowing the GP to receive a portion (often 100%) of excess profits until reaching the full carry proportion; and finally, ongoing 80/20 splits between LPs and GP.^[17] Key protective terms include clawback provisions, which require GPs to repay excess distributions if the fund underperforms overall upon final liquidation, ensuring LPs receive their full entitlements before GP carry crystallizes.^[17]^[2] Vesting schedules typically span 4-5 years, often back-loaded to retain key personnel, with allocations tied to individual contributions and fund performance milestones.^[21]^[22] Crystallization—when carry entitlements are fixed—occurs either deal-by-deal (American-style waterfall) or at fund wind-down (European-style), with the former predominant in modern funds alongside clawbacks to mitigate interim overpayments.^[23] Variations arise across fund types and negotiations. In hedge funds, carry often lacks a formal hurdle, instead applying 20% to profits exceeding a high-water mark, with greater flexibility in rates (ranging 10-30%) due to liquid strategies and shorter horizons.^[20] Venture capital funds may feature lower hurdles or none, emphasizing whole-fund waterfalls to encourage high-risk bets, while side letters allow favored LPs to negotiate co-investment rights or reduced fees. Carry percentages can deviate to 10-40% based on fund size, strategy, or market conditions, with larger funds sometimes offering tiered rates or deal bonuses; however, post-2008 trends have pressured reductions amid LP demands for alignment.^[20]^[24] Hurdle types vary between "hard" (strict LP priority without catch-up) and "soft" (with catch-up), influencing risk-sharing.^[1]

Distinction from Other Forms of Compensation

Carried interest differs fundamentally from management fees, which are recurring payments to general partners for operational services such as fund administration and investment oversight, typically calculated as a fixed percentage—often 2%—of committed capital or assets under management during the investment period.^[1]^[2] Management fees provide steady income irrespective of fund performance and are taxed as ordinary income at marginal rates up to 37% in the United States.^[25] In contrast, carried interest allocates a performance-contingent share of profits—commonly 20%—only after limited partners recover their capital contributions plus a preferred return (hurdle rate, often 8%), ensuring alignment between general partners' incentives and investor outcomes.^[26]^[27] Unlike salaried compensation or performance bonuses in traditional employment, which remunerate labor or short-term results and qualify as ordinary income subject to payroll taxes, carried interest represents a partnership interest in the fund's unrealized and realized gains, treated as long-term capital gains eligible for preferential rates of 0%, 15%, or 20% upon holding periods exceeding three years under U.S. tax rules implemented in 2018.^[28]^[29] This structure reflects the general partners' assumption of economic risk, as they receive no allocation absent net profits exceeding thresholds, fostering long-term value creation rather than immediate service-based pay.^[30]^[31] The distinction extends to co-investment opportunities, where general partners may commit their own capital alongside limited partners, further blurring lines with equity participation but remaining separate from carried interest's profit-sharing mechanism; co-investments directly expose managers to losses, whereas carried interest activates solely on upside.^[32] Critics argue this framework understates service elements in carried interest generation, prompting reform proposals to recharacterize portions as ordinary income, though proponents emphasize its role in risk-sharing absent which fund performance incentives would weaken.^[25] Empirical analyses of private equity returns indicate that carried interest's deferred, variable nature correlates with superior net investor gains post-fees, validating its compensatory rationale over fixed alternatives.^[33]

Historical Origins and Evolution

Maritime Trade and Early Precedents

The concept of carried interest originated in medieval European maritime trade partnerships, where managing partners received a share of profits from successful ventures as compensation for operational risks and efforts, without contributing capital. In the commenda contract, prevalent in Italian city-states like Genoa and Venice from the 11th century onward, a capital-providing investor (socio) funded overseas expeditions, while the traveling manager (tractator) handled trade logistics; profits were divided—often 75% to the investor and 25% to the manager— with losses absorbed entirely by the investor to encourage risk-taking in perilous sea voyages.^[34]^[35] This structure, adapted from earlier Islamic mudarabah precedents, facilitated long-distance commerce by aligning incentives without exposing the manager's limited personal assets.^[35] In Venice, the related colleganza form, documented as early as 1073, structured joint ventures for trade with Constantinople and the Levant, where merchants managed ships and goods funded by investors, splitting net proceeds per agreed terms that granted operators a performance-based portion—typically substantial to offset voyage uncertainties like storms or piracy.^[36] By the early 14th century, such innovations, including limited liability provisions, had propelled Venice's merchant class to political dominance, exemplified by the election of the first merchant Doge in 1036, underscoring the economic impact of these profit-sharing mechanisms.^[36] Shipping captains in these eras commonly received around 20% of profits from transported cargo as "carried interest" to remunerate navigation hazards and management, a practice evident in Genoese and Venetian records of the 12th–15th centuries.^[37]^[38] This share covered no upfront investment but rewarded successful outcomes, distinct from fixed wages, and evolved from broader commenda customs where profit splits reflected customary maritime norms, such as three-quarters to capital providers in Genoese trade by the 13th century.^[34] An early modern extension appeared in the 18th–19th century American whaling industry, where the "lay" system distributed voyage proceeds proportionally: ship owners claimed the largest shares (often 50% or more), captains received 1/8 to 1/12 as incentive for command, and crew got fractional "lays" (e.g., 1/150 for ordinary seamen), applied to whale oil and bone values after costs.^[39]^[40] These high-risk expeditions, averaging 3.6 years by 1850 with failure rates around 6% for ships, resembled venture investments, financing via ownership stakes in vessels rather than loans, and prioritizing profit-sharing over salaries to motivate performance amid uncertain yields.^[41]^[42] Unlike British whalers' salaried model, this American approach, rooted in colonial maritime traditions, amplified returns in profitable hunts but exposed participants to total loss if voyages yielded no catch.^[40]

20th-Century Partnerships and Expansion

The practice of carried interest gained prominence in the early 20th century within U.S. oil and gas partnerships, particularly in speculative "wildcat" drilling ventures in regions like Texas and Oklahoma. General partners, often experienced drillers or promoters, contributed expertise and bore operational risks without providing capital; limited partners funded the explorations, and upon profitable outcomes, general partners received a disproportionate share of net profits—typically structured as a profits interest to qualify for preferential capital gains taxation under emerging tax codes.^[6] This arrangement incentivized risk-taking in high-uncertainty endeavors, with the term "carried" reflecting the investors' subsidization of the general partners' participation.^[43] By the mid-20th century, the model expanded to other resource-intensive sectors, including ranching, mining, and real estate syndications, where limited partnerships proliferated to pool capital for development projects amid post-Depression recovery and wartime demands.^[43] The structure's appeal lay in aligning incentives: general partners earned no carry until limited partners recouped investments plus a preferred return, often 8-10%, fostering disciplined capital deployment.^[37] Legal standardization through state-adopted uniform acts facilitated this growth, enabling passive investors limited liability while granting general partners control and upside participation. The post-World War II investment boom marked carried interest's adaptation to financial partnerships, beginning with Alfred Winslow Jones's 1949 hedge fund, which levied a 20% fee on profits exceeding a 4% hurdle—establishing a performance-based compensation precedent that echoed carried interest's risk-reward dynamics.^[44] Venture capital followed suit in the 1950s and 1960s, as firms shifted from corporate structures to limited partnerships to attract institutional capital; early examples included allocations where general partners claimed 20% of realized gains after return of capital, standardizing the "2-and-20" fee model (2% management fee plus 20% carry).^[37] By the 1970s, amid rising leveraged buyouts, private equity funds embedded carried interest as a core feature, with commitments from pension funds and endowments surging—U.S. private equity assets under management grew from negligible levels in 1969 to over $5 billion by 1980—propelled by the mechanism's ability to tie manager compensation to long-term value creation.^[37]

Adoption in Modern Alternative Investments

Carried interest structures were integrated into modern alternative investments through limited partnership vehicles, beginning with venture capital firms in the post-World War II period. The American Research and Development Corporation, established in 1946 as one of the first institutional venture capital entities, employed profit-sharing mechanisms for fund managers that resembled early forms of carried interest, allocating a portion of investment gains to incentivize risk-taking in unproven technologies. By the mid-20th century, these arrangements evolved from precedents in oil and gas exploration partnerships, where general partners received a share of profits without upfront capital contribution, adapting to the illiquid, long-term nature of alternative assets.^[6] The structure gained standardization in private equity during the 1970s and 1980s, coinciding with the rise of leveraged buyout firms such as Kohlberg Kravis Roberts, founded in 1976. These entities formalized carried interest at typically 20% of profits exceeding a preferred return hurdle for limited partners, aligning manager incentives with fund performance amid growing institutional capital flows into buyouts.^[37] This adoption facilitated the industry's expansion, with private equity assets under management increasing from approximately $5 billion in 1980 to over $100 billion by the late 1980s, as carried interest enabled managers to commit "skin in the game" via co-investments while sharing upside.^[37] In hedge funds, carried interest—often structured as performance or incentive allocations—emerged concurrently with the asset class's inception, exemplified by Alfred Winslow Jones's 1949 fund, which charged a 20% fee on net gains above a high-water mark to compensate for active management in liquid strategies.^[2] Unlike the deferred realizations in private equity and venture capital, hedge fund variants allowed more frequent distributions but incorporated similar risk-sharing elements, becoming embedded in the "2 and 20" fee model that dominated the industry through the 1990s.^[2] Subsequent adoption extended to other alternative sectors, including real estate and infrastructure funds by the 1990s, where carried interest adapted to asset-specific holding periods and risk profiles, typically retaining the 20% profit share to attract managerial expertise amid diversification of institutional portfolios into non-traditional assets. This proliferation reflected carried interest's role in bridging agency gaps in opaque, high-variance investments, though variations emerged, such as lower carry rates (10-15%) in some hedge strategies post-2008 to accommodate investor demands for alignment.^[37]

Operational Mechanics

Profit Allocation and Calculation

In private equity and venture capital funds, carried interest is allocated to the general partner (GP) as a performance-based share of the fund's net profits, typically amounting to 20% after limited partners (LPs) receive their initial capital contributions and a preferred return.^[45]^[46] This allocation incentivizes the GP to generate returns exceeding baseline thresholds, with profits defined as realized gains from asset sales minus contributed capital, expenses, and any prior losses.^[47]^[48] The calculation follows a distribution waterfall structure outlined in the limited partnership agreement (LPA), which prioritizes cash flows from investment realizations in sequential tiers to ensure LP protection before GP participation.^[15]^[49] In a standard American (deal-by-deal) waterfall, the first tier returns 100% of capital to LPs from individual investment proceeds; the second tier provides LPs with a preferred return, often 8% annualized IRR compounded; the third tier applies a GP catch-up, allocating 100% to the GP until it receives its full 20% share of cumulative profits above the hurdle; and subsequent tiers split distributions 80% to LPs and 20% to GP.^[17]^[50] European (whole-fund) waterfalls, by contrast, calculate carry across the entire fund portfolio at maturity, deferring GP allocations until all capital and hurdles are met fund-wide, reducing early GP payouts but aligning with overall performance.^[15]^[51] Hurdle rates vary by fund strategy and market conditions, with private equity funds commonly setting them at 5-10% to reflect opportunity costs, while clawback provisions ensure GPs repay excess distributions if later losses erode LP returns below hurdles.^[52]^[53] Carried interest is computed on realized gains only, excluding unrealized appreciation to avoid premature allocations, and net of management fees (typically 2% of committed capital).^[47]^[54] Variations include tiered waterfalls with escalating GP shares (e.g., 20% up to a multiple, then higher) or hybrid models blending deal-by-deal and fund-level calculations for balanced risk.^[51]^[55]

Timing, Vesting, and Distributions

In private equity and venture capital funds, carried interest typically vests over the fund's investment period to align general partner (GP) incentives with long-term performance and retention. Common vesting schedules vest the interest on a straight-line basis, often matching the fund's expected 5-year investment horizon, with allocations occurring monthly or annually.^[22] One prevalent structure vests 80% of carried interest over the first 5 years and the remaining 20% over the subsequent 5 years, ensuring GPs remain committed through the harvest period.^[56] Vesting may accelerate upon fund milestones or terminate upon GP departure, with unvested portions often forfeited to mitigate turnover risks.^[48] Distributions of carried interest occur upon realization events, such as asset sales or exits, following the fund's distribution waterfall, which prioritizes limited partner (LP) returns before GP carry. In the American waterfall model—prevalent in U.S. funds—GPs may receive interim carried interest (e.g., 20% of profits) after returning invested capital plus a preferred return (typically 8%), with a catch-up provision allowing GPs to recoup prior deferrals; this enables earlier distributions but exposes GPs to clawback if later losses erode overall profits.^[57] ^[49] In contrast, the European waterfall delays all carried interest until the entire fund achieves the preferred return and full capital return, reducing interim payouts but minimizing clawback exposure; this model is more common in Europe and certain U.S. funds emphasizing LP protection.^[58] ^[53] Timing of distributions aligns with cash flow realizations rather than accrual, with carried interest calculated on cumulative net profits across the fund, not individual investments, to promote portfolio-level discipline.^[59] Crystallization events, where unrealized gains convert to distributable carry, often occur at fund milestones or audits, but actual payouts depend on liquidity and waterfall hurdles.^[60] Clawback provisions enforce repayment if early distributions exceed final entitlements, typically secured via escrow (10-25% of carry) or GP guarantees, with enforcement varying by fund terms and jurisdiction.^[2] These mechanisms ensure distributions reflect sustained outperformance, though empirical data from funds like those managed by Blackstone indicate average clawback realizations of under 5% due to conservative interim payouts.^[61]

Risk Mitigation Features

Hurdle rates, or preferred returns, serve as a foundational risk mitigation tool in carried interest structures, mandating that limited partners (LPs) receive a minimum internal rate of return—commonly 8% annually—before general partners (GPs) can claim their profit share.^[62]^[63] This threshold prioritizes capital preservation and baseline yields for investors, compelling GPs to surpass investor hurdles amid market volatility, thereby curbing excessive risk-taking for short-term gains.^[64] In practice, hurdle rates are embedded in limited partnership agreements, often compounded annually on unreturned capital, with non-compounding variants used in lower-risk strategies.^[65] Clawback provisions further protect LPs by requiring GPs to repay excess carried interest distributions if aggregate fund performance ultimately fails to meet agreed benchmarks upon liquidation.^[2]^[66] These mechanisms address the timing mismatch in private equity, where early exits may trigger interim carry payments that subsequent underperformance erodes, ensuring net returns align with whole-fund economics.^[67] Clawbacks typically apply fund-wide, with GPs personally liable or backed by escrow holds—often 10-20% of distributions—to enforce repayment, though enforcement varies by jurisdiction and fund size.^[68]^[69] Industry analyses show clawback risks affecting roughly 7% of funds, underscoring their role in deterring opportunistic behavior.^[69] Vesting schedules and co-investment mandates add layers of alignment, with carried interest often vesting over 4-6 years or tied to investment realizations to mitigate key-person risks and promote retention.^[70] GPs committing 1-2% of fund capital personally exposes them to downside, fostering skin-in-the-game without diluting LP protections.^[70] Fund-level (whole-of-fund) carry calculations, versus deal-by-deal, prevent GPs from harvesting profits on isolated wins amid broader losses, enhancing overall portfolio discipline.^[2] These features collectively reduce moral hazard, as evidenced by their prevalence in standard agreements from firms like Blackstone and KKR.^[27]

Taxation Treatment

United States Framework

In the United States, carried interest represents a profits interest granted to investment fund managers, such as general partners in partnerships, and is generally eligible for taxation as long-term capital gains rather than ordinary income, provided specific statutory requirements are satisfied.^[71] This preferential treatment stems from the characterization of carried interest as a return on investment capital exposed to fund risks, aligning with Internal Revenue Code (IRC) provisions governing partnership allocations under Section 704(b).^[13] Qualifying long-term capital gains are taxed at a maximum federal rate of 20%, plus a 3.8% net investment income tax (NIIT) for high-income taxpayers, contrasting with ordinary income rates reaching 37% as of 2025.^[1]^[9] IRC Section 1061, enacted as part of the 2017 Tax Cuts and Jobs Act and applicable to applicable partnership interests (APIs) acquired on or after January 1, 2018, imposes a three-year holding period requirement for gains allocated via carried interest to qualify as long-term capital gains.^[5] An API is defined as a partnership interest transferred or held in connection with the performance of substantial services in an "applicable trade or business," typically involving raising or returning capital and investing in or disposing of specified assets like securities, commodities, real estate held for rental or investment, or partnership interests.^[71] Gains failing the three-year threshold—measured from the fund's acquisition of the underlying asset to its disposition—are recharacterized as short-term capital gains, taxed at ordinary income rates.^[12] This rule targets short-term trading strategies while preserving preferential treatment for longer-term investments, with final Treasury regulations issued in January 2021 clarifying application to lookthrough gains and exceptions for certain capital contributions.^[72] Exceptions to Section 1061 include qualified capital interests (where the partner contributes capital without service-related conditions), family transfers, and gains attributable to assets held by corporations or certain working capital.^[4] Partnerships must furnish Form 8997 annually to API holders reporting short-term recharacterization amounts, with funds aggregating dispositions exceeding $10 million triggering additional IRS reporting via Form 1065 Schedule K-1.^[5] No substantive changes to this framework occurred through 2025 legislation, including the One Big Beautiful Bill Act, maintaining the three-year period without further extensions proposed in prior bills like the Inflation Reduction Act.^[73] State-level taxation may vary, often conforming to federal treatment but subject to local modifications.^[74]

United Kingdom Developments

In the United Kingdom, carried interest has historically been taxed as a capital gain, subject to capital gains tax (CGT) rates rather than income tax, on the basis that it represents a share of investment profits aligned with long-term fund performance.^[75] This treatment was formalized through specific legislation, including provisions in the Finance Act 2015 that outlined CGT application to carried interest, allowing deductions only for acquisition costs of the right to the interest.^[76] Concerns over potential disguised remuneration led to the introduction of anti-avoidance measures in 2016 under Part 13, Chapter 5A of the Taxation of Income from Partnerships (TIOPA) 2010, targeting income-based carried interest (IBCI). These rules recharacterize carried interest as trading income—taxable at rates up to 45% plus National Insurance Contributions (NICs)—if it fails to meet conditions such as a minimum 40-month holding period for underlying investments or sufficient profit thresholds attributable to genuine investment risk.^[77] HMRC guidance emphasizes that carried interest must reflect a meaningful economic interest in fund profits, with ongoing compliance checks requiring detailed reporting in self-assessment returns to verify qualifying status.^[78] The October 2024 Budget introduced immediate changes, raising the CGT rate on carried interest to 32% for additional-rate taxpayers (from 28%), effective 6 April 2025, as part of broader CGT alignment while preserving its capital character for qualifying amounts.^[79] ^[80] Further reforms, announced in the same budget and refined through consultation, established a new regime from 6 April 2026, redefining carried interest as deemed trading profits within the income tax framework, subject to income tax up to 45% and Class 4 NICs.^[81] To account for the performance-risk alignment, only 27.5% of qualifying carried interest is charged as taxable trading profit, yielding an effective marginal rate of 34.075%; this applies without new qualifying conditions beyond existing IBCI tests, though draft legislation clarifies territorial scope to include UK-resident recipients and certain non-residents managing UK-taxable funds.^[82] ^[83] ^[84] Draft legislation published in July 2025 for inclusion in the Finance Bill 2025-26 confirms the regime's structure, prohibiting double taxation under other income provisions and adjusting IBCI rules to integrate with the new framework, while HMRC continues to enforce disclosure requirements for transparency.^[85] ^[86] These changes aim to close perceived loopholes but maintain a rate below full income tax levels, reflecting empirical recognition of carried interest's role in incentivizing investment returns, as evidenced by industry submissions during the 2025 consultation process.^[87]

Other Jurisdictions

In Canada, carried interest is typically taxed as ordinary income rather than capital gains, reflecting the Canada Revenue Agency's position that it constitutes compensation for services rather than investment returns, with effective marginal rates reaching up to 53.53% for non-Canadian interest or dividend components under tax-transparent structures.^[88]^[89] Australia distinguishes between general cases, where carried interest faces top marginal rates of 47% as income, and specific venture capital limited partnership (VCLP) structures, which qualify for capital gains treatment at an effective rate of 23.5% provided the fund meets early-stage investment criteria and other conditions.^[88]^[90] European jurisdictions often feature tailored regimes granting preferential taxation to qualifying carried interest, typically requiring minimum holding periods (e.g., 3-5 years), co-investment thresholds (e.g., 1%), and alignment with long-term fund strategies, with rates generally 25-30% versus ordinary income rates exceeding 45%. In France, the statutory regime imposes 30% (potentially 34% with surtaxes); Germany applies approximately 27% under its carried interest framework with 40% exemption; Ireland offers 15% for venture capital qualifying investments; Italy levies 26% under bespoke rules; the Netherlands taxes via Box II at 26.9% (2023 rate, rising to 31% in 2024); and Spain provides an effective 27% via a 50% tax base reduction for venture or buyout funds.^[88]^[91] Luxembourg lacks a dedicated favorable regime as of 2023, subjecting carried interest to capital gains rates up to 45.78% if held under six months or potential exemptions otherwise, though a July 2025 government draft bill proposes a unified system taxing it as extraordinary income at around 11% starting in 2026, pending adoption, to enhance competitiveness for fund managers.^[88]^[92]^[93] In Asia-Pacific hubs like Singapore, carried interest benefits from territorial taxation with capital gains and dividends exempt, and interest up to 24%, often routed through offshore entities for minimal effective burden; Hong Kong exempts it entirely under qualifying fund rules as of 2023, contrasting higher rates in non-regime scenarios at 17%.^[88] These variations underscore efforts to balance incentive alignment with revenue goals, though reforms in several locales aim to curb perceived avoidance by tightening qualification or elevating rates toward income parity.^[94]

Economic Rationale and Incentives

Incentive Alignment with Long-Term Performance

Carried interest aligns the interests of general partners (GPs) with those of limited partners (LPs) by tying GP compensation to the fund's net profits exceeding a preferred return threshold, typically 8%, ensuring GPs earn only after LPs recover their capital plus a baseline return. This structure incentivizes GPs to prioritize sustainable value creation over short-term gains, as compensation is deferred until successful exits, often spanning 7-10 years in private equity funds.^[45]^[20] For instance, in a standard "2-and-20" model, the GP's 20% carry applies solely to profits above the hurdle, calculated on a whole-fund basis rather than individual deals, which discourages high-risk bets on isolated transactions and promotes balanced portfolio management for enduring outperformance.^[48] The long-term orientation is reinforced by vesting schedules and clawback provisions, which condition carry realization on sustained fund performance. Vesting often extends over the fund's life, with distributions subject to recall if subsequent losses erode early gains, thereby compelling GPs to focus on operational improvements and strategic holding periods rather than premature sales. Empirical analyses indicate that such deferred compensation mechanisms correlate with superior fund returns; for example, studies on venture capital funds show that aligning GP pay timing with realized exits enhances internal rate of return (IRR) by linking rewards to verifiable long-term outcomes, rather than interim valuations.^[95]^[96] This contrasts with shorter-horizon incentives in liquid strategies, where carried interest's illiquidity—tied to multi-year lockups—fosters patience in asset transformation, such as through leveraged buyouts that yield compounded growth via revenue expansion and cost efficiencies.^[97] Critics occasionally argue that carry may encourage excessive leverage to hit hurdles quickly, but evidence from fund data suggests the opposite: GPs with significant carry exposure demonstrate higher persistence in value-add strategies, as their lifetime income depends on repeatable success across funds, where underperformance forfeits future allocations from LPs. In practice, co-investments by GPs, often required alongside carry, further amplify alignment by exposing managers to unlevered downside risk, ensuring decisions reflect long-term economic realities over speculative flips.^[98]^[99] Overall, this framework has underpinned private equity's historical outperformance relative to public markets, with net LP IRRs averaging 15-20% annually in top-quartile funds from 2000-2020, attributable in part to these incentive designs.^[100]

Managerial Risk Exposure

Carried interest exposes fund managers to significant downside risk, as it is a performance-contingent compensation that materializes only after limited partners (LPs) recover their invested capital plus a preferred return, typically 8%. If the fund fails to achieve this hurdle or generates losses, managers forgo the carry entirely, forgoing what often constitutes the majority of their economic upside while still incurring operational costs covered by modest management fees. This structure ties managerial rewards directly to net fund outcomes, subjecting compensation to market volatility, investment selection errors, and economic downturns over extended holding periods of 5-10 years.^[1]^[101] In addition to the illiquidity and deferral inherent in carried interest, general partners (GPs) typically commit 1-2% of the fund's capital from personal resources, amplifying risk exposure through direct "skin in the game." These commitments, drawn from GP wealth or firm capital, bear full pro-rata losses without offset from fees, and empirical analysis indicates that higher GP ownership correlates with reduced portfolio risk-taking, reflecting a conservative response to heightened personal stakes. Co-investments, where managers deploy additional personal or firm capital into specific deals alongside the fund, further concentrate exposure, often without management fee credits, thereby intensifying alignment but also potential losses in underperforming assets.^[102]^[103]^[104] Clawback mechanisms provide further risk mitigation for LPs but impose ongoing liability on managers, requiring repayment of prior distributions if subsequent fund performance deteriorates. This deferred and reversible nature of carried interest, combined with the absence of guaranteed income beyond base fees (usually 1-2% of assets under management), compels managers to bear entrepreneurial uncertainty akin to equity investors, fostering incentives for value creation amid illiquid, high-variance outcomes. While management fees offer some stability, they are insufficient to offset carry forfeiture in failed funds, underscoring the real economic hazard borne by GPs.^[105]^[106]

Empirical Contributions to Economic Growth

Private equity and venture capital funds, which rely on carried interest as a performance-based incentive for managers, have been empirically linked to enhanced economic growth through improved firm productivity, innovation, and capital allocation. A National Bureau of Economic Research study analyzing U.S. data from 1980 to 2018 found that private equity investments, encompassing both buyout and venture funds, accounted for 14-21% of aggregate growth in total factor productivity, with venture funds exhibiting particularly strong responsiveness to business cycles by directing capital toward high-potential opportunities during expansions.^[107] This contribution arises because carried interest ties managerial compensation to long-term fund returns, encouraging selections of underperforming or innovative assets that, post-investment, demonstrate higher output and efficiency compared to non-PE peers.^[108] In private equity buyouts, empirical analyses reveal accelerated employment and production growth, particularly in private-to-private transactions. Research from the University of Chicago Booth School of Business, based on European firm-level data from 2000-2016, showed that PE-backed firms experienced robust post-buyout employment increases—driven partly by acquisitions and operational improvements—outpacing matched control firms by up to 2-3% annually in the initial years.^[109] These outcomes stem from PE managers' incentives under carried interest to implement value-enhancing strategies, such as cost reductions and strategic expansions, which boost cash flows and firm valuations by 15-20% on average, as documented in meta-analyses of buyout performance.^[108] Across European economies, panel data regressions further confirm a positive correlation between private equity activity and GDP growth, mediated by increased innovation outputs like patents per capita.^[110] Venture capital, where carried interest similarly incentivizes high-risk, high-reward investments, disproportionately drives innovation and technological advancement. NBER research indicates that each dollar of venture capital generates 2-3 times more patented inventions than equivalent corporate R&D spending, with VC-backed firms contributing outsized shares of breakthrough technologies in sectors like biotechnology and software.^[111] In the U.S., VC-supported companies accounted for 62% of private-sector R&D expenditures and 48% of patent value among public firms from 1980-2015, underpinning broader economic expansion through spillovers like knowledge diffusion and firm scaling.^[112] Longitudinal studies of U.S. data from 1975-1995 estimate that venture capital raised aggregate productivity growth by channeling funds to startups, which later generated revenues equivalent to 16.6% of 2005 GDP.^[113]^[114] Carried interest's structure, rewarding only successful exits after multi-year horizons, aligns these incentives with patient capital deployment, fostering sustained contributions to GDP via scalable innovations rather than short-term gains.^[115]

Controversies and Debates

Claims of Tax Avoidance

Critics contend that the taxation of carried interest as long-term capital gains constitutes a form of tax avoidance by permitting investment fund managers to classify compensation for services as investment income, thereby accessing preferential rates of 20 percent plus a 3.8 percent net investment income tax, rather than ordinary income rates reaching 37 percent.^[9]^[13] This treatment, embedded in partnership tax rules since the Revenue Act of 1954, allows general partners in private equity, hedge funds, and venture capital entities to receive typically 20 percent of fund profits—after limited partners recover their capital plus a preferred return—as if it were a return on illiquid capital commitment, despite minimal or no actual capital at risk from the managers.^[116]^[117] Proponents of reform, including economists and fiscal policy analysts, argue that carried interest primarily rewards managerial labor and expertise in selecting and overseeing investments, akin to salary or bonus, rather than bearing the economic risk of capital ownership, thus warranting ordinary income taxation to align with Internal Revenue Code principles distinguishing service fees from true capital gains.^[9]^[118] The Congressional Budget Office has estimated that reclassifying carried interest associated with assets held over three years as ordinary income would generate $13 billion in federal revenue over the 2025–2034 period, reflecting the scale of foregone receipts from this structure.^[8] Earlier projections pegged similar reforms at $14 billion from 2019 through 2028, underscoring persistent budgetary impacts amid repeated legislative failures to enact closure.^[119] Legislative efforts, such as the Carried Interest Fairness Act introduced in February 2025 by Representatives Marie Gluesenkamp Perez and Don Beyer, highlight claims that the provision disproportionately benefits high-income fund managers—often earning tens of millions annually—while exacerbating income inequality and shifting tax burdens elsewhere, with private equity executives cited as primary beneficiaries of the differential.^[120] Critics from organizations like the Center on Budget and Policy Priorities have quantified that under pre-2013 law, managers could pay the 15 percent capital gains rate on most carried interest, a rate now adjusted but still lower than ordinary income, enabling avoidance of higher brackets on what they describe as performance-based pay rather than passive gains.^[116] These arguments persist despite industry pushback, with reform advocates estimating that full taxation as ordinary income could reduce effective rates for top earners by up to 17 percentage points, though actual realizations depend on holding periods and fund performance.^[9]

Counterarguments Based on Investment Realities

Proponents of the current tax treatment argue that carried interest reflects genuine investment risk undertaken by fund managers, who typically receive no share of profits unless portfolio companies achieve successful exits after years of illiquid holdings, often spanning three or more years to qualify for long-term capital gains rates.^[13] This structure mirrors the economic substance of equity ownership, as managers forgo guaranteed salaries in favor of deferred, uncertain upside tied to asset appreciation, exposing them to full downside risk if investments fail—realities absent in ordinary service income.^[7] Reclassifying it as ordinary income, taxed up to 37% federally plus state rates, would thus penalize this risk-bearing without altering the underlying causal dynamics of fund performance.^[7] The incentive alignment inherent in carried interest—typically 20% of profits above a hurdle rate—encourages managers to prioritize long-term value creation over short-term gains, as compensation vests only upon realized fund-level profits that benefit limited partners.^[121] This contrasts with fixed-fee models, fostering behaviors like operational improvements and patient capital deployment in private markets, where public equity benchmarks fail to capture illiquidity premiums and active management effects.^[2] Empirical data supports this: U.S. buyout funds have outperformed the S&P 500 by an average of over 20% across most vintage years since 1984, net of fees, due to such aligned risk-taking.^[122] Private equity's track record further underscores these realities, with state pension allocations yielding 11.0% annualized net returns from 2000 to June 2023, surpassing public equity amid comparable or lower volatility when adjusted for holding periods.^[123] A broader analysis of funds from 2000–2023 confirms a 4.8% annualized excess return over public equities, attributable to illiquid, transformative investments rather than mere financial engineering.^[124] Altering tax treatment could deter such allocations, reducing capital flows to high-growth sectors and job-creating enterprises, as evidenced by private equity's role in expanding tax bases through business scaling.^[125] Critics' focus on "loophole" framing often discounts these outcomes, prioritizing revenue optics over incentives for productive risk.^[9]

Regulatory Efforts and Empirical Outcomes

In the United States, repeated legislative efforts to alter the preferential tax treatment of carried interest as long-term capital gains have largely failed to eliminate it, though partial modifications occurred. Proposals date back to 2007, when bipartisan bills like H.R. 2834 sought to recharacterize carried interest as ordinary income, but none advanced significantly.^[6] During the Obama administration, annual budget proposals from 2009 to 2016 advocated taxing carried interest as ordinary income after a three-year holding period, yet these were not enacted amid opposition citing risks to investment incentives.^[6] The 2017 Tax Cuts and Jobs Act (TCJA) under President Trump introduced a compromise requiring a three-year holding period for carried interest to qualify for long-term capital gains rates (20% plus 3.8% net investment income tax), up from one year previously, but preserved the lower rate overall and expired provisions after 2025 unless extended.^[126] Subsequent Democratic-led initiatives, such as the 2021 For the People Act and Biden administration proposals, aimed to impose ordinary income taxation (up to 37%) but stalled in Congress due to filibuster rules and industry lobbying; as of 2025, bills like the Carried Interest Fairness Act remain pending without passage.^[127] In the United Kingdom, regulatory changes have progressed further toward income taxation. Following consultations, draft legislation published in August 2025 mandates that, from April 2026, carried interest will be taxed as trading profits subject to income tax (up to 45%) and Class 4 National Insurance contributions (up to 8%), replacing prior capital gains treatment, with relief only for "qualifying" carry meeting investment performance conditions and a five-year holding period.^[86] ^[128] Non-UK residents will face UK tax on carry linked to UK investment management services, broadening the scope.^[129] European Union efforts remain fragmented, focusing on fund-level regulations like AIFMD II without uniform carried interest taxation, though national variations apply.^[130] Empirical evidence on outcomes is constrained by the absence of wholesale reforms in major jurisdictions, yielding mostly modeling and correlational studies rather than causal post-reform data. Research indicates that private equity firms factor carried interest tax benefits into acquisition decisions, with higher investment income taxes linked to reduced deal activity; for instance, a 10% tax rate increase correlates with a 1-2% drop in private equity acquisitions.^[131] Economic modeling projects that reclassifying U.S. carried interest as ordinary income could shrink private equity assets under management by 2.81-3.94%, potentially curtailing capital deployment and job creation, as managers adjust compensation or relocate activities.^[132] No large-scale studies show enhanced economic growth from proposed hikes, while private equity's historical contributions—such as 2.7 million U.S. jobs supported in 2022—align with incentive structures preserved under current rules.^[133] In jurisdictions with partial shifts, like the UK's pre-2026 regime, fund inflows persisted without evident disruption, but the full 2026 effects remain unobserved.^[134] Critics' claims of revenue gains (e.g., $14 billion over a decade from U.S. reform) assume static behavior, overlooking behavioral responses like reduced risk-taking documented in tax sensitivity analyses.^[135]

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The purpose of this paper is to provide empirical evidence on the relationship between private equity, innovations, and economic growth in 13 European countries
[112]
Venture Capital Spurs Innovation | NBER
A dollar of venture capital is far more likely to produce patented innovations than a dollar of traditional corporate R and D spending.
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Measuring Venture Capital's Impact on the Economy
Nov 1, 2021 · Gornall and Strebulaev find that VC-backed companies account for 62% of research and development (R&D) spending and 48% of patent value for the ...
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[PDF] Venture Capital's Impact on American Economic Growth and ... - LSE
Aug 22, 2023 · Introduction. 'Did venture capital (VC) impact American economic growth between 1975-1995 and was the efficiency of this relationship ...
[115]
Venture-backed Companies Make Formidable Impact on Economy
In fact, 16.6 percent of the 2005 U.S. gross domestic product (GDP) was directly attributable to the $2.1 trillion in revenues received by venture-backed U.S. ...
[116]
[PDF] Venture Capital's Role in Financing Innovation
Venture capital has been a highly efficacious way to support certain kinds of innovation, as reflected in the importance of venture-backed companies in the ...
[117]
An Analysis of the "Carried Interest" Controversy
Jul 31, 2007 · The analysis concludes that carried interest does indeed constitute compensation for work performed; it then examines efficiency arguments for ...
[118]
[PDF] THE TAXATION OF CARRIED INTERESTS IN PRIVATE EQUITY
Part V will turn to the key considerations of tax avoidance and complexity, arguing that because we cannot and often do not at- tempt to distinguish between ...
[119]
Close the carried interest loophole that is a tax dodge for super-rich ...
Oct 14, 2021 · The carried interest tax loophole is tax alchemy that magically turns ordinary compensation income into preferentially taxed investment income.<|separator|>
[120]
Tax Carried Interest as Ordinary Income | Congressional Budget Office
Dec 13, 2018 · If implemented, the change would produce an estimated $14 billion in revenues from 2019 through 2028, according to the staff of the Joint ...Missing: loophole | Show results with:loophole
[121]
Gluesenkamp Perez, Beyer Introduce Bill to Close Carried Interest ...
Feb 6, 2025 · Don Beyer (VA-08) introduced the Carried Interest Fairness Act to eliminate a tax loophole that benefits wealthy money managers on Wall Street.
[122]
Carried Interest Explained: Definition & Structure | CFI
This real-world case illustrates how carried interest is designed to align the GP's incentives with those of investors and reward long-term performance.Hurdle Rates · Carried Interest Vs... · Why Carried Interest Matters...
[123]
Reassessing Private Equity | Chicago Booth Review
They find that buyout funds did better than public markets in most vintage years since 1984. The average US buyout fund outperformed the S&P 500 by at least 20 ...
[124]
Private Equity Versus Public Equity Returns - - Alpha Architect
Dec 13, 2024 · Cliffwater found that private equity allocations by state pensions produced a 11.0% net-of-fee annualized return over the 23-year period ending June 30, 2023.
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Long-Term Private Equity Performance: 2000 to 2023 - CAIA
Apr 23, 2024 · The study finds that private equity produced a meaningful 4.8% annualized excess return over public equity. We test for any diminution of excess ...
[126]
Carried Interest | NAIOP | Commercial Real Estate Development ...
Carried interest has traditionally been treated as capital gains income taxed at favorable capital gains rates. Efforts to change the taxation of carried ...
[127]
2025 carried interest tax reform and impact on sponsors and investors
Feb 10, 2025 · During his first term, President Trump enacted the most significant reform to the taxation of carried interest under the 2017 Tax Cuts and Jobs ...Missing: timeline | Show results with:timeline
[128]
The Carried Interest Fairness Act and Potential Tax Impact in 2025
Mar 3, 2025 · During his first term, President Trump enacted the most significant reform to the taxation of carried interest under the 2017 Tax Cuts and Jobs ...Missing: history timeline
[129]
The UK's New Regime for Carried Interest Taxation — How the Draft ...
Jul 24, 2025 · From 6 April 2026, carried interest in the UK will be treated as deemed trading profits and subject to Income Tax and Class 4 National ...Missing: United | Show results with:United
[130]
What fund managers need to know about the UK's new carried ...
Aug 20, 2025 · Under the new regime, non-UK residents will be subject to income tax on carried interest to the extent that it relates to investment management ...
[131]
https://www.sciencedirect.com/science/article/abs/pii/S0927539820300463
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Investment income taxes and private equity acquisition activity
Our findings suggest that private equity firms consider the tax benefit, in part from the use of carried interest, to be an important factor when making ...
[133]
[PDF] Economic Impact on the Private Funds and Real Estate Industries ...
Apr 8, 2025 · Applying standard economic theory, the tax increase from treating carried interest as ordinary income may cause up to a 3.94%/2.81% downsizing ...
[134]
The Tax Treatment of Carried Interest | Tax Policy Center
Mar 26, 2025 · Supporters of the lower rate of tax on carried interest argue that a higher tax rate would discourage investment and harm economic growth.
[135]
Bridging the Atlantic: Carried Interest and US-UK taxation | KPMG UK
Oct 2, 2025 · One impact of this change is that fund managers who leave the UK but continue to receive carry will be liable to UK tax as non-residents, on the ...
[136]
The Tax Hike on Carried Interest | American Enterprise Institute - AEI
Because carried interest does usually provide tax savings, tax motivations have probably prompted its increased use to some extent. It also may have attracted ...Missing: evidence improves