Why Is Carried Interest So Controversial?

Carried interest is a share of profits from an investment fund, paid to the fund’s managers. Common in private equity, venture capital, and hedge funds, this compensation receives preferential tax treatment, which is the source of a long-standing debate. While investment managers see this income as a return on their successful investments, critics argue it is a fee for services that should be taxed at higher rates. This disagreement over how to tax carried interest places it at the center of discussions about economic fairness and tax policy.

Understanding Carried Interest and Its Tax Treatment

Carried interest is a performance fee. Investment fund managers, often called general partners, are compensated in two primary ways. They receive a management fee, typically around 2% of the total assets under management, which is used to cover the operational costs of the fund. This management fee is taxed as ordinary income, while the carried interest, a share of the fund’s profits, is the focus of the controversy.

This “2 and 20” model is standard in the private equity world. The 2% management fee provides a steady income stream for the general partners, while the 20% carried interest is designed to incentivize them to generate high returns for their investors, known as limited partners. Think of a real estate developer who manages a large construction project. They might receive a management fee for overseeing the project, but the real prize is a percentage of the profit when the building is sold. The carried interest for a fund manager functions in a similar way.

The tax treatment of this income is the contentious issue. Carried interest is taxed as a long-term capital gain, provided the fund holds the underlying assets for more than three years. As of 2025, the top federal tax rate on long-term capital gains is 20%, but for high-income earners, an additional 3.8% Net Investment Income Tax applies, bringing the effective top rate to 23.8%. This is significantly lower than the 37% top marginal rate for ordinary income.

A fund manager receiving $1 million in carried interest would pay approximately $238,000 in federal taxes. If that same $1 million were taxed as ordinary income, the tax bill could be as high as $370,000. Furthermore, income classified as capital gains is not subject to the 15.3% self-employment tax that funds Social Security and Medicare. This preferential treatment remains a focal point of tax policy debates.

The Argument for Preferential Tax Treatment

Supporters of the current tax treatment for carried interest argue that it is not a salary, but a return on investment and a reward for entrepreneurial risk-taking. They contend that fund managers are partners who invest their expertise, time, and “sweat equity” into building successful companies. From this perspective, the carried interest is the profit share that compensates them for the risk they undertake and the value they create over several years.

This tax structure encourages long-term investment strategies that benefit the broader economy. By incentivizing fund managers to hold investments for longer periods to achieve capital gains status, the policy promotes patient capital that can fund innovation and support start-ups. Proponents claim that changing this tax treatment would discourage this type of risk-taking, potentially reducing the flow of capital to new and expanding businesses.

Another justification is the alignment of interests between the fund managers and their investors. Since the carried interest is a percentage of the profits, managers only receive this compensation if the fund performs well and generates returns for its investors. This structure ensures that both parties are working towards the same goal: maximizing the fund’s success. Supporters argue this alignment is a powerful economic driver.

Treating carried interest as ordinary income would mischaracterize the nature of the work. It would equate the high-risk, long-term efforts of a fund manager with the more predictable, salaried income of other professionals. The potential for a large payout via carried interest is what attracts top talent to the demanding world of private equity and venture capital, where they can apply their skills to generate economic growth.

The Argument Against Preferential Tax Treatment

Critics of the current tax policy argue that carried interest is compensation for the service of managing other people’s money. From this viewpoint, fund managers are highly skilled professionals performing a service, much like corporate executives, lawyers, or consultants. These other professions are paid salaries and bonuses that are taxed at ordinary income rates, and opponents see no justifiable reason why investment managers should be treated differently.

A primary argument against this tax treatment is the issue of fairness. The fact that a private equity manager earning millions of dollars can pay a lower federal tax rate than many middle-class professionals strikes many as inequitable. This disparity is often labeled the “carried interest loophole” by critics, who see it as a flaw in the tax code that benefits a small number of very wealthy individuals.

This perceived unfairness is linked to broader concerns about income and wealth inequality. By allowing some of the highest earners in the country to pay a lower tax rate on the bulk of their income, the policy exacerbates the gap between the rich and the rest of the population. Government analyses have projected that taxing carried interest as ordinary income could generate billions of dollars in additional revenue over a decade, which could be used to fund public services or reduce the national debt.

Opponents also challenge the idea that managers are risking their own capital. In most cases, the vast majority of the money being invested belongs to the limited partners, such as pension funds and university endowments. While managers may make a small co-investment, their primary contribution is their management expertise, not their personal wealth. Therefore, the profits they receive are a direct result of their labor, not a return on their own capital at risk, and should be taxed accordingly.

Proposed Legislative Changes

For years, the tax treatment of carried interest has been a target for legislative reform, with proposals originating from both major political parties. The objective of these proposals is to reclassify carried interest as ordinary income, thereby aligning the taxation of fund managers with that of other high-income earners.

The most significant recent change came with the Tax Cuts and Jobs Act of 2017, which extended the holding period for assets to qualify for long-term capital gains treatment from one year to three years. While this was a step toward reform, it did not alter the fundamental nature of the tax break. Many subsequent proposals have sought to go further, either by eliminating the capital gains treatment for carried interest entirely or by extending the required holding period to five or more years.

These reform efforts are often met with significant lobbying from the private equity industry. The debate continues to be a recurring theme in discussions about tax policy, with various bills being introduced in Congress over the years aiming to address the issue. The tax treatment of carried interest is likely to remain a prominent issue in American politics and finance.