Guides
Carried Interest: How It’s Taxed and Why It’s Debated
Carried interest is the share of investment profits, commonly around 20%, that a fund’s general partner keeps as its performance reward. In the United States it is taxed based on the character of the underlying gains, so profits from assets held long enough often qualify for long-term capital gains rates (up to 20% federal, plus the 3.8% net investment income tax) rather than the top 37% ordinary rate that applies to wages. That gap is the entire debate.
The mechanics turn on a partnership structure called a profits interest and on a rule added in 2017, Section 1061, that extended the holding period needed for capital gains treatment from one year to three. Whether this outcome is a justified reward for risk or a loophole for the wealthy is a policy question Congress has revisited for nearly two decades.
What is carried interest?
Carried interest, often shortened to “carry,” is a general partner’s share of a fund’s investment profits, paid on top of any capital the manager personally invests. In private equity and venture capital, the standard split has long been about 20% of profits, though it varies by fund. It rewards the manager for gains above a set threshold.
Investment funds are usually organized as limited partnerships. Outside investors are the limited partners (LPs) who supply most of the capital. The management firm serves as the general partner (GP) and makes the investment decisions. The GP typically earns money two ways: a management fee and carried interest.
The management fee, historically around 2% of committed capital per year, covers salaries and operating costs. It is compensation for services and is taxed as ordinary income at rates up to 37%. Carried interest is different: it is a slice of the fund’s profits, not a fixed fee, and its tax treatment follows the character of those profits.
Many funds also apply a hurdle rate, or preferred return, often near 8%. The GP collects carry only after LPs receive that baseline return on their capital, which ties the manager’s payout to fund performance.
How is carried interest taxed?
Carried interest is taxed according to the character of the fund’s underlying income. When a fund sells an asset held long enough to produce long-term capital gains, the GP’s carry share passes through as long-term capital gain, taxed at up to 20% federal, plus the 3.8% net investment income tax. Short-term gains, dividends, and interest flow through with their own character.
Because a fund is a pass-through entity, it pays no entity-level income tax. Gains, losses, and income items flow to the partners and keep their tax character on the way. The GP reports its carry on a Schedule K-1 issued by the fund, which the partnership files with Form 1065.
The result: a manager whose carry derives from long-term gains may face a combined federal rate near 23.8%, while wage income at the same level can reach 37% plus payroll or self-employment tax. The difference between the marginal and effective rate on that income can be substantial. Actual outcomes depend on the fund’s holdings, holding periods, and the partner’s overall situation.
The table below contrasts the two GP income streams under current federal rules.
| Feature | Management fee | Carried interest |
|---|---|---|
| What it is | Fixed annual fee (historically ~2%) | Share of profits (commonly ~20%) |
| Tax character | Ordinary income | Character of underlying gains (often long-term capital gain) |
| Top federal income rate | 37% | Up to 20% on long-term capital gains |
| Additional taxes | May face self-employment tax | 3.8% net investment income tax may apply |
| Tied to performance | No | Yes, often above a hurdle rate |
The Section 1061 three-year holding rule
Section 1061, added by the Tax Cuts and Jobs Act for tax years beginning after December 31, 2017, requires assets tied to carried interest to be held more than three years for the related gain to keep long-term capital gains treatment. Gains on assets held three years or less are recharacterized as short-term and taxed at ordinary rates.
Before 2018, the general one-year holding period applied. Section 1061 created a stricter three-year test that applies only to an “applicable partnership interest” (API), which is broadly a profits interest received for services in a business that raises or invests capital. Final regulations (TD 9945) were published January 19, 2021, in Treasury Regulation Section 1.1061.
The rule does not touch the GP’s own invested capital. Under the capital interest exception, gains attributable to money the manager actually put into the fund are measured against the normal one-year period, not the three-year API rule. Only the profits-interest portion faces the longer test.
In practice, private equity funds often hold portfolio companies for five years or more, so the three-year rule can have limited bite there. It can matter more for strategies with faster turnover. Managers may plan holding periods around the threshold, and the recharacterization is calculated on IRS worksheets that separate API gains from capital-interest gains.
Why carried interest is debated
The debate centers on whether carry is a return on investment or payment for work. Critics argue that carried interest is compensation for managing other people’s money, so it should be taxed as ordinary income like a salary. Supporters argue it is a share of investment gains earned by taking risk, so capital gains treatment is appropriate.
Critics, including several members of Congress across recent sessions, describe the treatment as a loophole. Their point: the GP often contributes little or no capital yet converts a labor-based reward into lower-taxed capital gains. The Congressional Budget Office has estimated that taxing carried interest as ordinary income would raise roughly $13 billion over fiscal years 2025 to 2034.
Supporters, including much of the private equity, venture capital, and real estate industry, counter that carry reflects entrepreneurial risk. The GP commits years to building portfolio companies, earns nothing if the fund underperforms the hurdle, and shares the upside like any equity owner. On this view, taxing sweat equity at capital gains rates is consistent with how other founders are taxed.
There is also a middle position reflected in Section 1061 itself: rather than reclassify all carry as ordinary income, the 2017 change kept capital gains treatment but raised the holding-period bar. That compromise left the core preference intact while limiting it for shorter-term gains.
Where carried interest reform stands
As of mid-2026, carried interest still receives capital gains treatment under Section 1061, and recent legislation has left that framework in place. The 2025 Republican tax law preserved the existing rules despite earlier proposals to change them. New reform bills continue to be introduced, so the rules could shift depending on future legislation.
Reform proposals have taken several forms. The Carried Interest Fairness Act of 2025 (S.445) would have created a new Code Section 710 to tax carry as ordinary compensation subject to self-employment tax. On April 16, 2026, Senators Ron Wyden, Sheldon Whitehouse, and Angus King introduced the Ending the Carried Interest Loophole Act, which uses a deemed income recognition approach paired with a deemed capital loss to reach ordinary-rate treatment.
None of these proposals had become law as of this writing. Fund managers and their advisers watch each tax package closely, because a change from capital gains to ordinary income, plus possible self-employment tax, could raise the effective rate on carry by roughly 15 to 20 percentage points depending on structure. Outcomes vary by fund type, state, and the partner’s circumstances, so managers should confirm treatment with a qualified tax adviser.
Carry is one part of a broader shift toward pass-through structures documented in the pass-through economy, and it intersects with related planning such as rollover equity in private equity deals.
Frequently asked questions
Is carried interest taxed as capital gains or ordinary income?
It depends on the underlying income. Carried interest keeps the character of the fund’s gains as they pass through the partnership. Profits from assets held more than three years generally qualify as long-term capital gains (up to 20% federal, plus a possible 3.8% net investment income tax). Gains on assets held three years or less are recharacterized as short-term and taxed at ordinary rates under Section 1061.
What is the carried interest loophole?
The “loophole” label refers to the fact that a fund manager can receive a performance reward, effectively a form of compensation, yet have it taxed at capital gains rates rather than the top 37% ordinary rate on wages. Critics see this as labor income taxed as investment income. Supporters see it as a legitimate share of investment gains that reflects entrepreneurial risk.
How much is carried interest usually?
In private equity and venture capital, carried interest has historically been about 20% of a fund’s profits, though it varies by fund and strategy. Managers often collect carry only after limited partners receive a preferred return, or hurdle rate, commonly near 8%. Some funds negotiate different splits or tiered structures depending on performance.
What is Section 1061 and when did it start?
Section 1061 is a tax rule added by the Tax Cuts and Jobs Act, effective for tax years beginning after December 31, 2017. It extends the holding period for carried interest to qualify for long-term capital gains from one year to more than three years. It applies to an applicable partnership interest, and final regulations (TD 9945) were published January 19, 2021.
Does Section 1061 apply to a manager’s own invested capital?
No. The capital interest exception generally keeps a manager’s own invested capital outside the three-year rule. Gains on money the general partner personally contributes to the fund are measured against the standard one-year holding period, not the longer API test. Only the profits-interest portion of the manager’s stake is subject to Section 1061 recharacterization.
Could carried interest tax rules change soon?
They could. As of mid-2026, capital gains treatment under Section 1061 remains in place, and the 2025 tax law left it unchanged. Multiple bills, including the Carried Interest Fairness Act of 2025 and the 2026 Ending the Carried Interest Loophole Act, propose ordinary-income treatment, but none have been enacted. Any change would depend on future legislation, so managers should monitor pending tax packages.
Reviewed by The Ledgerism Editorial Team. Last reviewed: July 2026.