The “carried interest” provision draws a lot of political attention because it is a popular way for venture capitalists to structure their fees and, arguably, re-characterize ordinary income to capital gain income, thus cutting their tax by as much as half.
The tax advantage of the carried interest is viewed as an example of “what’s wrong with Wall Street.” Venture capitalists are not the only ones who take advantage of the carried interest provision; real estate developers also use the same structure in their deals to earn a “promote,” which is just another term for the carried interest. Upon the sale of a property, gain that is allocated to the developer through the promote is taxed at capital gain rates. Developers don’t typically invest capital for the promote; rather, it is earned through their successful development, management and/or sale activity.
Carried interest, or “carry,” is a profits interest in a partnership, as used in venture capital, private equity and hedge funds environments. Typically, upon formation of such a partnership, an individual or a group of individuals are hired to manage the fund. They are compensated with a management fee, most commonly equal to 2% of the assets being managed. Additionally, they might receive a right to 20% of the future profits of the fund.
It is that profits interest that is commonly referred to as “carried interest.” A profits interest is usually received tax-free, as it has no value when awarded. On the other hand, when capital investment is awarded, it has a definite value (i.e., the capital account received), and the receipt of a capital account is generally a taxable event.
A profits interest holder is usually allocated long-term capital gains and qualified dividends, which are taxed at a maximum 20% tax rate.
Most successful funds can generate enormous profits. The concern expressed by this election season’s presidential candidates is that the profits received from carry are effectively a salary to the investors; but they are not taxed at the ordinary 39.6% marginal tax rates that an average person would have to pay on such income.