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Carried interest, or carry, in finance, is a share of the profits of an investment paid to the
investment manager Investment management is the professional asset management of various securities, including shareholdings, bonds, and other assets, such as real estate, to meet specified investment goals for the benefit of investors. Investors may be institut ...
specifically in alternative investments (
private equity In the field of finance, the term private equity (PE) refers to investment funds, usually limited partnerships (LP), which buy and restructure financially weak companies that produce goods and provide services. A private-equity fund is both a typ ...
and
hedge fund A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as shor ...
s). It is a
performance fee A performance fee is a fee that a client account or an investment fund may be charged by the investment manager that manages its assets. A performance fee may be calculated many ways. With respect to a separate account, it is often based on th ...
, rewarding the manager for enhancing performance.Lemke, Lins, Hoenig and Rube, ''Hedge Funds and Other Private Funds: Regulation and Compliance'', §13:20 (Thomson West, 2013–2014 ed.). Since these fees are generally not taxed as normal income, some believe that the structure unfairly takes advantage of favorable tax treatment, e.g. in the United States.


History

The origin of carried interest can be traced to the 16th century when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20% share of the profit from the carried goods to pay for the transport and the risk of sailing over oceans.


Definition and calculation

Carried interest is a share of the profits of an investment paid to the
investment manager Investment management is the professional asset management of various securities, including shareholdings, bonds, and other assets, such as real estate, to meet specified investment goals for the benefit of investors. Investors may be institut ...
in excess of the amount that the manager contributes to the partnership, specifically in alternative investments, e.g.,
private equity In the field of finance, the term private equity (PE) refers to investment funds, usually limited partnerships (LP), which buy and restructure financially weak companies that produce goods and provide services. A private-equity fund is both a typ ...
and
hedge fund A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as shor ...
s. It is a
performance fee A performance fee is a fee that a client account or an investment fund may be charged by the investment manager that manages its assets. A performance fee may be calculated many ways. With respect to a separate account, it is often based on th ...
rewarding the manager for enhancing performance.


Amount and calculation

The manager's carried interest allocation varies depending on the type of investment fund and the demand for the fund from investors. In private equity, the standard carried interest allocation historically has been 20% for funds making buyout and venture investments, but there is some variability. Notable examples of
private equity firm A private equity firm is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through a variety of loosely affiliated investment strategies including lev ...
s with carried interest of more than 20% ("super carry") include
Bain Capital Bain Capital is an American private investment firm based in Boston. It specializes in private equity, venture capital, credit, public equity, impact investing, life sciences, and real estate. Bain Capital invests across a range of industry se ...
and
Providence Equity Partners Providence Equity Partners L.L.C. is a specialist private equity investment firm focused on media, communications, education, technology investments across North America and Europe. The firm specializes in growth-oriented private equity investmen ...
. Hedge fund carry percentages have historically centered on 20% but have had greater variability than those of
private equity funds A private equity fund (abbreviated as PE fund) is a collective investment scheme used for making investments in various equity (and to a lesser extent debt) securities according to one of the investment strategies associated with private equity. ...
. In extreme cases performance fees have reached as high as 44% of a fund's profits but is usually between 15% and 20%. The distribution of fund returns is often directed by a distribution waterfall. Returns generated by the investment are first distributed to return each investor's initial capital contribution, including the manager. This is not "carried interest" because it is a repayment of principal. Second, returns are paid to investors other than the manager, up to a certain previously agreed rate of return (the " hurdle rate" or "preferred return"). The customary hurdle rate is 7% to 9% per annum. Third, returns are paid to the manager until it has received a rate of return equal to the hurdle rate (the "catch-up"). Not every fund provides for a hurdle and a catch-up. Often, returns during the catch-up phase are split with the manager receiving the larger (e.g. 80%) share and the investors receiving a smaller (e.g. 20%) share, until the manager's catch-up percentage has been collected. Fourth, once the manager's returns equal the investor returns, the split reverses, with the manager taking a lower (often 20%) share and the investors taking the higher (often 80%) share. All manager returns above the returns from the manager's initial contribution are "carry" or "carried interest."


Timing

Private equity funds distribute carried interest to managers and other investors only upon a successful exit from an investment, which may take years. In a hedge fund environment, carried interest is usually referred to as a "performance fee" and because it invests in liquid investments, it is often able to pay carried interest annually if the fund has generated a profit. This has implications for both the amount and timing of the taxes on the interest.


Tax treatment

Some believe that carried interest takes advantage of favorable tax treatment in the United States.


Other fees

Historically, carried interest has served as the primary source of income for manager and firm in both private equity and hedge funds. Both funds also tend to have an annual
management fee In the investment advisory industry, a management fee is a periodic payment that is paid by an investment fund to the fund's investment adviser for investment and portfolio management services. Often, the fee covers not only investment advisory serv ...
of 1% to 2% of assets under management per year. The management fee covers the costs of investing and managing the fund. The management fee, unlike the 20% carried interest, is treated as ordinary income in the United States. As the sizes of both private equity and hedge funds have increased, management fees have become a more meaningful portion of the value proposition for fund managers as evidenced by the 2007
initial public offering An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail (individual) investors. An IPO is typically underwritten by one or more investment ...
of the
Blackstone Group Blackstone Inc. is an American alternative investment management company based in New York City. Blackstone's private equity business has been one of the largest investors in leveraged buyouts in the last three decades, while its real estate b ...
.


Taxation

Private equity returns are tax-advantaged in several ways. Private equity carried interest is treated as a long-term capital gain for tax purposes in many jurisdictions. Long-term capital gains are returns on financial and other investments that have been held for a certain statutorily determined amount of time before being sold. They are taxed at a lower rate than ordinary income to promote investment. The long time horizons of funds allow their returns, including the manager's carried interest, to typically qualify as long-term capital gains. A manager's carried interest can be categorized as capital gains even if the return on the manager's initial investment is higher than the total rate of return for the asset. Furthermore, taxes on the increase in value of an investor or manager's share of the fund are not due until a realization event occurs, most commonly the sale of an investment.


United States

Treatment of active partners' return on investment as capital gains in the United States originated in the oil and gas industry of the early 20th century. Oil exploration companies, funded by financial partners' investments, explored and developed hydrocarbon resources. The profits generated were split between the explorers and the investors. The explorers' profits were subject to favorable capital gains treatment alongside the investors. The logic was that the non-financial partner's "sweat equity" was also an investment, since it entailed the risk of loss if the exploration was unsuccessful. Taxes on carried interest are deferred until a realization event due to the difficulties of measuring the
present value In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has int ...
of an interest in future profits. The
Internal Revenue Service The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory tax ...
affirmed this approach in 1993 as a general administrative rule, and again in regulations proposed in 2005. Carried interest is tax advantaged in several other ways as well. Private equity and hedge funds are usually structured as legal partnerships or other
pass-through entities A flow-through entity (FTE) is a legal entity where income "flows through" to investors or owners; that is, the income of the entity is treated as the income of the investors or owners. Flow-through entities are also known as pass-through entities ...
for tax purposes, which reduces taxes at the entity level as compared to corporations. That said, investment managers are still taxed on the pass-through income on their individual tax returns. Private equity funds also benefit from the interest deduction although this benefit decreased significantly in 2017 due to changes in the tax law. The implication of treating private equity carried interest as capital gains is that investment managers face significantly lower tax burdens than others in similar income brackets. As of 2021, the maximum long-term capital gains rate (including the net investment income tax) is 23.8% compared to the maximum 37% ordinary income rate. This has generated significant criticism.


Controversy and regulatory attempts

Critics of the carried interest system (as opposed to critics of the broader tax systems that affect private equity) primarily object to the ability of the manager to treat most of their return as capital gains, including amounts above and beyond the amount directly related to the capital contributed by the manager. Critics characterize this as managers taking advantage of tax loopholes to receive what is effectively a salary without paying the 37% marginal ordinary income tax rate. However, some feel this criticism is not appropriate for small businesses that are not blind pools as the manager did risk capital prior to the partnership formation. This controversy has been ongoing since the mid-2000s and has increased as the growth in assets under management by private equity and hedge funds has driven up manager compensation. , the carried interest tax regime's total tax benefit for private equity partners is estimated to be from $2 billion to $16 billion per year. On June 22, 2007,
U.S. Representative The United States House of Representatives, often referred to as the House of Representatives, the U.S. House, or simply the House, is the lower chamber of the United States Congress, with the Senate being the upper chamber. Together they c ...
Sander M. Levin (D-MI) introduced , which would have eliminated the ability of managers to receive capital-gains tax treatment on their income. On June 27, 2007,
Henry Paulson Henry Merritt Paulson Jr. (born March 28, 1946) is an American banker and financier who served as the 74th United States Secretary of the Treasury from 2006 to 2009. Prior to his role in the Department of the Treasury, Paulson was the Chairman a ...
said that altering the tax treatment of a single industry raises tax policy concerns, and that changing the way partnerships in general are taxed is something that should only be done after careful consideration, although he was not speaking only about carried interest. In July 2007 the
U.S. Treasury Department The Department of the Treasury (USDT) is the national treasury and finance department of the federal government of the United States, where it serves as an executive department. The department oversees the Bureau of Engraving and Printing and ...
addressed carried interest in testimony before the U.S. Senate Finance Committee. U.S. Representative Charles B. Rangel included a revised version of H.R. 2834 as part of the "Mother of All Tax Reform" and the 2007 House extenders package. In 2009, the
Obama Administration Barack Obama's tenure as the List of presidents of the United States, 44th president of the United States began with First inauguration of Barack Obama, his first inauguration on January 20, 2009, and ended on January 20, 2017. A Democratic Pa ...
included a line item on taxing carried interest at ordinary income rates in the 2009 Budget Blueprint. On April 2, 2009, Congressman Levin introduced a revised version of the carried interest legislation as . Proposals were made by the Obama Administration for the 2010, 2011, and 2012 budgets. Favorable taxation for carried interest generated national interest during the 2012 Republican primary race for president because 31% of presidential candidate
Mitt Romney Willard Mitt Romney (born March 12, 1947) is an American politician, businessman, and lawyer serving as the junior United States senator from Utah since January 2019, succeeding Orrin Hatch. He served as the 70th governor of Massachusetts ...
's 2010 and 2011 income was carried interest. Billionaire
Warren Buffett Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net ...
, who also benefits from the capital gains system, famously opined that he should not be paying lower taxes than his assistant. On May 28, 2010, the House approved carried interest legislation as part of amendments to the Senate-passed version of . On February 14, 2012, Congressman Levin introduced . On February 26, 2014,
House Committee on Ways and Means The Committee on Ways and Means is the chief tax-writing committee of the United States House of Representatives. The committee has jurisdiction over all taxation, tariffs, and other revenue-raising measures, as well as a number of other program ...
chairman
Dave Camp David Lee Camp (born July 9, 1953) is a former American politician who served as a member of the United States House of Representatives from 1991 to 2015. Camp represented since 1993, and previously served one term representing . A member of the ...
(R-MI) released draft legislation to raise the tax on carried interest from the current 23.8 percent to 35 percent. In June 2015, Levin introduced the Carried Interest Fairness Act of 2015 (H.R. 2889) to tax investment advisers with ordinary income tax rates. some in the private equity and hedge fund industries had been lobbying against changes, being among the biggest political donors on both sides of the aisle. In June 2016 presidential candidate Hillary Clinton said that if Congress were to fail to act, as president she would ask the Treasury Department to use its regulatory authority to end a tax advantage. In 2018, under President
Donald Trump Donald John Trump (born June 14, 1946) is an American politician, media personality, and businessman who served as the 45th president of the United States from 2017 to 2021. Trump graduated from the Wharton School of the University of P ...
's administration, tax legislation passed that increased the length of time assets must be held by investment managers in order to qualify for long-term capital gains treatment from one year to three years. The legislation also limited the amount of interest deduction that could be taken to 30% of
earnings before interest and taxes In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses (operating and non-operating) except interest expenses and income tax expenses. Operating income and op ...
. The new rule had many exceptions including excepting the real estate sector. Proposed Treasury guidance in August 2020 tightened certain of these exceptions. In 2022, a proposal to narrow the carried interest loophole as part of the
Inflation Reduction Act of 2022 The Inflation Reduction Act of 2022 (IRA) is a landmark United States federal law which aims to curb inflation by reducing the deficit, lowering prescription drug prices, and investing into domestic energy production while promoting clean ener ...
was removed to allow the act to pass, reportedly due to "a last-minute intervention by Senator
Kyrsten Sinema Kyrsten Lea Sinema (; born July 12, 1976) is an American politician and former social worker serving as the senior United States senator from Arizona since January 2019. A former member of the Democratic Party, Sinema became an independent in ...
of Arizona."


United Kingdom

The Finance Act 1972 provided that gains on investments acquired by reason of rights or opportunities offered to individuals as directors or employees were, subject to various exceptions, taxed as income and not capital gains. This may strictly have applied to the carried interests of many venture-capital executives, even if they were partners and not employees of the investing fund, because they were often directors of the investee companies. In 1987, the
Inland Revenue The Inland Revenue was, until April 2005, a department of the British Government responsible for the collection of direct taxation, including income tax, national insurance contributions, capital gains tax, inheritance tax, corporation ta ...
and the British Venture Capital Association (BVCA) entered into an agreement which provided that in most circumstances gains on carried interest were not taxed as income. The Finance Act 2003 widened the circumstances in which investment gains were treated as employment-related and therefore taxed as income. In 2003 the Inland Revenue and the BVCA entered into a new agreement which had the effect that, notwithstanding the new legislation, most carried-interest gains continued to be taxed as capital gains and not as income. Such capital gains were generally taxed at 10% as opposed to a 40% rate on income. In 2007, the favorable tax rates on carried interest attracted political controversy. It was said that cleaners paid taxes at a higher rate than the private equity executives whose offices they cleaned. The outcome was that the capital-gains tax rules were reformed, increasing the rate on gains to 18%, but carried interest continued to be taxed as gains and not as income."HMRC PBRN 17"
(
PDF Portable Document Format (PDF), standardized as ISO 32000, is a file format developed by Adobe in 1992 to present documents, including text formatting and images, in a manner independent of application software, hardware, and operating systems ...
).
HM Revenue and Customs , patch = , patchcaption = , logo = HM Revenue & Customs.svg , logocaption = , badge = , badgecaption = , flag = , flagcaption = , image_size = , co ...
. 9 October 2007.


See also

* Taxation of private equity and hedge funds


References


Further reading

* Lily Batchelder
Business Taxation: What is carried interest and how should it be taxed?
''
Tax Policy Center The Urban-Brookings Tax Policy Center, typically shortened to the Tax Policy Center (TPC), is a nonpartisan think tank based in Washington D.C. A joint venture of the Urban Institute and the Brookings Institution, it aims to provide independent ...
'' (last updated June 25, 2008) * Lily Batchelder
What are the options for reforming the taxation of carried interest?
''
Tax Policy Center The Urban-Brookings Tax Policy Center, typically shortened to the Tax Policy Center (TPC), is a nonpartisan think tank based in Washington D.C. A joint venture of the Urban Institute and the Brookings Institution, it aims to provide independent ...
'' (last updated June 25, 2008) *
Peter R. Orszag Peter Richard Orszag (born December 16, 1968) is the CEO of Financial Advisory at Lazard. Before June 2019, he was the firm's Head of North American M&A and Global Co-Head of Healthcare. Orszag previously served as a Vice Chairman of Corporate ...

The Taxation of Carried Interest: Statement of Peter R. Orszag, Director, Congressional Budget Office, before the Committee on Finance United States Senate
''
Congressional Budget Office The Congressional Budget Office (CBO) is a federal agency within the legislative branch of the United States government that provides budget and economic information to Congress. Inspired by California's Legislative Analyst's Office that manages ...
'' (July 11, 2007). * Chris William Sanchirico
The Tax Advantage to Paying Private Equity Fund Managers with Profit Shares—What is it? Why is it Bad?
University of Chicago Law Review, Vol. 75, pp. 1071–1153 (2008) {{private equity and venture capital Hedge funds Private equity Venture capital