Carried Interest: Definition, Compensation, & Taxation

Key Takeaways

• Carried interest is the share of investment profits that fund managers earn. It is a primary source of compensation for general partners in venture capital, private equity, and hedge funds.
• Carried interest is unique because it acts as a performance fee that is typically only paid if the fund achieves a predetermined minimum return called a hurdle rate.
• Carried interest is typically taxed at a lower rate than ordinary rate as a long-term capital gain. However, proposed legislation is challenging this provision.

Definition of Carried Interest

The origins of carried interest date back to the 16th century. During this time, European ship captains took on significant risks embarking on perilous voyages to Asia and the America to trade goods. In return, they were rewarded with a 20% share of the profits from the goods they transported. Today, carried interest is a type of compensation that similarly rewards fund managers for shouldering risk and exceeding performance benchmarks.

Carried interest is the share of investment profits, typically 20%, that fund managers earn. Often referred to as “carry” or “promote,” it is a slice of the profit pie dedicated to general partners (GPs) when an investment achieves success. It is typically the primary source of compensation for GPs in venture capital firms, private equity funds, and hedge funds.

Carried interest is a unique form of compensation for several reasons.

Performance Fee

First, it aligns the interests of general partners with investors, ensuring that the former only get compensated when the investment achieves certain returns. By tying a significant portion of their compensation to the fund’s performance, carry incentivizes GPs to not just perform, but excel. In this way, carried interest serves as a performance fee, motivating GPs to generate positive returns.

Hurdle Rate

Second, limited partners need to earn back their initial investment before GPs earn carry. Even then, it is typically only paid if the fund hits an agreed-upon minimum return called the hurdle rate. So if a private equity fund targets an 8% annual return but falls short, GPs may forgo carry. Furthermore, a clawback mechanism is sometimes used to reclaim distributed carried interest if specific performance benchmarks aren’t met.

Taxation

Finally, carried interest is defined as a return on investment rather than regular earnings. As a result, it receives favorable tax treatment as a long-term capital gain, which is taxed at a lower rate than ordinary income.

General Partner Compensation

In the intricate world of investment funds, general partners are the linchpins. They are the driving force behind a fund’s strategy, execution, and ultimately, its success.

Compared to limited partners (LPs), GPs shoulder far more risk. They are actively involved in the fund’s daily management: sourcing investment opportunities, conducting due diligence, and making high-stakes decisions that dictate the fund’s direction. They also tend to contribute to the fund’s initial capital which means they have a personal financial stake in the fund.

The compensation structure of general partners is crafted to reflect their roles and the risks that they undertake. There are two primary forms of GP compensation: carried interest and management fees.

Carried Interest vs. Management Fees

• Carried Interest: As discussed, carried interest represents the share of investment profits, typically 20%, that fund managers earn. Unlike management fees, it is usually taxed as long-term capital gains.
• Management Fees: GPs typically charge an annual management fee of 2% of the assets managed under the fund. This fee provides a consistent revenue stream for GPs and covers the costs associated with managing the fund. They’re generally subjected to ordinary income tax, which peaks at a top marginal rate of 37%.

	Management Fees	Carried Interest
Basis	Percentage of assets under management	Percentage of funds’ profits
Typical Rate	~2%	~20%
Tax Treatment	Ordinary income (up to 37% marginal rate)	Long-term capital gains (up to 23.8% rate)
Pay-out Conditions	Regular income	Performance-dependent on meeting hurdle rate

Taxation of Carried Interest

A key characteristic of carried interest is its favorable tax treatment.

Carried interest is considered a return on investment and therefore taxed as a long-term capital gain rather than ordinary income. This means carried interest enjoys a top tax rate of 23.8% (20% on net capital gains plus 3.8% net investment income tax) compared to ordinary income, which can skyrocket to a top rate of 37%. This results in a considerably lower tax burden for fund managers.

Recent Legislation around Taxation

In 2017, the Tax Cuts and Jobs Act extended the required holding period from one to three years for assets generating carried interest to enjoy long-term capital gains rates.

In 2021, the Carried Interest Fairness Act, which proposes carried interest be taxed as ordinary income, was introduced to Congress.

Today, its taxation continues to be a timely and evolving issue as lawmakers weigh potential revenue generators. In February 2025, lawmakers proposed another iteration of the Carried Interest Fairness Act for which President Trump has expressed support.

Recent studies estimate that taxing carried interest as ordinary income could increase tax revenue by around $10 billion and decrease the federal budget deficit by around $13 billion over the next ten years. However, critics of the legislation argue doing so will curtail entrepreneurship and job growth.

Summary

Carried interest is a unique form of compensation due to how it’s structured, earned, and taxed. As debate around its taxation heats up this year, fund managers should stay informed and work closely with their advisors to ensure compliance with evolving legislation.