If you’re involved in private equity, venture capital, or hedge funds, then you’re likely familiar with the term “carried interest.” Carried interest is a type of investment profit-sharing arrangement between fund managers and investors. It’s an important component of the compensation structure for private equity and hedge fund managers. However, carried interest is a complex issue when it comes to taxation. In this article, we’ll provide an overview of the US taxation of carried interest.

What is Carried Interest?

Carried interest is a share of the profits that a private equity, venture capital, or hedge fund manager earns on investments. The fund manager receives a percentage of the profits generated by the fund as compensation for their investment expertise and services. The percentage of the profits that the manager receives is typically around 20% but can vary depending on the fund agreement.

How is Carried Interest Taxed in the US?

The taxation of carried interest has been a subject of controversy for years. Carried interest is treated as a capital gain and taxed at a lower tax rate than ordinary income, which has been a point of contention for some politicians and taxpayers. However, recent tax reforms have resulted in some changes to the tax treatment of carried interest.

Under the current tax law, carried interest is generally taxed at the long-term capital gains rate of 20%, plus the Net Investment Income Tax (NIIT) of 3.8% for high-income taxpayers. In order to qualify for long-term capital gains treatment, the fund manager must hold the asset for more than one year. Short-term capital gains, which are gains on assets held for less than one year, are taxed as ordinary income, which can be up to 37% for high-income taxpayers.

In addition, recent tax reforms have added new restrictions on the eligibility for carried interest tax treatment. Fund managers are now required to hold their investments for at least three years in order to receive the long-term capital gains treatment. This is known as the “three-year rule.” If the investment is sold before the three-year mark, the carried interest will be taxed as ordinary income.

Why is Carried Interest Taxation Controversial?

Carried interest taxation is controversial for several reasons. Some argue that fund managers are not providing a service that is different from other service providers, such as lawyers or doctors, who are taxed at ordinary income rates. Additionally, some argue that carried interest is a form of compensation and should be taxed as such.

However, supporters of the current tax treatment argue that it encourages investment and job creation by private equity and venture capital firms. They also argue that it aligns the interests of the fund managers with those of the investors, as the manager only receives a share of the profits if the investments are successful.

Conclusion

The taxation of carried interest is a complex issue, and recent tax reforms have added new rules and restrictions on its treatment. Fund managers should be aware of these changes and work with a qualified tax professional to ensure that they are complying with all applicable tax laws. At JTT Accounting, our team of tax accounting experts can help you navigate the complexities of carried interest taxation and ensure that you are in compliance with all relevant tax laws. Contact us today to learn more about our services.