Taxation of Carried Interest

Changes from July 9, 2020 to August 4, 2022

This page shows textual changes in the document between the two versions indicated in the dates above. Textual matter removed in the later version is indicated with ~~red strikethrough~~ and textual matter added in the later version is indicated with blue.

Taxation of Carried Interest
~~July 9, 2020~~August 4, 2022
Congress has had a long-standing interest in the tax treatment of carried interest—a form of Congress has had a long-standing interest in the tax treatment of carried interest—a form of
compensation often received by fund managers of alternative investment vehicles (e.g., private compensation often received by fund managers of alternative investment vehicles (e.g., private
Donald J. Marples
equity or hedge funds). This interest dates back to a series of hearings on the topic in 2007. Much equity or hedge funds). This interest dates back to a series of hearings on the topic in 2007. Much
Specialist in Public Finance Specialist in Public Finance
of the concern over the tax treatment of carried interest has been about its fairness and economic of the concern over the tax treatment of carried interest has been about its fairness and economic

efficiency, which may be of increased salience as investments in alternative investment vehicles efficiency, which may be of increased salience as investments in alternative investment vehicles
have grown. As of the have grown. As of the ~~second~~fourth quarter of quarter of ~~2019~~2021, private equity and hedge funds had roughly $, private equity and hedge funds had roughly $1420.3 .3

For a copy of the full report, trillion in assets under management—an increase of nearly trillion in assets under management—an increase of nearly 4063% over the past four years. % over the past four years.
please call 7-5700 or visit www.crs.gov. The current tax treatment of carried interest is the result of the intersection of several parts of The current tax treatment of carried interest is the result of the intersection of several parts of ~~t he~~ the Internal Revenue Code Internal Revenue Code
(IRC)—relating to partnerships, capital gains, qualified dividends, and property transferred for services provided. The net (IRC)—relating to partnerships, capital gains, qualified dividends, and property transferred for services provided. The net
result of these interactions is that carried interest is generally taxed as a capital gain or qualified result of these interactions is that carried interest is generally taxed as a capital gain or qualified ~~div idend~~dividend, often at a rate of , often at a rate of
20%. This 20% rate for carried interest is the top rate applicable to long-term capital gains, which applies to carried interest if 20%. This 20% rate for carried interest is the top rate applicable to long-term capital gains, which applies to carried interest if
held for more than three years. (In general, long-term capital gains tax treatment requires assets to be held for one year.) By held for more than three years. (In general, long-term capital gains tax treatment requires assets to be held for one year.) By
contrast, the top tax rate on ordinary income—for example, earned income—is 37% through the end of 2025, and 39.6% contrast, the top tax rate on ordinary income—for example, earned income—is 37% through the end of 2025, and 39.6%
thereafter.thereafter.
Arguments to change the tax treatment of carried interest are often based on the economic principles of efficiency and equity. Arguments to change the tax treatment of carried interest are often based on the economic principles of efficiency and equity.
Tax systems are generally deemed to be more efficient when they tax similar activities in a like manner. Under the current Tax systems are generally deemed to be more efficient when they tax similar activities in a like manner. Under the current
characterization of carried interest, general partners’ performance fees are taxed less heavily than other forms of characterization of carried interest, general partners’ performance fees are taxed less heavily than other forms of
compensation, leading to distortions in employment, organizational form, and compensation decisions. It is also argued that compensation, leading to distortions in employment, organizational form, and compensation decisions. It is also argued that
the current treatment of carried interest violates the principles of both horizontal and vertical equity.the current treatment of carried interest violates the principles of both horizontal and vertical equity.
Perhaps as a result of these arguments, a number of legislative proposals have been introduced over the years. The proposals Perhaps as a result of these arguments, a number of legislative proposals have been introduced over the years. The proposals
would, if enacted, tax all or some of carried interest as ordinary income or treat the granting of carried interest as a subsidized would, if enacted, tax all or some of carried interest as ordinary income or treat the granting of carried interest as a subsidized
loan. The loan. The ~~proposed Ending the Carried Interest Loophole Act (S. 1639) would treat the grant of~~Inflation Reduction Act of 2022 would increase the holding period for carried interest to qualify for long-term capital gains tax treatment to five years, broaden the definition of carried interest to include partnership assets under the taxpayer’s direct or indirect control, and add additional rules for measuring the holding period (including for tiered partnerships). ~~carried interest to a general~~
~~partner as a loan from the limited partners made at a preferred interest rate. The bill proposes interest rates above the~~
~~applicable federal rate, setting the interest rate at the average five-year corporate bond interest rate plus 9 percentage points.~~

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ongress has long taken notice of the tax treatment of carried interest—a form of ongress has long taken notice of the tax treatment of carried interest—a form of
compensation often received by fund managers of alternative investment vehicles (e.g., compensation often received by fund managers of alternative investment vehicles (e.g.,
C private equity or hedge funds). This interest dates back to a series of hearings on the topic C private equity or hedge funds). This interest dates back to a series of hearings on the topic
in 2007.1 Much of the concern over the tax treatment of carried interest has been about its fairness in 2007.1 Much of the concern over the tax treatment of carried interest has been about its fairness
and economic efficiency, which may be of increased salience as investments in alternative and economic efficiency, which may be of increased salience as investments in alternative
investment vehicles have grown. As of the investment vehicles have grown. As of the ~~second~~fourth quarter of quarter of ~~2019~~2021, private equity and hedge funds , private equity and hedge funds
had roughly $had roughly $~~14.3 tril ion~~20.4 trillion in assets under management—an increase of nearly in assets under management—an increase of nearly 4063% over the past % over the past
four years. four years.
This report begins by providing an overview of how investment funds are structured, their This report begins by providing an overview of how investment funds are structured, their
compensation structures, and their current tax treatment. The remainder of the report discusses compensation structures, and their current tax treatment. The remainder of the report discusses
concerns with the current tax treatment of carried interest and options to address these concerns.2 concerns with the current tax treatment of carried interest and options to address these concerns.2
Fund Structure and Compensation
Over the past several decades, private equity funds, venture capital funds, hedge funds, and Over the past several decades, private equity funds, venture capital funds, hedge funds, and
similar alternative investment vehicles have attracted large amounts of capital investment from similar alternative investment vehicles have attracted large amounts of capital investment from
institutional investors, such as pension funds and educational and charitable institution institutional investors, such as pension funds and educational and charitable institution
endowments, as endowments, as ~~wel~~ well as from wealthy individual investors.3 These funds pursue a wide range of as from wealthy individual investors.3 These funds pursue a wide range of
investment activities. For example, private equity funds investment activities. For example, private equity funds ~~general y~~generally acquire ownership stakes in acquire ownership stakes in
other companies and seek to profit by improving operating results or through financial other companies and seek to profit by improving operating results or through financial
restructuring, whereas hedge funds follow multiple strategies, investing in any market where restructuring, whereas hedge funds follow multiple strategies, investing in any market where
managers see profit opportunities. managers see profit opportunities.
Fund Structure
Although private equity firms and hedge funds may differ in their investment strategies, their Although private equity firms and hedge funds may differ in their investment strategies, their
structures are similar (structures are similar (seesee Figure 1). Nearly . Nearly al all are organized as partnerships, which means their are organized as partnerships, which means their
earnings are not taxed at the firm level, but rather passed through to each partner and reported on earnings are not taxed at the firm level, but rather passed through to each partner and reported on
their individualtheir individual income tax returns. Hence, most partnerships can be thought of as conduits of income tax returns. Hence, most partnerships can be thought of as conduits of
taxable income or loss and tax attributes (e.g., whether the income is treated as a capital gain or taxable income or loss and tax attributes (e.g., whether the income is treated as a capital gain or

1 Congressional hearings on carried interest in 2007 included the following:1 Congressional hearings on carried interest in 2007 included the following: U.S. Congress,U.S. Congress, Senate Committee on Senate Committee on
Finance, Finance, Carried Interest Part I, 110th Cong., July, 110th Cong., July 11, 2007, https://www.finance.senate.gov/hearings/carried-interest11, 2007, https://www.finance.senate.gov/hearings/carried-interest --
part-i; U.S. Congress,part-i; U.S. Congress, Senate Committee on Finance, Senate Committee on Finance, Carried Interest, Part II, 110th Cong., July, 110th Cong., July 30, 2007, 30, 2007,
https://www.finance.senate.gov/hearings/carried-interesthttps://www.finance.senate.gov/hearings/carried-interest -part-ii; U.S. Congress, Senate Committee on Finance, -part-ii; U.S. Congress, Senate Committee on Finance, Carried
Interest Part III: Pension Issues, 110th Cong., September 6, 2007, https://www.finance.senate.gov/hearings/carried-, 110th Cong., September 6, 2007, https://www.finance.senate.gov/hearings/carried-
interestinterest -part-iii-pension-issues; and U.S.-part-iii-pension-issues; and U.S. Congress, HouseCongress, House Committee on Ways and Means, Committee on Ways and Means, Fair and Equitable Tax
Policy for America’s Working Families, 110th Cong., September 6, 2007, https://www.govinfo.gov/content/pkg/CHRG-, 110th Cong., September 6, 2007, https://www.govinfo.gov/content/pkg/CHRG-
110hhrg43307/pdf/CHRG-110hhrg43307.pdf. 110hhrg43307/pdf/CHRG-110hhrg43307.pdf.
2 This~~2 T his~~ report does not attempt to address other tax issues related to investment funds. For further reading on this topic, report does not attempt to address other tax issues related to investment funds. For further reading on this topic,
see Greggsee Gregg D. Polsky, “A Compendium of Private Equity D. Polsky, “A Compendium of Private Equity ~~T ax~~Tax Games,” Games,” Tax Notes, February 2, 2015, pp. 615-625. , February 2, 2015, pp. 615-625.
3 Small3 Small ~~public~~ public investors are generally not able to invest in hedgeinvestors are generally not able to invest in hedge funds, becausefunds, because they lack either the they lack either the ~~asset s~~assets or the or the
income. Under U.S. law,income. Under U.S. law, the sale of shares, or interests, in an investment partnership constitutes an offering of the sale of shares, or interests, in an investment partnership constitutes an offering of
securities, and must be registered with the SECsecurities, and must be registered with the SEC if the offering is public.if the offering is public. ~~T o~~ To avoid registration and the associated avoid registration and the associated
disclosuredisclosure requirements, most funds rely on exemptions in the securities lawsrequirements, most funds rely on exemptions in the securities laws that allow them to make unregulated that allow them to make unregulated
“private” offerings. “private” offerings. ~~T o~~To qualify for these exemptions, prospective limited partners must meet various income and asset qualify for these exemptions, prospective limited partners must meet various income and asset
thresholds. (thresholds. (~~T he~~The most basic is the “accredited investor” standard—income of $200,000 or more in the past two years most basic is the “accredited investor” standard—income of $200,000 or more in the past two years
and at least $1 million in assets.) Seeand at least $1 million in assets.) See http://www.sec.gov/answers/accred.htm.http://www.sec.gov/answers/accred.htm.
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ordinary income) to the individual ordinary income) to the individual partners.4 They can, however, also be used to manipulate the partners.4 They can, however, also be used to manipulate the
~~al ocation~~allocation of tax attributes so as to shelter income and assets from taxation. of tax attributes so as to shelter income and assets from taxation.
Figure 1. Basic Private Investment Fund Structure

Source: CRS adaptation of Joint Committee CRS adaptation of Joint Committee on Taxation. on Taxation.
There are two kinds of partners in investment funds ( There are two kinds of partners in investment funds (seesee Figure 1). The fund managers, who ). The fund managers, who
guide the investment strategy, are guide the investment strategy, are general partners.5 Their background .5 Their background ~~typical y~~typically includes includes
experience at a experience at a ~~Wal~~ Wall Street investment bank. The general partners often invest their own capital in Street investment bank. The general partners often invest their own capital in
the funds, but this is the funds, but this is ~~usual y a smal~~ usually a small share of the total capital managed by the fund.6 share of the total capital managed by the fund.6
Outside investors, who contribute capital but have no say in investment or management decisions, Outside investors, who contribute capital but have no say in investment or management decisions,
are the are the limited partners. They are . They are ~~general y~~generally institutional investors—public and corporate pension institutional investors—public and corporate pension
funds, insurance companies, foundations, and endowments—or individual investors with funds, insurance companies, foundations, and endowments—or individual investors with
significant financial resources. In contrast to the general partners, limited partners’ contributions significant financial resources. In contrast to the general partners, limited partners’ contributions
~~are usual y~~are usually a large share of the total capital managed by the fund. a large share of the total capital managed by the fund.
Private funds7—a term which Private funds7—a term which ~~general y~~generally refers to private equity and hedge funds— refers to private equity and hedge funds—~~typical y~~typically
establish multiple funds to accommodate the tax-planning preferences of different investors. establish multiple funds to accommodate the tax-planning preferences of different investors.
Although these funds Although these funds ~~general y~~generally share a common pool of underlying assets, they are chartered in share a common pool of underlying assets, they are chartered in
different jurisdictions to cater to different clientele. According to SEC data, different jurisdictions to cater to different clientele. According to SEC data, ~~more than~~nearly one-third one-third
of of the 42,717~~the 32,537~~ registered private funds are registered in the Cayman Islands for tax purposes.8 registered private funds are registered in the Cayman Islands for tax purposes.8

4 Examples of tax attributes that pass through to the individual partners include tax credits and net operating losses 4 Examples of tax attributes that pass through to the individual partners include tax credits and net operating losses
(NOLs). (NOLs).
5 General partners are not required to contribute capital to form the partnership, although many contribute when the 5 General partners are not required to contribute capital to form the partnership, although many contribute when the
partnership is formed or subsequentpartnership is formed or subsequent to formation. to formation.
6 According to media reports, general partners accounted for about 3% of funds 6 According to media reports, general partners accounted for about 3% of funds raised by private equity firms in 2005. raised by private equity firms in 2005.
DowDow Jones Private Equity Analyst, “Jones Private Equity Analyst, “ Here’s Where the Capital Came From In 2005,” April 2006, p. 16. Here’s Where the Capital Came From In 2005,” April 2006, p. 16.
7 https://www.sec.gov/divisions/investment/guidance/private-fund-adviser-resources.htm 7 https://www.sec.gov/divisions/investment/guidance/private-fund-adviser-resources.htm
8 8 ~~Securities~~ U.S. Securities and Exchange Commission, and Exchange Commission, Private Fund Statistics~~, First~~: Fourth Calendar Quarter Calendar Quarter ~~2019, October 25, 2019~~2021, June 19, 2022, ,
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Foreign investors and U.S. tax-exempt institutions may prefer to invest in foreign-chartered Foreign investors and U.S. tax-exempt institutions may prefer to invest in foreign-chartered
funds, whereas other types of U.S. investors find it disadvantageous to invest in foreign funds.9 funds, whereas other types of U.S. investors find it disadvantageous to invest in foreign funds.9
A number of hedge funds and private equity partnerships have gone public by A number of hedge funds and private equity partnerships have gone public by ~~sel ing~~selling shares (or shares (or
units) in an initialunits) in an initial public offering (IPO). Their securities are now traded on the New York Stock public offering (IPO). Their securities are now traded on the New York Stock
Exchange and other major markets, and may be purchased by anyone. These firms, which include Exchange and other major markets, and may be purchased by anyone. These firms, which include
the Fortress Investment Group and Blackstone, operate much as before, but are required to file the Fortress Investment Group and Blackstone, operate much as before, but are required to file
quarterly and annual financial statements and make the full range of disclosures required by the quarterly and annual financial statements and make the full range of disclosures required by the
SEC. SEC.
Types of Compensation
Fund managers, or general partners, Fund managers, or general partners, ~~typical y~~typically receive two types of compensation for managing a receive two types of compensation for managing a
fund.10 In a common compensation agreement, general partners receive a management fee equal fund.10 In a common compensation agreement, general partners receive a management fee equal
to 2% of the invested assets plus a 20% share in profits as carried interest. This has led to the to 2% of the invested assets plus a 20% share in profits as carried interest. This has led to the
compensation structure being referred to compensation structure being referred to ~~casual y~~casually as “2 and 20.”11 Whereas the management fee is as “2 and 20.”11 Whereas the management fee is
~~general y~~generally fixed as a percentage of assets, the carried interest is variable because it is fixed as a percentage of assets, the carried interest is variable because it is ~~general y~~generally a a
share of fund profits once specified investment returns have been met (i.e., subject to a hurdle share of fund profits once specified investment returns have been met (i.e., subject to a hurdle
rate). rate).
Taxation of Carried Interest
The current tax treatment of carried interest is the result of the intersection of several parts of the The current tax treatment of carried interest is the result of the intersection of several parts of the
Internal Revenue Code (IRC)—relating to partnerships, capital gains, qualified dividends, and Internal Revenue Code (IRC)—relating to partnerships, capital gains, qualified dividends, and
property transferred for services provided.12 The net result of these interactions is that carried property transferred for services provided.12 The net result of these interactions is that carried
interest is interest is ~~general y~~generally taxed as a capital gain or qualified dividend, often at a rate of 20%. This 20% taxed as a capital gain or qualified dividend, often at a rate of 20%. This 20%
rate is the top rate applicable to long-term capital gains, which are rate is the top rate applicable to long-term capital gains, which are gains on assets held for more than a year. (The held for more than a year. (The
tax rates on qualified dividends are the same as the tax rates applicable to long-term capital tax rates on qualified dividends are the same as the tax rates applicable to long-term capital
gains.) By contrast, the top tax rate on ordinary income—for example, earned income—is 37% gains.) By contrast, the top tax rate on ordinary income—for example, earned income—is 37%
through the end of 2025, and 39.6% thereafter. through the end of 2025, and 39.6% thereafter.
The 2017 tax revision (P.L. 115-97 The 2017 tax revision (P.L. 115-97, commonly known as the Tax Cuts and Jobs Act or TCJA) ) lengthened—from one year to three years—the period for lengthened—from one year to three years—the period for
which an investment fund is required to hold assets for the carried interest to be taxed as a long-which an investment fund is required to hold assets for the carried interest to be taxed as a long-
term capital gain at a rate of 20%.13 This term capital gain at a rate of 20%.13 This ~~change theoretical y limited the preferential tax~~

https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-~~2019-q1~~2021-q4.pdf. .pdf.
9 For example, foreign investors may prefer to invest in non9 For example, foreign investors may prefer to invest in non -U.S. funds-U.S. funds to avoid creating a U.S.to avoid creating a U.S. tax presence or paying tax presence or paying
U.S.U.S. tax on the fund’s earnings, whiletax on the fund’s earnings, while tax-exempt institutions may prefer non-U.S. funds (relative to other U.S. tax-exempt institutions may prefer non-U.S. funds (relative to other U.S.
investors) becauseinvestors) because they do not pay taxes on repatriated earnings. they do not pay taxes on repatriated earnings.
10 Limited partners receive their profits as interests that are generally taxed as capital gains. 10 Limited partners receive their profits as interests that are generally taxed as capital gains.
~~11 T his~~ 11 This terminology for hedge fund compensation is generally attributed to Victor Fleischer, “ terminology for hedge fund compensation is generally attributed to Victor Fleischer, “~~T wo and T wenty: T axing~~Two and Twenty: Taxing
Partnership Profits in Private Equity Funds,” Partnership Profits in Private Equity Funds,” New York University Law Review, 2008. , 2008. ~~T he~~The actual mix of compensation actual mix of compensation
is set in the individualis set in the individual partnership agreements. See Ingo Stoff and Reiner Braun, “partnership agreements. See Ingo Stoff and Reiner Braun, “~~T he~~The Evolution of Private Equity Evolution of Private Equity
FundFund ~~T erms~~ Terms Beyond 2 and 20,” Beyond 2 and 20,” Journal of Applied Corporate Finance, vol. 26, no. 1 (Winter 2014), for discussion of , vol. 26, no. 1 (Winter 2014), for discussion of
this evolution. this evolution.
12 A full description of these interactions can be found in U.S. 12 A full description of these interactions can be found in U.S. Congress, Joint Committee on Congress, Joint Committee on ~~T axation~~Taxation, , Present Law
and Analysis Relating to Tax ~~Treatm ent~~Treatment of Partnership Carried Interests,, committee print, 110th Cong., July 10, 2007, committee print, 110th Cong., July 10, 2007,
JCX-41-07. JCX-41-07.
13 Carried interest held less 13 Carried interest held less than three years is taxed as ordinary income at a maximum rate of 37%.than three years is taxed as ordinary income at a maximum rate of 37%.
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change theoretically limited the preferential tax treatment of carried interest—though the actual effect is uncertain given that funds customarily treatment of carried interest—though the actual effect is uncertain given that funds customarily
employ five- to seven-year holding periods.14employ five- to seven-year holding periods.14
Although capital gains income is included when calculating the net investment income tax Although capital gains income is included when calculating the net investment income tax
(NIIT), carried interest received by fund managers is likely exempt. The NIIT is an additional (NIIT), carried interest received by fund managers is likely exempt. The NIIT is an additional
3.8% tax on certain net investment income when a taxpayer’s income is above statutory 3.8% tax on certain net investment income when a taxpayer’s income is above statutory
thresholds.15 The NIIT does not apply to active partnership income, which would likely exempt thresholds.15 The NIIT does not apply to active partnership income, which would likely exempt
carried interest received by fund managers.16 carried interest received by fund managers.16
Policy Proposals for the Taxation of Carried
Interest17
Arguments to retain the current tax treatment of carried interest often center on how increasing Arguments to retain the current tax treatment of carried interest often center on how increasing
taxes on general partners’ compensation would reduce their incentive to start investment funds. taxes on general partners’ compensation would reduce their incentive to start investment funds.
That reduced incentive, in turn, could diminish innovation and possibly make private equity That reduced incentive, in turn, could diminish innovation and possibly make private equity
markets—and consequently businesses—less efficient. It is unclear to what extent the current markets—and consequently businesses—less efficient. It is unclear to what extent the current
treatment of carried interest promotes innovation and market efficiency. treatment of carried interest promotes innovation and market efficiency.
Arguments to change the tax treatment of carried interest are often based on the economic Arguments to change the tax treatment of carried interest are often based on the economic
principles of efficiency and equity. Tax systems are principles of efficiency and equity. Tax systems are ~~general y~~generally deemed to be more efficient when deemed to be more efficient when
they tax similar activities in a like manner. Critics note that under the current characterization of they tax similar activities in a like manner. Critics note that under the current characterization of
carried interest, general partners’ performance fees are taxed less heavily than other forms of carried interest, general partners’ performance fees are taxed less heavily than other forms of
compensation, leading to distortions in employment, organizational form, and compensation compensation, leading to distortions in employment, organizational form, and compensation
decisions.18 As a result of these distortions, critics maintain that the economy decisions.18 As a result of these distortions, critics maintain that the economy ~~misal ocates~~misallocates its its
scarce resources. This scarce resources. This ~~misal ocation~~misallocation could result in investment funds choosing riskier investments could result in investment funds choosing riskier investments
in an effort to exceed the hurdle rates required for the granting of carried interest. in an effort to exceed the hurdle rates required for the granting of carried interest.
Critics also argue that the current treatment of carried interest violates the principles of both Critics also argue that the current treatment of carried interest violates the principles of both
horizontal and vertical equity. Horizontalhorizontal and vertical equity. Horizontal equity holds that individuals with the same income equity holds that individuals with the same income
should owe the same in taxes regardless of the income’s form. Vertical equity holds that should owe the same in taxes regardless of the income’s form. Vertical equity holds that
individualsindividuals who earn more should pay more in taxes than those who earn less. The following who earn more should pay more in taxes than those who earn less. The following
sections discuss various proposals regarding the taxation of carried interest. sections discuss various proposals regarding the taxation of carried interest.
Maintain the Current Tax Treatment of Carried Interest
Policymakers may choose to maintain the current tax treatment of carried interest, effectively Policymakers may choose to maintain the current tax treatment of carried interest, effectively
taxing it as a long-term capital gain in most cases. This option reflects a view that the current tax taxing it as a long-term capital gain in most cases. This option reflects a view that the current tax
treatment of carried interest strikes an appropriate policy balance. According to the chief treatment of carried interest strikes an appropriate policy balance. According to the chief
executive officer of the American Investment Council, an industry advocacy group, raising taxes executive officer of the American Investment Council, an industry advocacy group, raising taxes

14 Adrian M. Schrock, David H. Benz, and Sal14 Adrian M. Schrock, David H. Benz, and Sal (Kislay) Shah, “(Kislay) Shah, “~~T CJA Renews Focus~~ TCJA Renews Focus on Carried Interest Models for on Carried Interest Models for
Private Equity Funds,”Private Equity Funds,” Crowe LLP, JulyCrowe LLP, July 24, 2018, https://www.crowe.com/insights/tcja-renews-focus-on-carried-24, 2018, https://www.crowe.com/insights/tcja-renews-focus-on-carried-
interestinterest -models-for-private-equity-funds. -models-for-private-equity-funds.
15 Income above $200,000 ($250,000) is subject to this tax for single (married) tax filers. 15 Income above $200,000 ($250,000) is subject to this tax for single (married) tax filers.
16 Donald Marron, 16 Donald Marron, Goldilocks Meets Private Equity: Taxing Carried Interest Just Right, , ~~T ax~~Tax Policy Center, October 6, Policy Center, October 6,
2016, p. 15. 2016, p. 15.
17 17 ~~T his~~This section does not attempt to provide a comprehensive list of all policy options, but instead covers the range that section does not attempt to provide a comprehensive list of all policy options, but instead covers the range that
has been actively debated over the past decade. has been actively debated over the past decade.
18 Aviva Aron-Dine, 18 Aviva Aron-Dine, An Analysis of the “Carried Interest” Controversy, Center on Budget, Center on Budget and Policy Priorities, and Policy Priorities,
AugustAugust 1, 2007. 1, 2007.
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on carried interest would discourage entrepreneurship and investment.19 Others assert that on carried interest would discourage entrepreneurship and investment.19 Others assert that
increasing the taxation of carried interest would result in a reduction in the rate of return to increasing the taxation of carried interest would result in a reduction in the rate of return to
investors—including pension funds and other institutional investors. In addition, some have investors—including pension funds and other institutional investors. In addition, some have
argued that the issue is more nuanced than it argued that the issue is more nuanced than it ~~initial y~~ initially appears and that an appears and that an ~~economical y~~economically optimal optimal
treatment is not possible.20 treatment is not possible.20
Taxation of Carried Interest as Ordinary Income
Policymakers may choose to change the current tax treatment of carried interest and tax it like Policymakers may choose to change the current tax treatment of carried interest and tax it like
ordinary income (e.g., salaries, wages). Multiple commentators over the past decade have ordinary income (e.g., salaries, wages). Multiple commentators over the past decade have
suggested that carried interest is the return to the general partner’s labor effort and should suggested that carried interest is the return to the general partner’s labor effort and should
therefore be taxed as labor income (including being subject to payroll taxes).21 In the therefore be taxed as labor income (including being subject to payroll taxes).21 In the ~~116th~~117th
Congress, the Carried Interest Fairness Act (S. Congress, the Carried Interest Fairness Act (S. ~~781~~1598 and H.R. and H.R. ~~1735~~1068) has proposed this change. ) has proposed this change.
According to the Congressional Budget Office, According to the Congressional Budget Office, ~~this option would raise $14 bil ion~~ a prior version of this option would have raised $14 billion in tax revenues ~~in tax revenues~~
over the 2019-2028 budget window.22 over the 2019-2028 budget window.22
This option’s proponents argue that the general partner is being compensated for providing the This option’s proponents argue that the general partner is being compensated for providing the
labor to generate a positive return on investment for the fund—similar to how other workers labor to generate a positive return on investment for the fund—similar to how other workers
provide their services to their employers. From this view, the current-law tax treatment of carried provide their services to their employers. From this view, the current-law tax treatment of carried
interest violates the principle of horizontal equity because carried interest income is taxed interest violates the principle of horizontal equity because carried interest income is taxed
differently than other forms of labor income.23 This violation of horizontal equity holds as long as differently than other forms of labor income.23 This violation of horizontal equity holds as long as
carried interest is analogous to either wages or performance-based compensation (e.g., a bonus). carried interest is analogous to either wages or performance-based compensation (e.g., a bonus).
Opponents have criticized these proposals, asserting that they have the potential to tax carried Opponents have criticized these proposals, asserting that they have the potential to tax carried
interest too heavily. For example, one researcher argued that recharacterizing carried interest as interest too heavily. For example, one researcher argued that recharacterizing carried interest as
ordinary income would result in excessive taxation without other reforms.24 Opponents also ordinary income would result in excessive taxation without other reforms.24 Opponents also
raised concerns that increased taxation would encourage general partners to direct investment to raised concerns that increased taxation would encourage general partners to direct investment to
riskier options. Why this would occur is unclear, as a change in tax rates faced by fund managers riskier options. Why this would occur is unclear, as a change in tax rates faced by fund managers
would apply to the disposition of assets and not the choice of which assets to hold.25 would apply to the disposition of assets and not the choice of which assets to hold.25
Some commentators have also argued that taxing Some commentators have also argued that taxing al all carried interest as ordinary income would carried interest as ordinary income would
not be appropriate based on the view that a portion of carried interest is a return on the investment not be appropriate based on the view that a portion of carried interest is a return on the investment

19 Naomi Jagoda,19 Naomi Jagoda, ~~“T op~~ “Top Finance Democrat offers bill to end tax ‘loophole’ Finance Democrat offers bill to end tax ‘loophole’ ~~T rump~~Trump pledged to eliminate,” pledged to eliminate,” The Hill, May , May
23, 2019. 23, 2019.
20 Alan Viard, 20 Alan Viard, ~~“T he T axation~~ “The Taxation of Carried Interest: Understanding the Issues,” of Carried Interest: Understanding the Issues,” National Tax Issue, vol. 61, no. 3 , vol. 61, no. 3
(September 2008), pp. 445-460. (September 2008), pp. 445-460.
21 See21 See Steven M. Rosenthal, Steven M. Rosenthal, Taxing Private Equity Funds as Corporate “Developers,,” Urban Institute, January 28, Urban Institute, January 28,
2013, https://www.urban.org/research/publication/taxing-private-equity-funds-corporate-developers and “2013, https://www.urban.org/research/publication/taxing-private-equity-funds-corporate-developers and “ Monsters, Monsters,
Inc?” Inc?” The Economist, January 28, 2012, as examples of this view. , January 28, 2012, as examples of this view.
22 Sen. Baldwin22 Sen. Baldwin and Rep. Pascrell have pointed to the Congressional Budgetand Rep. Pascrell have pointed to the Congressional Budget Office, Office, Options for Reducing the Deficit:
2019 to 2028, December 13, 2018 (https://www.cbo.gov/publication/54667), as an estimate of their legislative , December 13, 2018 (https://www.cbo.gov/publication/54667), as an estimate of their legislative
proposal’s revenue-raising potential. proposal’s revenue-raising potential.
23 23 ~~T he~~The principle of horizontal equity is based principle of horizontal equity is based on the idea that taxpayers with equal income shouldon the idea that taxpayers with equal income should pay equalpay equal taxes. A taxes. A
second application of this principle to carried interest is that all income earned from the provision of labor shouldsecond application of this principle to carried interest is that all income earned from the provision of labor should be be
taxed the same. taxed the same.
24 Donald Marron, 24 Donald Marron, Goldilocks Meets Private Equity: Taxing Carried Interest Just Right, Urban-Brookings , Urban-Brookings ~~T ax~~Tax Policy Policy
Center, October 7, 2016. Center, October 7, 2016. ~~T o~~To the extent that the fund’s limited partners are tax-exempt or foreign persons not subject to the extent that the fund’s limited partners are tax-exempt or foreign persons not subject to
U.S.U.S. tax, the issue of doubletax, the issue of double taxation is irrelevant. taxation is irrelevant. ~~T he~~The argument presented was based argument presented was based on the fact that management fees on the fact that management fees
werewere then deductiblethen deductible against ordinary income. against ordinary income. ~~T he~~The 2017 tax revision 2017 tax revision eliminated the deductibility of investment eliminated the deductibility of investment
expenses. In addition, the author’s preferred policy option would facilitate tax arbitrage opportunities where expenses expenses. In addition, the author’s preferred policy option would facilitate tax arbitrage opportunities where expenses
couldcould offset income taxed as ordinary income instead of beingoffset income taxed as ordinary income instead of being realized asrealized as income taxed as income taxed as ~~ca pital~~capital gains. gains.
25 Theoretically~~25 T heoretically~~, higher tax rates can actually encourage risk-taking by reducing, higher tax rates can actually encourage risk-taking by reducing variance in the return to risk—if full variance in the return to risk—if full
loss offsets are available. loss offsets are available.
Congressional Research Service Congressional Research Service

5 5

Taxation of Carried Interest

of human capital from the general partners. The general partners’ sweat equity—or “enterprise of human capital from the general partners. The general partners’ sweat equity—or “enterprise
value”—is more broadly used to describe the portion of a fund’s increased value that can be value”—is more broadly used to describe the portion of a fund’s increased value that can be
attributed to the fund’s good track record or valued brand (i.e., attributed to the fund’s good track record or valued brand (i.e., ~~goodwil~~ goodwill). In this view, the fund ). In this view, the fund
manager is analogous to a business owner contributing labor to a business—and should face manager is analogous to a business owner contributing labor to a business—and should face
capital gains taxes upon the sale of the business. This analogy may hold for investment funds capital gains taxes upon the sale of the business. This analogy may hold for investment funds
listed and sold on public stock exchanges. However, it appears to break down when applied to listed and sold on public stock exchanges. However, it appears to break down when applied to
income derived from fund operations because profits from business operations are income derived from fund operations because profits from business operations are ~~general y~~
generally treated as ordinary income. treated as ordinary income.
Taxation of a Portion of Carried Interest as Ordinary Income
Policymakers may choose to tax part of carried interest as ordinary income and part as a long-Policymakers may choose to tax part of carried interest as ordinary income and part as a long-
term capital gain. Perhaps as a result of general concerns about the potential to tax carried interest term capital gain. Perhaps as a result of general concerns about the potential to tax carried interest
too heavily, several policy proposals have too heavily, several policy proposals have ~~cal ed~~called for taxing a portion of carried interest as for taxing a portion of carried interest as
ordinary income. In the 111th Congress, a House-passed amendment to the American Jobs and ordinary income. In the 111th Congress, a House-passed amendment to the American Jobs and
Closing Tax Loopholes Act of 2010 (H.R. 4213) would have treated a portion of carried interest Closing Tax Loopholes Act of 2010 (H.R. 4213) would have treated a portion of carried interest
as ordinary income. Alternatively, the CUT Loopholes Act (S. 268 in the 113th Congress) would as ordinary income. Alternatively, the CUT Loopholes Act (S. 268 in the 113th Congress) would
have addressed concerns about the “enterprise value” portion of carried interest by taxing the have addressed concerns about the “enterprise value” portion of carried interest by taxing the
~~goodwil~~ goodwill component of carried interest as a capital gain, but the remaining carried interest as component of carried interest as a capital gain, but the remaining carried interest as
ordinary income. However, valuing the components of carried interest is not straightforward ordinary income. However, valuing the components of carried interest is not straightforward
because the return on intangible assets, such as enterprise value, is difficult to directly determine. because the return on intangible assets, such as enterprise value, is difficult to directly determine.
In addition to In addition to ~~partial y~~partially addressing economic equity concerns, these proposals addressing economic equity concerns, these proposals ~~general y~~generally would would
have taxed carried interest income only when it was realized (through the have taxed carried interest income only when it was realized (through the ~~sel ing~~selling of fund assets). of fund assets).
Thus, these Thus, these ~~bil s~~bills did not address deferral, whereby taxpayers can choose to delay recognition of did not address deferral, whereby taxpayers can choose to delay recognition of
~~income to future years.~~
~~Taxation of Carried Interest as a Loan~~
~~As an alternative to resolve the valuation difficulties, two legislative proposals would treat the~~
~~grant of carried interest to the general partner as a loan from the limited partners made at a~~
~~preferred interest rate.26 Senate Finance Committee Ranking Member Ron Wyden (in the Ending~~
~~the Carried Interest Loophole Act, S. 1639, 116th~~income to future years. Modifying the Capital Gains Holding Period for Carried Interest Policymakers may choose to change the capital gains holding period for carried interest. If the holding period is increased, this change could increase the amount of carried interest taxed as a short-term capital gain. As discussed above, this approach was enacted by the TCJA, which increased the period for which an investment fund is required to hold assets for the carried interest to be taxed as a long-term capital gain—from one year to three years. A committee report for the TCJA included the following reason for this change: “The Committee believes that the lower rates that apply to long-term capital gain from sales or exchanges of capital assets of partnerships should not be available to holders of applicable partnership interests unless an extended holding period requirement has been met.”26 The Inflation Reduction Act of 2022 would extend the holding period to five years for certain taxpayers.27 26 U.S. Congress, House Committee on Ways and Means, Tax Cuts and Jobs Act, H.R. 1 together with Dissenting and Additional Views, 115th Cong., 1st sess., November 13, 2017, H.Rept. 115-409, p. 277. 27 The legislative text of the Inflation Reduction Act of 2022 is available at https://www.democrats.senate.gov/07/27/2022/inflation-reduction-act-of-2022. In addition to extending the holding period to qualify for long-term capital gains rates, the legislation would make additional changes to the tax treatment of carried interest by broadening the definition of carried interest to include partnership assets under the taxpayer’s direct or indirect control, and adding additional rules for measuring the holding period (including for tiered partnerships). Congressional Research Service 6 link to page 5 link to page 5 Taxation of Carried Interest Taxation of Carried Interest as a Loan As an alternative to resolve the valuation difficulties, two legislative proposals would treat the grant of carried interest to the general partner as a loan from the limited partners made at a preferred interest rate.28 Senate Finance Committee Ranking Member Ron Wyden (in the Ending the Carried Interest Loophole Act, S. 2617, 117th Congress) and former House Ways and Means Congress) and former House Ways and Means
Committee Chairman Dave Camp (in the Tax Reform Act of 2014, H.R. 1, 113th Congress) each Committee Chairman Dave Camp (in the Tax Reform Act of 2014, H.R. 1, 113th Congress) each
introduced legislation that would treat carried interest in this manner, though the proposals differ introduced legislation that would treat carried interest in this manner, though the proposals differ
along a number of dimensions.along a number of dimensions.2729 The proposals would The proposals would ~~general y~~generally tax fund managers currently at tax fund managers currently at
ordinary income tax rates on the difference between an “adequate” amount of interest on the loan ordinary income tax rates on the difference between an “adequate” amount of interest on the loan
and the amount of interest paid to limitedand the amount of interest paid to limited partners as interest from the fund managers. Any gains partners as interest from the fund managers. Any gains
fund managers received from subsequently fund managers received from subsequently ~~sel ing~~selling the share in the fund that represent carried the share in the fund that represent carried
interest would then be taxed at capital gains tax rates. interest would then be taxed at capital gains tax rates.
Determining the reference rate needed to set the “adequate” amount of interest requires an Determining the reference rate needed to set the “adequate” amount of interest requires an
element of judgement. Internal Revenue Code Section 7872 uses the applicable federal rate (as element of judgement. Internal Revenue Code Section 7872 uses the applicable federal rate (as
determined by interest rates on U.S. treasury debt) as a reference for a below-market loan. This determined by interest rates on U.S. treasury debt) as a reference for a below-market loan. This
rate is rate is ~~general y~~generally considered the risk-free rate of return and may not be appropriate to apply to considered the risk-free rate of return and may not be appropriate to apply to

~~26 T his treatment is analogous to the cost -of-capital approach discussed in Victor Fleischer, “ T wo and T wenty: T axing~~
~~Partnership Profits in Private Equity Funds,” New York University Law Review, 2008.~~
~~27 One of the notable differences is that the T ax Reform Act of 2014 would have exempted real estate partnerships from~~
~~this change in tax treatment.~~
~~Congressional Research Service~~

6

~~link to page 5 link to page 5~~ ~~Taxation of Carried Interest~~

~~carried interest, given the risky nature of fund investments.28~~carried interest, given the risky nature of fund investments.30 Both the Ending Carried Interest Both the Ending Carried Interest
Loophole Act and the Tax Reform Act of 2014 proposed interest rates above the applicable Loophole Act and the Tax Reform Act of 2014 proposed interest rates above the applicable
federal rate.federal rate.2931
Additional Policy Concerns
In addition to the issues identified above, discussions have occurred on several other issues In addition to the issues identified above, discussions have occurred on several other issues
related to carried interest. related to carried interest.
The Use of Offshore Entities
Investment funds may adopt more complex structures than the basic example provided iInvestment funds may adopt more complex structures than the basic example provided in Figure
1. A structure may include a foreign corporation inserted between the investment fund and certain A structure may include a foreign corporation inserted between the investment fund and certain
types of investors—types of investors—~~typical y~~typically the fund’s foreign and tax-exempt investors—to address specific the fund’s foreign and tax-exempt investors—to address specific
concerns with U.S. taxes and U.S.-based fund managers. These “blocker corporations” are concerns with U.S. taxes and U.S.-based fund managers. These “blocker corporations” are
~~general y~~generally incorporated in low-tax or zero-tax foreign jurisdictions. incorporated in low-tax or zero-tax foreign jurisdictions.
U.S. tax-exempt investors (e.g., pension funds or university endowments) may prefer the use of U.S. tax-exempt investors (e.g., pension funds or university endowments) may prefer the use of
blocker corporations to shield the tax-exempt investor from the unrelated business income tax blocker corporations to shield the tax-exempt investor from the unrelated business income tax
(UBIT). UBIT income is (UBIT). UBIT income is ~~general y~~generally income earned by tax-exempt organizations on activity not 28 This treatment is analogous to the cost-of-capital approach discussed in Victor Fleischer, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” New York University Law Review, 2008. 29 One of the notable differences is that the Tax Reform Act of 2014 would have exempted real estate partnerships from this change in tax treatment. 30 U.S. Congress, Joint Committee on Taxation, Present Law and Analysis Related to the Tax Treatment of Partnership Carried Interests and Related Issues, Part 1, committee print, 110th Cong, and U.S. Congress, Joint Committee on Taxation, Present Law and Analysis Related to the Tax Treatment of Partnership Carried Interests and Related Issues, Part 2, committee print, 110th Cong., September 4, 2007, JCX-63-07. 31 The Ending Carried Interest Loophole Act would set the interest rate at the average five-year corporate bond interest rate plus 9 percentage points, while the Tax Reform Act of 2014 would have set the interest rate at the federal long-term interest rate plus 10 percentage points. Congressional Research Service 7 Taxation of Carried Interest ~~income earned by tax-exempt organizations on activity not~~
connected to their exempt purpose.connected to their exempt purpose.3032 In the absence of a blocker corporation, the investment In the absence of a blocker corporation, the investment
income financed by debt would income financed by debt would ~~general y~~generally be taxed at the 21% corporate tax rate. be taxed at the 21% corporate tax rate.
This structure is also This structure is also ~~general y~~generally beneficial for foreign investors (such as sovereign wealth funds), beneficial for foreign investors (such as sovereign wealth funds),
because it can reduce the likelihood that they are subject to U.S. tax or reporting requirements. because it can reduce the likelihood that they are subject to U.S. tax or reporting requirements.
The use of a blocker corporation does not The use of a blocker corporation does not ~~general y~~generally result in a reduction of total U.S. tax liability result in a reduction of total U.S. tax liability
for foreign investors.for foreign investors.3133
These more complex structures that include foreign blocker corporations provide a tax deferral These more complex structures that include foreign blocker corporations provide a tax deferral
opportunity not opportunity not ~~general y~~generally available available to an entirely U.S.-based fund structure. This deferral to an entirely U.S.-based fund structure. This deferral
opportunity can arise if the carried interest in the foreign corporation is structured as a contractual opportunity can arise if the carried interest in the foreign corporation is structured as a contractual
right instead of the right instead of the ~~general y~~generally used profits interest that is subject to forfeit. Further, the value of the used profits interest that is subject to forfeit. Further, the value of the
carried interest can compound over time, increasing the benefits of deferral. Then-House carried interest can compound over time, increasing the benefits of deferral. Then-House
Committee on Ways and Means Chairman Rangel introduced several Committee on Ways and Means Chairman Rangel introduced several ~~bil s~~bills in the 110th Congress in the 110th Congress
(H.R. 3996, H.R. 4351, and H.R. 6049) that would have included compensation deferred through (H.R. 3996, H.R. 4351, and H.R. 6049) that would have included compensation deferred through
~~foreign corporations as income to the fund manager in the year earned.~~

~~28 U.S. Congress, Joint Committee on T axation,~~ ~~Present Law and Analysis Related to the Tax Treatment of Partnership~~
~~Carried Interests and Related Issues, Part 1, committee print, 110th Cong, and U.S. Congress, Joint Committee on~~
~~T axation,~~ ~~Present Law and Analysis Related to the Tax Treatm ent of Partnership Carried Interests and Related Issues,~~
~~Part 2, committee print, 110th Cong., September 4, 2007, JCX-63-07.~~
~~29 T he Ending Carried Interest Loophole Act would set the interest rate at the average five-year corporate bond interest~~
~~rate plus 9 percentage points, while the T ax Reform Act of 2014 would have set the interest rate at the federal long-~~
~~term interest rate plus 10 percentage points.~~
~~30 See CRS~~ foreign corporations as income to the fund manager in the year earned. Payroll Taxes Although it is not directly linked to the taxation of carried interest, capital gains income is not subject to payroll taxes.34 If carried interest (or a part of it) were treated as earned income, then the income would be subject to payroll taxes. This would be most relevant to the 2.9% Medicare Hospital Insurance tax, which is not subject to an income cap.35 In addition, recharacterized income could also be subject to the 0.9% Medicare tax that applies to (earned) income over statutory thresholds.36 A number of the proposals mentioned above would have subjected carried interest to these payroll taxes. Author Information Donald J. Marples Specialist in Public Finance 32 See CRS Report R45922, Report R45922, Tax Issues Relating to Charitable Contributions and Organizations, by Jane G. Gravelle, , by Jane G. Gravelle,
Donald J. Marples, and Molly F. SherlockDonald J. Marples, and Molly F. Sherlock ; and CRS; and CRS Report R44293, Report R44293, College and University ~~Endowm ents~~Endowments: Overview
and Tax Policy Options, by Molly F. Sherlock et al. , by Molly F. Sherlock et al.
31 33 Deferred compensation arrangements are significantly less common in U.S.-chartered funds Deferred compensation arrangements are significantly less common in U.S.-chartered funds ~~because~~ because they result in they result in
investors losing the deduction associatedinvestors losing the deduction associated with compensation and facing higher tax with compensation and facing higher tax ~~liabilitie s.~~
~~Congressional Research Service~~

7

~~Taxation of Carried Interest~~

~~Payroll Taxes~~
~~Although it is not directly linked to the taxation of carried interest, capital gains income is not~~
~~subject to payroll taxes.32 If carried interest (or a part of it) were treated as earned income, then~~
~~the income would be subject to payroll taxes. This would be most relevant to the 2.9% Medicare~~
~~Hospital Insurance tax, which is not subject to an income cap.33 In addition, recharacterized~~
~~income could also be subject to the 0.9% Medicare tax that applies to (earned) income over~~
~~statutory thresholds.34 A number of the proposals mentioned above would have subjected carried~~
~~interest to these payroll taxes.~~

~~Author Information~~

~~Donald J. Marples~~

~~Specialist in Public Finance~~

liabilities. 34 See CRS Report R40425, Medicare Primer, coordinated by Patricia A. Davis, for more detail on Medicare finance. 35 In contrast, Social Security payroll taxes apply to a maximum of $137,700 in earnings in 2020. This cap is adjusted annually for inflation. 36 Income above $200,000 ($250,000) is subject to this tax for single (married) tax filers. Congressional Research Service 8 Taxation of Carried Interest

Disclaimer
This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan
shared staff to congressional committees and Members of Congress. It operates solely at the behest of and shared staff to congressional committees and Members of Congress. It operates solely at the behest of and
under the direction of Congress. Information in a CRS Report should under the direction of Congress. Information in a CRS Report should ~~n ot~~not be relied upon for purposes other be relied upon for purposes other
than public understanding of information that has been provided by CRS to Members of Congress in than public understanding of information that has been provided by CRS to Members of Congress in
connection with CRS’s institutional role. CRS Reports, as a work of the United States Government, are not connection with CRS’s institutional role. CRS Reports, as a work of the United States Government, are not
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copy or otherwise use copyrighted material. copy or otherwise use copyrighted material.

~~32 See CRS Report R40425, Medicare Primer, coordinated by Patricia A. Davis for more detail on Medicare finance.~~
~~33 In contrast, Social Security payroll taxes apply to a maximum of $137,700 in earnings in 2020. T his cap is adjusted~~
~~annually for inflation.~~
~~34 Income above $200,000 ($250,000) is subject to this tax for single (married) tax filers.~~
~~Congressional Research Service~~
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