Taxation of Carried Interest
Taxation of Carried Interest
August 4, 2022
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
Donald J. Marples
equity or hedge funds). This interest dates back to a series of hearings on the topic in 2007. Much
Specialist in Public Finance
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
have grown. As of the fourth quarter of 2021, private equity and hedge funds had roughly $20.3
For a copy of the full report,
trillion in assets under management—an increase of nearly 63% 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
Internal Revenue Code (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
dividend, 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 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% thereafter.
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
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
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
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 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).
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Contents
Fund Structure and Compensation .................................................................................................. 1
Fund Structure ........................................................................................................................... 1
Types of Compensation ............................................................................................................. 3
Taxation of Carried Interest ............................................................................................................. 3
Policy Proposals for the Taxation of Carried Interest ...................................................................... 4
Maintain the Current Tax Treatment of Carried Interest ........................................................... 4
Taxation of Carried Interest as Ordinary Income ...................................................................... 5
Taxation of a Portion of Carried Interest as Ordinary Income .................................................. 6
Modifying the Capital Gains Holding Period for Carried Interest ............................................ 6
Taxation of Carried Interest as a Loan ...................................................................................... 7
Additional Policy Concerns ............................................................................................................. 7
The Use of Offshore Entities ..................................................................................................... 7
Payroll Taxes ............................................................................................................................. 8
Figures
Figure 1. Basic Private Investment Fund Structure ......................................................................... 2
Contacts
Author Information .......................................................................................................................... 8
Congressional Research Service
link to page 5 Taxation of Carried Interest
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.,
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
and economic efficiency, which may be of increased salience as investments in alternative
investment vehicles have grown. As of the fourth quarter of 2021, private equity and hedge funds
had roughly $20.4 trillion in assets under management—an increase of nearly 63% over the past
four years.
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
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
similar alternative investment vehicles have attracted large amounts of capital investment from
institutional investors, such as pension funds and educational and charitable institution
endowments, as well as from wealthy individual investors.3 These funds pursue a wide range of
investment activities. For example, private equity funds generally acquire ownership stakes in
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
managers see profit opportunities.
Fund Structure
Although private equity firms and hedge funds may differ in their investment strategies, their
structures are similar (see Figure 1). Nearly all 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
their individual 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
1 Congressional hearings on carried interest in 2007 included the following: U.S. Congress, Senate Committee on
Finance, Carried Interest Part I, 110th Cong., July 11, 2007, https://www.finance.senate.gov/hearings/carried-interest-
part-i; U.S. Congress, Senate Committee on Finance, Carried Interest, Part II, 110th Cong., July 30, 2007,
https://www.finance.senate.gov/hearings/carried-interest-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-
interest-part-iii-pension-issues; and U.S. Congress, House 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-
110hhrg43307/pdf/CHRG-110hhrg43307.pdf.
2 This report does not attempt to address other tax issues related to investment funds. For further reading on this topic,
see Gregg D. Polsky, “A Compendium of Private Equity Tax Games,” Tax Notes, February 2, 2015, pp. 615-625.
3 Small public investors are generally not able to invest in hedge funds, because they lack either the assets or the
income. Under U.S. law, the sale of shares, or interests, in an investment partnership constitutes an offering of
securities, and must be registered with the SEC if the offering is public. To avoid registration and the associated
disclosure requirements, most funds rely on exemptions in the securities laws that allow them to make unregulated
“private” offerings. To qualify for these exemptions, prospective limited partners must meet various income and asset
thresholds. (The 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.) See http://www.sec.gov/answers/accred.htm.
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Taxation of Carried Interest
ordinary income) to the individual partners.4 They can, however, also be used to manipulate the
allocation 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 on Taxation.
There are two kinds of partners in investment funds (see Figure 1). The fund managers, who
guide the investment strategy, are general partners.5 Their background typically includes
experience at a Wall Street investment bank. The general partners often invest their own capital in
the funds, but this is usually a small share of the total capital managed by the fund.6
Outside investors, who contribute capital but have no say in investment or management decisions,
are the limited partners. They are generally institutional investors—public and corporate pension
funds, insurance companies, foundations, and endowments—or individual investors with
significant financial resources. In contrast to the general partners, limited partners’ contributions
are usually a large share of the total capital managed by the fund.
Private funds7—a term which generally refers to private equity and hedge funds—typically
establish multiple funds to accommodate the tax-planning preferences of different investors.
Although these funds generally share a common pool of underlying assets, they are chartered in
different jurisdictions to cater to different clientele. According to SEC data, nearly one-third of
the 42,717 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
(NOLs).
5 General partners are not required to contribute capital to form the partnership, although many contribute when the
partnership is formed or subsequent to formation.
6 According to media reports, general partners accounted for about 3% of funds raised by private equity firms in 2005.
Dow Jones Private Equity Analyst, “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
8 U.S. Securities and Exchange Commission, Private Fund Statistics: Fourth Calendar Quarter 2021, June 19, 2022,
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Taxation of Carried Interest
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
A number of hedge funds and private equity partnerships have gone public by selling shares (or
units) in an initial 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
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
SEC.
Types of Compensation
Fund managers, or general partners, typically receive two types of compensation for managing a
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
compensation structure being referred to casually as “2 and 20.”11 Whereas the management fee is
generally fixed as a percentage of assets, the carried interest is variable because it is generally a
share of fund profits once specified investment returns have been met (i.e., subject to a hurdle
rate).
Taxation of Carried Interest
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
property transferred for services provided.12 The net result of these interactions is that carried
interest is generally 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 gains on assets held for more
than a year. (The 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% through the end of 2025, and 39.6% thereafter.
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 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
https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q4.pdf.
9 For example, foreign investors may prefer to invest in non-U.S. funds to avoid creating a U.S. tax presence or paying
U.S. tax on the fund’s earnings, while tax-exempt institutions may prefer non-U.S. funds (relative to other U.S.
investors) because they do not pay taxes on repatriated earnings.
10 Limited partners receive their profits as interests that are generally taxed as capital gains.
11 This terminology for hedge fund compensation is generally attributed to Victor Fleischer, “Two and Twenty: Taxing
Partnership Profits in Private Equity Funds,” New York University Law Review, 2008. The actual mix of compensation
is set in the individual partnership agreements. See Ingo Stoff and Reiner Braun, “The Evolution of Private Equity
Fund Terms Beyond 2 and 20,” Journal of Applied Corporate Finance, vol. 26, no. 1 (Winter 2014), for discussion of
this evolution.
12 A full description of these interactions can be found in U.S. Congress, Joint Committee on Taxation, Present Law
and Analysis Relating to Tax Treatment of Partnership Carried Interests, committee print, 110th Cong., July 10, 2007,
JCX-41-07.
13 Carried interest held less than three years is taxed as ordinary income at a maximum rate of 37%.
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Taxation of Carried Interest
change theoretically limited the preferential tax treatment of carried interest—though the actual
effect is uncertain given that funds customarily employ five- to seven-year holding periods.14
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
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
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
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
markets—and consequently businesses—less efficient. It is unclear to what extent the current
treatment of carried interest promotes innovation and market efficiency.
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. Critics note that under the current 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.18 As a result of these distortions, critics maintain that the economy misallocates its
scarce resources. This misallocation could result in investment funds choosing riskier investments
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
horizontal and vertical equity. Horizontal equity holds that individuals with the same income
should owe the same in taxes regardless of the income’s form. Vertical equity holds that
individuals 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.
Maintain the Current Tax Treatment of Carried Interest
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
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
14 Adrian M. Schrock, David H. Benz, and Sal (Kislay) Shah, “TCJA Renews Focus on Carried Interest Models for
Private Equity Funds,” Crowe LLP, July 24, 2018, https://www.crowe.com/insights/tcja-renews-focus-on-carried-
interest-models-for-private-equity-funds.
15 Income above $200,000 ($250,000) is subject to this tax for single (married) tax filers.
16 Donald Marron, Goldilocks Meets Private Equity: Taxing Carried Interest Just Right, Tax Policy Center, October 6,
2016, p. 15.
17 This 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.
18 Aviva Aron-Dine, An Analysis of the “Carried Interest” Controversy, Center on Budget and Policy Priorities,
August 1, 2007.
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Taxation of Carried Interest
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
investors—including pension funds and other institutional investors. In addition, some have
argued that the issue is more nuanced than it initially appears and that an economically optimal
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
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
therefore be taxed as labor income (including being subject to payroll taxes).21 In the 117th
Congress, the Carried Interest Fairness Act (S. 1598 and H.R. 1068) has proposed this change.
According to the Congressional Budget Office, a prior version of this option would have raised
$14 billion in tax revenues over the 2019-2028 budget window.22
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
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
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).
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
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
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
Some commentators have also argued that taxing all 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
19 Naomi Jagoda, “Top Finance Democrat offers bill to end tax ‘loophole’ Trump pledged to eliminate,” The Hill, May
23, 2019.
20 Alan Viard, “The Taxation of Carried Interest: Understanding the Issues,” National Tax Issue, vol. 61, no. 3
(September 2008), pp. 445-460.
21 See Steven M. Rosenthal, Taxing Private Equity Funds as Corporate “Developers,” Urban Institute, January 28,
2013, https://www.urban.org/research/publication/taxing-private-equity-funds-corporate-developers and “Monsters,
Inc?” The Economist, January 28, 2012, as examples of this view.
22 Sen. Baldwin and Rep. Pascrell have pointed to the Congressional Budget Office, Options for Reducing the Deficit:
2019 to 2028, December 13, 2018 (https://www.cbo.gov/publication/54667), as an estimate of their legislative
proposal’s revenue-raising potential.
23 The principle of horizontal equity is based on the idea that taxpayers with equal income should pay equal taxes. A
second application of this principle to carried interest is that all income earned from the provision of labor should be
taxed the same.
24 Donald Marron, Goldilocks Meets Private Equity: Taxing Carried Interest Just Right, Urban-Brookings Tax Policy
Center, October 7, 2016. To the extent that the fund’s limited partners are tax-exempt or foreign persons not subject to
U.S. tax, the issue of double taxation is irrelevant. The argument presented was based on the fact that management fees
were then deductible against ordinary income. The 2017 tax revision eliminated the deductibility of investment
expenses. In addition, the author’s preferred policy option would facilitate tax arbitrage opportunities where expenses
could offset income taxed as ordinary income instead of being realized as income taxed as capital gains.
25 Theoretically, higher tax rates can actually encourage risk-taking by reducing variance in the return to risk—if full
loss offsets are available.
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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
attributed to the fund’s good track record or valued brand (i.e., goodwill). In this view, the fund
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
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 generally
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-
term capital gain. Perhaps as a result of general concerns about the potential to tax carried interest
too heavily, several policy proposals have called for taxing a portion of carried interest as
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
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
goodwill 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
because the return on intangible assets, such as enterprise value, is difficult to directly determine.
In addition to partially addressing economic equity concerns, these proposals generally would
have taxed carried interest income only when it was realized (through the selling of fund assets).
Thus, these bills did not address deferral, whereby taxpayers can choose to delay recognition of
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).
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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
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
along a number of dimensions.29 The proposals would generally tax fund managers currently at
ordinary income tax rates on the difference between an “adequate” amount of interest on the loan
and the amount of interest paid to limited partners as interest from the fund managers. Any gains
fund managers received from subsequently selling the share in the fund that represent carried
interest would then be taxed at capital gains tax rates.
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
determined by interest rates on U.S. treasury debt) as a reference for a below-market loan. This
rate is generally considered the risk-free rate of return and may not be appropriate to apply to
carried interest, given the risky nature of fund investments.30 Both the Ending Carried Interest
Loophole Act and the Tax Reform Act of 2014 proposed interest rates above the applicable
federal rate.31
Additional Policy Concerns
In addition to the issues identified above, discussions have occurred on several other issues
related to carried interest.
The Use of Offshore Entities
Investment 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
types of investors—typically 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
generally 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
blocker corporations to shield the tax-exempt investor from the unrelated business income tax
(UBIT). UBIT income is 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.
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connected to their exempt purpose.32 In the absence of a blocker corporation, the investment
income financed by debt would generally be taxed at the 21% corporate tax rate.
This structure is also generally 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.
The use of a blocker corporation does not generally result in a reduction of total U.S. tax liability
for foreign investors.33
These more complex structures that include foreign blocker corporations provide a tax deferral
opportunity not generally available 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
right instead of the generally 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
Committee on Ways and Means Chairman Rangel introduced several bills in the 110th Congress
(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.
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, Tax Issues Relating to Charitable Contributions and Organizations, by Jane G. Gravelle,
Donald J. Marples, and Molly F. Sherlock; and CRS Report R44293, College and University Endowments: Overview
and Tax Policy Options, by Molly F. Sherlock et al.
33 Deferred compensation arrangements are significantly less common in U.S.-chartered funds because they result in
investors losing the deduction associated with compensation and facing higher tax 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.
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Congressional Research Service
R46447 · VERSION 2 · UPDATED
9
August 4, 2022
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
Donald J. Marples
equity or hedge funds). This interest dates back to a series of hearings on the topic in 2007. Much
Specialist in Public Finance
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
have grown. As of the fourth quarter of 2021, private equity and hedge funds had roughly $20.3
For a copy of the full report,
trillion in assets under management—an increase of nearly 63% 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
Internal Revenue Code (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
dividend, 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 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% thereafter.
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
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
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
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 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).
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Contents
Fund Structure and Compensation .................................................................................................. 1
Fund Structure ........................................................................................................................... 1
Types of Compensation ............................................................................................................. 3
Taxation of Carried Interest ............................................................................................................. 3
Policy Proposals for the Taxation of Carried Interest ...................................................................... 4
Maintain the Current Tax Treatment of Carried Interest ........................................................... 4
Taxation of Carried Interest as Ordinary Income ...................................................................... 5
Taxation of a Portion of Carried Interest as Ordinary Income .................................................. 6
Modifying the Capital Gains Holding Period for Carried Interest ............................................ 6
Taxation of Carried Interest as a Loan ...................................................................................... 7
Additional Policy Concerns ............................................................................................................. 7
The Use of Offshore Entities ..................................................................................................... 7
Payroll Taxes ............................................................................................................................. 8
Figures
Figure 1. Basic Private Investment Fund Structure ......................................................................... 2
Contacts
Author Information .......................................................................................................................... 8
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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.,
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
and economic efficiency, which may be of increased salience as investments in alternative
investment vehicles have grown. As of the fourth quarter of 2021, private equity and hedge funds
had roughly $20.4 trillion in assets under management—an increase of nearly 63% over the past
four years.
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
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
similar alternative investment vehicles have attracted large amounts of capital investment from
institutional investors, such as pension funds and educational and charitable institution
endowments, as well as from wealthy individual investors.3 These funds pursue a wide range of
investment activities. For example, private equity funds generally acquire ownership stakes in
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
managers see profit opportunities.
Fund Structure
Although private equity firms and hedge funds may differ in their investment strategies, their
structures are similar (see Figure 1). Nearly all 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
their individual 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
1 Congressional hearings on carried interest in 2007 included the following: U.S. Congress, Senate Committee on
Finance, Carried Interest Part I, 110th Cong., July 11, 2007, https://www.finance.senate.gov/hearings/carried-interest-
part-i; U.S. Congress, Senate Committee on Finance, Carried Interest, Part II, 110th Cong., July 30, 2007,
https://www.finance.senate.gov/hearings/carried-interest-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-
interest-part-iii-pension-issues; and U.S. Congress, House 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-
110hhrg43307/pdf/CHRG-110hhrg43307.pdf.
2 This report does not attempt to address other tax issues related to investment funds. For further reading on this topic,
see Gregg D. Polsky, “A Compendium of Private Equity Tax Games,” Tax Notes, February 2, 2015, pp. 615-625.
3 Small public investors are generally not able to invest in hedge funds, because they lack either the assets or the
income. Under U.S. law, the sale of shares, or interests, in an investment partnership constitutes an offering of
securities, and must be registered with the SEC if the offering is public. To avoid registration and the associated
disclosure requirements, most funds rely on exemptions in the securities laws that allow them to make unregulated
“private” offerings. To qualify for these exemptions, prospective limited partners must meet various income and asset
thresholds. (The 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.) See http://www.sec.gov/answers/accred.htm.
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ordinary income) to the individual partners.4 They can, however, also be used to manipulate the
allocation 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 on Taxation.
There are two kinds of partners in investment funds (see Figure 1). The fund managers, who
guide the investment strategy, are general partners.5 Their background typically includes
experience at a Wall Street investment bank. The general partners often invest their own capital in
the funds, but this is usually a small share of the total capital managed by the fund.6
Outside investors, who contribute capital but have no say in investment or management decisions,
are the limited partners. They are generally institutional investors—public and corporate pension
funds, insurance companies, foundations, and endowments—or individual investors with
significant financial resources. In contrast to the general partners, limited partners’ contributions
are usually a large share of the total capital managed by the fund.
Private funds7—a term which generally refers to private equity and hedge funds—typically
establish multiple funds to accommodate the tax-planning preferences of different investors.
Although these funds generally share a common pool of underlying assets, they are chartered in
different jurisdictions to cater to different clientele. According to SEC data, nearly one-third of
the 42,717 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
(NOLs).
5 General partners are not required to contribute capital to form the partnership, although many contribute when the
partnership is formed or subsequent to formation.
6 According to media reports, general partners accounted for about 3% of funds raised by private equity firms in 2005.
Dow Jones Private Equity Analyst, “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
8 U.S. Securities and Exchange Commission, Private Fund Statistics: Fourth Calendar Quarter 2021, June 19, 2022,
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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
A number of hedge funds and private equity partnerships have gone public by selling shares (or
units) in an initial 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
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
SEC.
Types of Compensation
Fund managers, or general partners, typically receive two types of compensation for managing a
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
compensation structure being referred to casually as “2 and 20.”11 Whereas the management fee is
generally fixed as a percentage of assets, the carried interest is variable because it is generally a
share of fund profits once specified investment returns have been met (i.e., subject to a hurdle
rate).
Taxation of Carried Interest
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
property transferred for services provided.12 The net result of these interactions is that carried
interest is generally 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 gains on assets held for more
than a year. (The 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% through the end of 2025, and 39.6% thereafter.
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 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
https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q4.pdf.
9 For example, foreign investors may prefer to invest in non-U.S. funds to avoid creating a U.S. tax presence or paying
U.S. tax on the fund’s earnings, while tax-exempt institutions may prefer non-U.S. funds (relative to other U.S.
investors) because they do not pay taxes on repatriated earnings.
10 Limited partners receive their profits as interests that are generally taxed as capital gains.
11 This terminology for hedge fund compensation is generally attributed to Victor Fleischer, “Two and Twenty: Taxing
Partnership Profits in Private Equity Funds,” New York University Law Review, 2008. The actual mix of compensation
is set in the individual partnership agreements. See Ingo Stoff and Reiner Braun, “The Evolution of Private Equity
Fund Terms Beyond 2 and 20,” Journal of Applied Corporate Finance, vol. 26, no. 1 (Winter 2014), for discussion of
this evolution.
12 A full description of these interactions can be found in U.S. Congress, Joint Committee on Taxation, Present Law
and Analysis Relating to Tax Treatment of Partnership Carried Interests, committee print, 110th Cong., July 10, 2007,
JCX-41-07.
13 Carried interest held less 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 employ five- to seven-year holding periods.14
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
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
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
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
markets—and consequently businesses—less efficient. It is unclear to what extent the current
treatment of carried interest promotes innovation and market efficiency.
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. Critics note that under the current 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.18 As a result of these distortions, critics maintain that the economy misallocates its
scarce resources. This misallocation could result in investment funds choosing riskier investments
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
horizontal and vertical equity. Horizontal equity holds that individuals with the same income
should owe the same in taxes regardless of the income’s form. Vertical equity holds that
individuals 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.
Maintain the Current Tax Treatment of Carried Interest
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
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
14 Adrian M. Schrock, David H. Benz, and Sal (Kislay) Shah, “TCJA Renews Focus on Carried Interest Models for
Private Equity Funds,” Crowe LLP, July 24, 2018, https://www.crowe.com/insights/tcja-renews-focus-on-carried-
interest-models-for-private-equity-funds.
15 Income above $200,000 ($250,000) is subject to this tax for single (married) tax filers.
16 Donald Marron, Goldilocks Meets Private Equity: Taxing Carried Interest Just Right, Tax Policy Center, October 6,
2016, p. 15.
17 This 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.
18 Aviva Aron-Dine, An Analysis of the “Carried Interest” Controversy, Center on Budget and Policy Priorities,
August 1, 2007.
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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
investors—including pension funds and other institutional investors. In addition, some have
argued that the issue is more nuanced than it initially appears and that an economically optimal
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
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
therefore be taxed as labor income (including being subject to payroll taxes).21 In the 117th
Congress, the Carried Interest Fairness Act (S. 1598 and H.R. 1068) has proposed this change.
According to the Congressional Budget Office, a prior version of this option would have raised
$14 billion in tax revenues over the 2019-2028 budget window.22
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
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
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).
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
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
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
Some commentators have also argued that taxing all 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
19 Naomi Jagoda, “Top Finance Democrat offers bill to end tax ‘loophole’ Trump pledged to eliminate,” The Hill, May
23, 2019.
20 Alan Viard, “The Taxation of Carried Interest: Understanding the Issues,” National Tax Issue, vol. 61, no. 3
(September 2008), pp. 445-460.
21 See Steven M. Rosenthal, Taxing Private Equity Funds as Corporate “Developers,” Urban Institute, January 28,
2013, https://www.urban.org/research/publication/taxing-private-equity-funds-corporate-developers and “Monsters,
Inc?” The Economist, January 28, 2012, as examples of this view.
22 Sen. Baldwin and Rep. Pascrell have pointed to the Congressional Budget Office, Options for Reducing the Deficit:
2019 to 2028, December 13, 2018 (https://www.cbo.gov/publication/54667), as an estimate of their legislative
proposal’s revenue-raising potential.
23 The principle of horizontal equity is based on the idea that taxpayers with equal income should pay equal taxes. A
second application of this principle to carried interest is that all income earned from the provision of labor should be
taxed the same.
24 Donald Marron, Goldilocks Meets Private Equity: Taxing Carried Interest Just Right, Urban-Brookings Tax Policy
Center, October 7, 2016. To the extent that the fund’s limited partners are tax-exempt or foreign persons not subject to
U.S. tax, the issue of double taxation is irrelevant. The argument presented was based on the fact that management fees
were then deductible against ordinary income. The 2017 tax revision eliminated the deductibility of investment
expenses. In addition, the author’s preferred policy option would facilitate tax arbitrage opportunities where expenses
could offset income taxed as ordinary income instead of being realized as income taxed as capital gains.
25 Theoretically, higher tax rates can actually encourage risk-taking by reducing variance in the return to risk—if full
loss offsets are available.
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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
attributed to the fund’s good track record or valued brand (i.e., goodwill). In this view, the fund
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
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 generally
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-
term capital gain. Perhaps as a result of general concerns about the potential to tax carried interest
too heavily, several policy proposals have called for taxing a portion of carried interest as
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
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
goodwill 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
because the return on intangible assets, such as enterprise value, is difficult to directly determine.
In addition to partially addressing economic equity concerns, these proposals generally would
have taxed carried interest income only when it was realized (through the selling of fund assets).
Thus, these bills did not address deferral, whereby taxpayers can choose to delay recognition of
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).
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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
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
along a number of dimensions.29 The proposals would generally tax fund managers currently at
ordinary income tax rates on the difference between an “adequate” amount of interest on the loan
and the amount of interest paid to limited partners as interest from the fund managers. Any gains
fund managers received from subsequently selling the share in the fund that represent carried
interest would then be taxed at capital gains tax rates.
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
determined by interest rates on U.S. treasury debt) as a reference for a below-market loan. This
rate is generally considered the risk-free rate of return and may not be appropriate to apply to
carried interest, given the risky nature of fund investments.30 Both the Ending Carried Interest
Loophole Act and the Tax Reform Act of 2014 proposed interest rates above the applicable
federal rate.31
Additional Policy Concerns
In addition to the issues identified above, discussions have occurred on several other issues
related to carried interest.
The Use of Offshore Entities
Investment 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
types of investors—typically 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
generally 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
blocker corporations to shield the tax-exempt investor from the unrelated business income tax
(UBIT). UBIT income is 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.
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connected to their exempt purpose.32 In the absence of a blocker corporation, the investment
income financed by debt would generally be taxed at the 21% corporate tax rate.
This structure is also generally 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.
The use of a blocker corporation does not generally result in a reduction of total U.S. tax liability
for foreign investors.33
These more complex structures that include foreign blocker corporations provide a tax deferral
opportunity not generally available 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
right instead of the generally 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
Committee on Ways and Means Chairman Rangel introduced several bills in the 110th Congress
(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.
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, Tax Issues Relating to Charitable Contributions and Organizations, by Jane G. Gravelle,
Donald J. Marples, and Molly F. Sherlock; and CRS Report R44293, College and University Endowments: Overview
and Tax Policy Options, by Molly F. Sherlock et al.
33 Deferred compensation arrangements are significantly less common in U.S.-chartered funds because they result in
investors losing the deduction associated with compensation and facing higher tax 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.
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