Why fund managers pay 13 points less tax than their investors on the same profits
Private equity and hedge fund managers receive a profit share taxed as capital gains, not wages, creating a 13-percentage-point tax advantage that reform efforts have repeatedly failed to close.
Carried interest—the share of profits that private equity and hedge fund managers receive—comes with a significant tax advantage that has survived decades of reform attempts. These managers pay a federal tax rate of 23.8 percent on their carried interest, combining a 20 percent capital gains tax and 3.8 percent net investment income tax. The investors whose money they manage typically pay ordinary income tax rates as high as 37 percent on their compensation.
This 13.2-percentage-point difference creates a form of selective tax treatment: managers of capital get preferential rates while workers who generate the fees that fund operations pay higher rates on wages. The structure has prompted repeated reform attempts across multiple administrations—Obama proposed elimination, Trump called it "getting away with murder," and Biden included it in the Build Back Better bill—yet each has stalled against industry opposition and political gridlock. Understanding how this works, and why it persists, matters for anyone evaluating where fund manager compensation actually comes from and how it shapes investment incentives.
The split between management fees and carried interest
Fund managers receive compensation through two distinct channels. Management fees—typically 1.5 to 2 percent of assets under management annually—function as ordinary income. They are taxed at ordinary rates, reaching 37 percent at the top federal bracket.
Carried interest is different. It represents a manager's share of profits, conventionally 20 percent of gains beyond a threshold known as the hurdle rate. A manager might invest 1 to 5 percent of a fund's capital and receive carried interest on all profits exceeding the hurdle rate or high-water mark. The profits themselves, under current law, are characterized as long-term capital gains if held long enough.
The combination creates what is known in the industry as a "two and twenty" structure: the 2 percent annual management fee plus 20 percent of profits. The tax outcome: carried interest at 23.8 percent faces ordinary income treatment at 37 percent. Over ten years, a 2018 Congressional Budget Office report estimated that classifying carried interest as ordinary income would raise $14 billion in federal revenue.
This means that a private equity or hedge fund manager earning $100 million in carried interest would pay approximately $23.8 million in federal tax, while a worker earning $100 million in wages would pay approximately $37 million. The manager of the fund also retains the reinvestment advantage: money kept in capital gains can compound at the after-tax rate of 76.2 percent rather than the 63 percent available after ordinary income taxation.
The origins and rationale for capital gains treatment
Carried interest did not originate in finance. The term traces to 13th-century Venetian trade, when investors offered seafaring merchants a quarter of the overall profits from goods sold in foreign markets as a return on the merchants' effort and risk.
The U.S. tax code's treatment of partnership income reinforced this logic. Under Subchapter K of the tax code, partners in a partnership are taxed according to the character of the income earned by the partnership. If the fund earns long-term capital gains, the general partner's carried interest is also taxed as long-term capital gains. This framework treats a manager's performance-based profit share as economically equivalent to capital appreciation, not as compensation for services.
Tax lawyers and academics have long argued this characterization misclassifies what carried interest actually is: compensation for service. In most other industries, success fees, bonuses, and performance payments are taxed as ordinary income. A film producer's percentage of box office receipts, a litigation lawyer's contingency fee, or a real estate agent's commission are all ordinary income. But fund managers' percentage of profits remain capital gains, a distinction that has created what critics call the "carried interest loophole."
How Section 1061 changed the rules in 2017
For decades, carried interest qualified for long-term capital gains treatment after a one-year holding period. The Tax Cuts and Jobs Act of 2017 introduced Section 1061, which extended that holding period to three years for "applicable partnership interests" held by individuals performing substantial services. The change was modest but real: it reduced the advantage without eliminating it.
Under Section 1061, capital gains held for three years or longer still qualify for the 20 percent rate. Gains recognized within three years face ordinary income tax rates reaching 37 percent. The regulation also created a critical "capital interest exception": managers who have invested their own capital can claim that a portion of their gains reflects returns on that investment rather than compensation for services, and those portions may still qualify for favorable treatment even within the three-year window.
The capital interest exception requires that "allocations on capital interests must be reasonably consistent" with those given to unrelated investors, considering capital amount, timing, returns, and risk levels. A service provider cannot claim a capital interest exception simply by investing one dollar alongside investors. The partnership agreement must clearly identify capital interests separately from carried interests, and contemporaneous records must document the distinction.
The IRS finalized Section 1061 regulations on January 7, 2021, after releasing proposed regulations on July 31, 2020. These regulations clarified that when a partnership sells property, the partnership's holding period—not the individual manager's holding period in their interest—determines whether a three-year requirement is met. A manager can combine the partnership's holding period with their own when receiving in-kind distributions. For example, if a partnership held property for 2 years 9 months and distributed it to a carried interest holder who held it 6 months before selling, the combined period exceeds three years, qualifying the gain for long-term treatment.
Why carried interest reform keeps failing
Reform proposals have emerged from the Obama, Trump, and Biden administrations, each taking different approaches but none succeeding in changing the underlying tax treatment. During his first term, Trump's Treasury negotiated a compromise through the 2017 Tax Cuts and Jobs Act that extended holding periods but left the core advantage intact. Trump publicly said fund managers were "getting away with murder" on taxes, yet his administration chose to merely lengthen the timeline rather than eliminate the preference.
The Biden administration included carried interest elimination in the Build Back Better bill in 2021, framing it as ensuring wealthy individuals do not "pay a lower tax rate than a teacher or a firefighter." But the provision was quietly removed during Senate negotiations. Senator Kyrsten Sinema drew a hard line against closure during Democratic deliberations, forcing party leadership to drop the language.
Yet no legislative action followed. Reaching agreement on specifics has proven difficult; industry groups representing private equity firms, venture capital funds, and real estate partnerships have lobbied successfully against change.
Industry lobbying spending tells part of the story. Carried interest lobbying expenditures jumped from $3.6 million in 2006 to approximately $75 million over four years as reform pressure intensified. Law firms and consulting groups that represent the private equity industry mobilized across multiple fronts, arguing that carried interest encourages long-term investment and job creation.
“A manager who will pay 37 percent tax on management fees but only 23.8 percent on carried interest gains faces a tax-induced incentive to delay distributions and hold assets longer.”
Why the compensation structure endures
The persistence of carried interest taxation reflects both structural and political factors. Legally, carried interest is structured as a capital gain allocation from a partnership, and the tax code has long treated capital gains favorably. Changing that treatment requires reclassifying how partnership income flows to service providers, a complexity that gives legislative opponents room to argue about implementation details.
Politically, the private equity industry has resisted change across Democratic and Republican administrations. The firms employing carried interest holders include some of the most sophisticated actors in Washington, with deep relationships to both parties. Large investment firms employ sophisticated tax planning, hire top lobbying talent, and contribute substantially to political campaigns. While reform proposals have drawn bipartisan support among some lawmakers concerned about tax fairness, they have not overcome the industry's capacity to block legislation in divided Congresses or delay action in moments when other priorities occupy attention.
The carried interest debate also highlights disagreement about what constitutes "loophole" versus legitimate tax policy. Supporters argue that carried interest represents real capital at risk and aligns managers' long-term interests with investors. Critics respond that a compensation arrangement structured as profit-sharing should be taxed as compensation. The fact that neither side has overwhelming political support suggests the dispute will persist.
What this means for fund managers and returns
The carried interest structure creates genuine incentives for long-term holding and alignment between managers and investors. A manager who will pay 37 percent tax on management fees but only 23.8 percent on carried interest gains faces a tax-induced incentive to delay distributions and hold assets longer. Whether this incentive generates value or merely postpones capital redeployment remains central to the reform debate.
For investors, the structure is economically significant. If a fund manager retains 20 percent of profits at a 23.8 percent effective tax rate, the net is approximately 15.2 percent retained after tax. The same profits flowing to an investor or employee as ordinary income might retain only 63 percent after tax. Over ten-year holding periods and billion-dollar funds, the difference compounds substantially.
The 2018 Congressional Budget Office estimate of $14 billion in ten-year revenue from taxing carried interest as ordinary income is among the figures cited in the reform debate. The fact that carried interest has survived reform attempts from multiple administrations suggests that the coalition defending it remains resilient, even as the gap between fund manager and investor tax rates persists as one of the most discussed features of American tax law.
