Carried interest is income that is typically earned by partners in private equity funds. Since carried interest is treated as a capital gain for tax purposes, it has drawn scrutiny in recent years because it stretches the definition of a capital gain.
Private Equity Defined
Private equity funds invest in privately-held businesses of a certain minimum size. Companies with $1 million or more in EBITDA are considered middle-market businesses (or lower middle market businesses). (Note: EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization.) Middle market businesses are large enough to attract the interest of institutional investors (as opposed to individual investors). The most common of these institutional investors are private equity firms.
Private Equity Returns
In a nutshell, private equity firms use investor money to buy private businesses and sell them at a profit in the future. They then return the original capital, plus a profit, to their investors. The private equity fund gets a share of the profit as their reward for making a good investment.
Taxation of Carried Interest
This income to the private equity firm/partner is the carried interest. Rather than being taxed as ordinary income, carried interest is taxed as capital gains. Since the capital gains tax rate is significantly lower than the ordinary income tax rate, it is an important tax benefit to private equity firms and investors. Many people consider it to be a tax loophole. Consequently, it has received some attention lately. The Tax Policy Center does a good job explaining carried interest in their article here.
Carried Interest Taxation Update
Since the original publishing of this article, U.S. tax law was changed in 2017. According to the Tax Policy Center, the minimum holding period for treatment as a capital gain was increased to 3 years from 1 year. Since the typical holding period for private equity investments exceeds 3 years, the impact on the taxation of these investments is zero in most cases.