The carried interest loophole has long been a source of debate in U.S. tax policy. While it primarily affects private equity and hedge fund managers, it also plays a role in broader discussions around tax fairness and high-income earners.
In essence, the loophole allows certain investment professionals to pay long-term capital gains tax rates, which are lower than ordinary income tax rates, on money they receive for managing other people’s investments. This tax treatment has been criticized as unfair, since it allows wealthy individuals to pay lower tax rates than many middle-class workers.
This guide explains how the carried interest loophole works, the tax advantages it provides, why it’s controversial, and how recent and proposed reforms could reshape the tax landscape for fund managers and investors.
How Carried Interest Works
Carried interest refers to the share of profits that investment fund managers receive from successful investment returns—typically about 20% of the fund’s gains. This share is earned without the manager contributing significant capital, which sets it apart from other investment returns.
Here’s how it typically works:
- An investment fund pools money from investors, such as pension funds, institutional investors, and high-net-worth individuals.
- The fund is managed by a general partner (the fund manager) and financed primarily by limited partners (the investors).
- The general partner receives a management fee (usually 2% of assets) and carried interest (often 20% of profits above a certain return threshold).
- The carried interest is the portion of the fund’s gains that the manager receives for their work—but instead of being taxed as compensation, it’s taxed as a capital gain because it’s linked to investment performance.
This means that, even though carried interest functions like a performance bonus, it is taxed at a maximum rate of 20%, rather than the top ordinary income tax rate of 37%.
Tax Benefits and Controversy Around the Carried Interest Loophole
The primary benefit of the carried interest loophole is that it allows fund managers to pay significantly lower taxes on a substantial portion of their income. Capital gains tax rates are much lower than ordinary income tax rates, especially for high earners.
For example, if a fund manager earns $5 million in carried interest, they would pay around $1 million in taxes under the capital gains rate—compared to over $1.8 million if it were taxed as ordinary income.
Critics argue that this tax treatment is unfair for several reasons:
- It favors wealthy individuals who are already among the top income earners in the country.
- It treats labor as investment—even though carried interest is compensation for managing other people’s money, not from investing personal capital.
- It creates an uneven playing field—middle-class workers who earn wages or salaries are taxed at higher effective rates.
Supporters of the current treatment argue that it incentivizes long-term investment and helps grow the economy. They claim that taxing carried interest as capital gains is justified because the fund manager’s earnings are tied to the performance of long-term investments.
However, most economists and tax policy experts agree that the loophole provides an outsized benefit to a small, wealthy group of professionals.
Legislative Efforts to Close the Carried Interest Loophole
Efforts to eliminate or limit the carried interest loophole have been ongoing for more than a decade, with multiple proposals introduced in Congress.
Several bills have aimed to reclassify carried interest as ordinary income, ensuring it is taxed at higher rates. However, strong lobbying from the private equity and hedge fund industries has helped prevent major changes.
Here are some key legislative moments:
- Dodd-Frank Era (2010s) – Initial efforts to close the loophole gained traction following the financial crisis but ultimately stalled.
- Tax Cuts and Jobs Act of 2017 – Rather than closing the loophole, the law increased the holding period for carried interest from 1 year to 3 years in order to qualify for long-term capital gains treatment. This modest change was seen as a compromise.
- Build Back Better Act (2021) – Included provisions to end the loophole by treating carried interest as ordinary income, but those provisions were dropped during negotiations.
- Inflation Reduction Act (2022) – Originally included carried interest reforms, but those were removed to gain enough votes for passage.
Although there is ongoing political pressure to close the loophole, no major legislation has passed to eliminate it entirely. Future tax reform proposals may revisit the issue.
Impact of Carried Interest on High-Income Taxpayers
While the carried interest loophole is highly specific to fund managers and general partners in investment firms, it is often used as an example of how the tax code disproportionately benefits the ultra-wealthy.
Here’s how it affects high-income taxpayers:
- Unequal tax treatment – Investment fund managers earning millions through carried interest pay lower tax rates than many doctors, lawyers, or corporate executives who earn ordinary income.
- Contributes to wealth inequality – By allowing high earners to retain more of their income, the loophole widens the gap between the wealthiest individuals and the rest of the population.
- Influences tax planning strategies – Some high-net-worth individuals structure their compensation to mimic carried interest, seeking to benefit from the lower capital gains rate.
Although the average taxpayer is not directly affected by the carried interest loophole, its presence in the tax code reflects broader debates about fairness, economic growth, and tax reform.
If the loophole is eventually closed, high-income fund managers will likely see their tax bills increase significantly—shifting more tax revenue to the federal government.
Who Benefits Most from the Carried Interest Loophole?
The carried interest loophole primarily benefits a small but highly influential group of professionals in the financial industry. Understanding who gains the most from this tax treatment helps clarify why it’s been so resistant to reform.
- Private equity fund managers – These individuals manage large investment funds that acquire, restructure, and sell companies. Their compensation often includes carried interest, giving them a significant tax advantage on their earnings.
- Hedge fund managers – While less reliant on long-term investments, some hedge fund managers still qualify for carried interest treatment, especially when gains are held for three years or more.
- Real estate investment professionals – Some real estate fund managers also benefit from the loophole when profits from long-term property investments are structured to qualify as carried interest.
- Venture capital firms – Venture capitalists backing early-stage startups often receive carried interest when successful exits generate returns for their limited partners.
For these groups, the carried interest loophole can result in millions of dollars in tax savings each year. Because of the financial stakes involved, there has been strong lobbying to preserve the current tax treatment—despite growing public scrutiny and bipartisan interest in reform.
Understanding who benefits from the loophole offers insight into how tax policy shapes income inequality and wealth distribution at the highest levels of the economy.
Need Professional Tax Assistance?
The carried interest loophole is one of the most debated tax provisions in the United States. It allows fund managers to pay capital gains tax rates on what is essentially compensation for their services—resulting in significant tax savings for some of the wealthiest individuals.
While efforts to close the loophole have repeatedly failed, the topic remains at the forefront of tax reform discussions. If legislative changes do occur, they could have serious implications for private equity professionals, fund managers, and other high-income earners.
At Dimov Tax, we stay ahead of the curve on proposed tax reforms and how they impact clients across all income levels. Whether you’re navigating complex investment income, structuring compensation, or planning for potential changes in the tax code, our team provides personalized tax guidance to help you stay compliant and tax-efficient.
Contact Dimov Tax today to understand how current tax rules—and possible future changes—may affect your financial strategy.