Carried interest

Carried interest is the profit-sharing component of hedge fund compensation. Fund managers only receive this compensation when their fund performs well and generates profits above certain benchmarks. Think of it as a performance bonus that rewards successful investing.

The concept comes from the shipping industry. Ship captains historically received a share of profits from the cargo they "carried" across the ocean. In hedge funds today, carried interest refers to the manager's contractual right to share in fund profits beyond what their own money invested would normally earn.

Here's how it typically works: managers receive 20% of net profits above a high-water mark—the fund's previous peak value. This ensures managers only get paid when they recover any previous losses for investors first. However, institutional investors with more bargaining power increasingly negotiate for lower rates or additional performance requirements.

This structure aligns the interests of fund managers and investors. Managers only earn carried interest when their investors make money, creating strong incentives for good performance.

The tax treatment of carried interest depends on how the compensation is structured. When organized as a partnership allocation rather than a service fee, carried interest may qualify for capital gainsProfits realized from the sale of capital assets, typically taxed at preferential rates compared to ordinary income. tax rates instead of ordinary income rates. Since capital gains rates are typically lower than ordinary income rates, this creates significant tax advantages for fund managers.

However, Congress modified this treatment in 2017 with Section 1061Tax code provision enacted in 2017 requiring assets to be held for three years before carried interest can qualify for long-term capital gains treatment. of the Internal Revenue Code. This law now requires assets to be held for three years before carried interest can qualify for long-term capital gains treatment. Previously, the holding period was only one year. Under current law, carried interest from assets held for three years or less gets taxed at ordinary income rates.

To receive this preferential tax treatment, several conditions must be met. The compensation must represent a genuine partnership profit interest rather than disguised fees for services. Additionally, funds must be structured as partnerships or LLCs that elect partnership tax treatment, and the allocations must reflect real economic arrangements rather than predetermined compensation formulas.

Fund managers typically use specialized partnership structureLegal arrangements that organize business entities as partnerships for operational, tax, and regulatory purposes. to separate different income streams and optimize taxes. Most hedge fund managers create what's called a "multi-headed structure." In this arrangement, a management company receives management fee while separate fund general partner receive carried interest allocations.

Here's how it works: the management company operates as a limited partnership to minimize self-employment tax on profit distributions to the fund managers who are limited partner. Meanwhile, the fund general partners are structured as limited liability companies that receive only carried interest allocations—no fee income.

This structure can also reduce local business taxes in some jurisdictions. For example, New York City's Unincorporated Business TaxLocal business tax imposed by New York City on unincorporated businesses operating within the city. applies to businesses receiving fee income but generally not to entities receiving only profit allocations. For management companies in New York City, this separation can create meaningful tax savings.

Partnership tax rules require annual income allocation for tax purposes, which creates specific requirements for how carried interest works in practice. Carried interest allocations are typically calculated at year-end based on fund performance relative to high-water marks. Importantly, managers receive tax allocations even when no cash is actually distributed to them.

For funds with multi-year lock-up period Lock-up period A lock-up period is a specified timeframe during which investors in a hedge fund are prohibited from redeeming their investment, designed to provide the manager with stable capital to execute the investment strategy. where investors cannot withdraw money, some managers implement performance measurement periods that align with when investors can actually access their funds. These structures may involve provisional allocations that can be adjusted based on subsequent performance, creating more sophisticated clawback Clawback provision A clawback provision is a contractual term that requires hedge fund managers to return previously received performance compensation if the fund later experiences losses that reduce its overall performance below the level that originally justified those payments. mechanisms similar to what private equity funds use.

The mechanics must balance economic substance with tax compliance requirements. This means the allocations must reflect genuine partnership economics rather than predetermined compensation formulas that look more like disguised fees.

Section 1061 established specific holding period requirements that affect both realized gains and sales of carried interest positions. For gains at the partnership level, the three-year holding period applies to the underlying assets the fund owns, not to how long the manager has held the carried interest itself.

Additionally, if managers sell their carried interest positions, they face "look-through" rules designed to prevent circumvention of the holding period requirements. These rules may convert what would normally be long-term gains into short-term gains when underlying fund assets have been held for less than three years.

The Treasury Department issued final regulations in January 2021 that provide clarity on implementation, but the rules remain complex around timing and measurement. Fund managers must carefully track holding periods for all investments and may face anti-abuse rulesRegulatory provisions designed to prevent tax avoidance schemes and circumvention of statutory requirements. targeting arrangements designed to circumvention Section 1061.

Implementation varies significantly between domestic U.S. funds and offshore fund. Domestic funds typically use incentive allocation to general partner entities, while offshore funds may pay performance-based fees to investment managers. However, anti-deferral provisionTax code provisions that require immediate income recognition of deferred compensation when no longer subject to substantial risk of forfeiture. under Section 457ATax provision requiring immediate income recognition of deferred compensation from nonqualified entities when no longer subject to substantial risk of forfeiture. have made fee structures less attractive for complex arrangements involving deferred compensation.

Offshore funds increasingly use intermediate partnership structures to replicate the tax benefits available to domestic funds. These arrangements involve special classes of partnership interests that receive both proportional returns on invested capital and incentive allocations similar to domestic carried interest structures.

The choice between allocation-based and fee-based structures depends on several factors, including how the fund's investors are taxed, the manager's tax optimization goals, and preferences for operational complexity.

Carried interest faces different treatment under various Medicare-related taxes. The 3.8% Net Investment Income TaxMedicare tax that applies to certain investment income for high-income taxpayers as part of the Affordable Care Act. may apply to carried interest depending on the recipient's income level and the nature of the underlying fund activities.

Self-employment tax treatment also differs based on structure. Limited partners in partnerships generally avoid self-employment tax on profit allocations, though the IRS has challenged this treatment in some cases. Management fees and incentive fees (as opposed to allocations) are generally subject to self-employment tax.

The distinction between allocations and fees affects not only income tax rates but also employment tax obligations. This makes structure selection crucial for overall tax efficiency.

Multi-headed structures require additional operational complexity compared to simple fee arrangements. Each legal entity needs separate governing documents, accounting records, and potentially separate audits. Since cash flows between entities cannot be consolidated, managers must carefully coordinate distributions and tax obligations across multiple entities.

Each partner in the business typically holds interests in both the management company and the various fund general partners. This creates complexity in ownership tracking and succession planning. Despite these operational burdens and costs, most fund managers conclude that the potential tax savings justify the additional complexity.

Carried interest remains subject to ongoing policy debate and potential legislative changes. In 2025, discussions have renewed regarding eliminating preferential tax treatment entirely, with some proposals to treat all carried interest as ordinary income subject to self-employment tax.

Previous legislative attempts have proposed extending holding periods from three to five years or treating carried interest as ordinary income regardless of holding period. The Inflation Reduction ActFederal legislation enacted in 2022 that addressed climate change, healthcare costs, and tax policy, including consideration of carried interest reforms. of 2022 considered such changes, though they were ultimately excluded from the final legislation.

Fund managers must stay informed about potential changes that could significantly affect their compensation structures and tax obligations. This area continues to generate political attention as policymakers seek additional revenue sources and address perceived inequities in the tax system.