LC-03 · Tax
Carried interest
Pay taxed like an investment
In ordinary words
Private-equity and hedge-fund managers are often paid a share of profits — the “carry” — and, if holding-period rules are met, that pay is taxed at long-term capital-gains rates instead of ordinary wage rates.
Why people call it a crime
A teacher’s salary is taxed as wages. A fund manager’s performance fee can be taxed at a lower rate. To a lot of people that is a rigged tax code, not a loophole they can use.
A scene, not a hypothetical statute
Two people each clear $10 million. One is paid a bonus and owes ordinary rates. The other is paid carry on a four-year deal and owes capital-gains rates. Both followed the forms. Only one gets the discount.
In legal terms
Carry is typically a profits interest in a partnership. IRC § 1061, added by the 2017 tax law, recharacterizes certain gains on “applicable partnership interests” as short-term unless the relevant holding period exceeds three years. Gains that clear that period can still be long-term capital gain, generally 20% plus the 3.8% net investment income tax for high earners, rather than the top ordinary rate of 37%. Bills to tax carry as ordinary income have been introduced repeatedly and have not become law.
The code treats a partnership profits interest as a share of the partnership’s own capital gain when the underlying assets qualify. Industry argument: the manager earns nothing if the fund fails, so the return is investment risk, not a salary.
IRC § 1061; IRC § 1(h); IRC § 1411.
Where it stops being legal
Disguised fees, short holding periods, and interests that fail § 1061 are taxed as ordinary income. Fraudulent allocation, backdated documents, or unreported income is tax evasion, which is a crime.