Why do hedge fund managers get a Special "carried interest" as tax rate?

Carried interest is a contractual right that entitles the general partner of an investment fund to share in the fund’s profits. These funds invest in a wide range of assets, including real estate, natural resources, publicly-traded stocks and bonds, and private businesses. Hedge funds, for example, typically trade stocks, bonds, currencies, and derivatives. Venture capital funds invest in start-up businesses. And private equity funds invest in established businesses, often buying publicly traded companies and taking them private.

As it applies to investment funds, the term “carried interest” itself represents the portion of net gains earned by investment funds that are allocated, versus paid, to the fund manager’s capital account. While the manager will also earn management fees to cover costs of operating his or her investment advisory practice, the reallocation of investment earnings from the limited partners’ capital accounts to the manager’s or general partner’s capital account represents additional compensation that is contingent on the ability of the manager to generate gains. This reallocation of gains is typically referred to as an incentive or performance allocation, and until the gains are actually withdrawn from the fund by the manager, they continue to be “carried” as capital invested in the fund.

When a portfolio investment is sold and a taxable gain occurs, the manager will have taxable income associated with his or her pro-rata capital balance being held as carried interest at that point in time. Prior to 2018, these allocations were taxed at long-term capital gains rates if the investments generating the gains were held for more than a year. The Tax Cuts and Jobs Act legislation, effective in 2018, changed the tax treatment of carried interest. The new law now requires a three-year holding period on realized gains for the general partner to receive long-term capital gain treatment. The greatest impact of this new law is for hedge fund managers who tend to hold investments for more than one year but less than three years.

Carried interest is considered to be capital gains and hence is taxed at preferential capital gains rates. Critics say this is unjust and that these payments should be taxed as ordinary income. This issue has been the subject of a number of political debates over tax policy in recent years. The argument for taxing carried interest at capital gains rates is that general partners are akin to other entrepreneurs who start a business and get to treat portions of their return from that business as capital gains, not exclusively wages and salary. Those on the other side of the argument liken the general partners to investment bankers who receive their compensation as wages, including the portion of their compensation that is tied to a bonus system. This compensation is taxed at ordinary income tax rates.