The Carried Interest Loophole

One of the most controversial aspects of carried interest (carry) is its tax treatment.

From a tax perspective, carry is classified as a return on investment, so it benefits from long-term capital gains tax rates (max 20%) rather than ordinary income tax, which can go up to 37%. Simply put, this means VC (and more widely PE) profits are taxed similarly to long-term asset gains as opposed to that of a salary, hence the name, “The Carried Interest Loophole.”

This tax break benefiting GPs is once again under intense scrutiny, with policymakers and lobbyists south of the border preparing to debate its future yet again.

The Reality:
To qualify for the lower tax rate, GPs must hold their interests for at least three years. This means that, rather than being taxed like a high-income salary, these profits receive capital gains treatment, provided they meet the holding period requirement. Given that carry makes up a large portion of GPs’ earnings (refer back to last week’s post on how carry is calculated), such a large change in tax treatment would have massive ripple effects throughout the venture industry and the interests that lie within.

Politicians across the spectrum, from Donald Trump to Elizabeth Warren and Joe Biden, have proposed taxing carry as ordinary income, nearly doubling the tax rate. While multiple reform efforts have emerged, the current tax structure remains intact.

According to the Congressional Budget Office, closing this tax break could reduce the federal deficit by approximately $13 billion through 2034.

Recent History:
For more than a decade, U.S. lawmakers have debated reforms to the carried interest tax treatment, favoured by private equity, hedge fund, and real estate managers, but have achieved limited success.

The 2017 Tax Cuts and Jobs Act lengthened the required holding period from one year to three, though this had minimal practical impact given the typically longer holding periods of most PE investments.

Similarly, a more ambitious attempt to eliminate the carried interest provision entirely from the 2022 Inflation Reduction Act was ultimately removed from the bill’s final version following intense lobbying.

With billions on the line, the debate over carried interest is far from finished—and it seemingly won’t be long before Washington makes its next move in the never ending saga.