President Donald Trump has called for raising taxes on carried interest, a form of income earned by hedge funds and private equity.
Trump and other critics, generally liberal Democrats, maintain that the current tax treatment of carried interest amounts to a loophole that benefits some of the richest people in the country. Supporters, however, argue that hiking taxes on carried interest would be arbitrary and deprive businesses of a source of investment.
Here’s what to know about carried interest.
What is carried interest?
Carried interest is a kind of income that some investment firms earn while managing investors’ money.
It is particularly important to private equity firms, which use money from investors to buy companies and then help manage them before reselling them. Sometimes carried interest also applies to hedge funds, which manage money for limited numbers of wealthy and sophisticated individuals or institutions.
Those investment firms typically charge their clients a fee, such as 2% of the funds they manage. But they also take a share, commonly 20%, of any profits earned on their investments.
The 2% fee would be taxed as ordinary labor income, at rates up to 37%.
The 20% of profits, though, the carried interest, would be taxed at the lower rate for long-term capital gains of 20%.
An example would be a private equity manager who used investors’ funds to buy a major retail store. After seven years of reorganizing and improving the retailer, the private equity fund sells it for a profit of $1 billion. The private equity manager’s carried interest would be $200 million. He would pay a capital gains tax of $40 million. If he had to pay the higher labor income tax rate, he would have to pay $74 million.
Why should carried interest be taxed as labor income?
Critics of the status quo, such as Sen. Ron Wyden (OR), the top Democrat on the Senate Finance Committee, argue that carried interest represents a “recharacterization” of income from labor income to capital income to benefit from the lower rates. In other words, fund managers have disguised their labor income as capital gains.
They also note that it benefits some of the wealthiest members of society. For example, the liberal group Americans for Financial Reform noted that four executives at the private equity firm KKR saved $26 million in taxes in 2020 alone via carried interest.
Many on the Left see hedge funds and private equity firms as exploitative to begin with and favor measures to rein them in or raise their taxes.
Trump has portrayed investment managers as tax dodgers who have not earned their wealth.
“A lot of them, it’s like they’re paper pushers,” he said in 2015. “They make a fortune, they pay no tax. … The hedge funds guys are getting away with murder.”
White House press secretary Karoline Leavitt reiterated Trump’s interest in raising taxes on carried interest in February, describing it as a “loophole.”
What’s the argument in favor of the status quo on carried interest?
Private equity managers argue that raising taxes on carried interest will limit investments facilitated by the industry, which accounts for millions of jobs through the companies it manages.
They also contend that there is no “loophole” and that carried interest is no different from other forms of capital income and should not be taxed differently.
They compare carried interest to “sweat equity,” a term used to refer to owners who do not contribute financial capital to a business but do contribute the work that gets the company off the ground.
Take, for example, two friends who decide to open a hardware store. One friend contributes all the money needed for the location, inventory, and payroll. The other friend works at the store every day, managing the employees and taking care of the business. They share the company 50-50.
The shop is successful, and five years later, they decide to sell it for $10 million. Both would have $5 million in capital gains and owe $1 million in capital gains taxes.
The first friend was a financial investor — he had equity in the firm via the money he put in. The second had sweat equity, but both would be taxed the same.
Private equity managers maintain that they are like the second friend in the hypothetical example: They work with investors, who provide the money, to buy and manage companies. Then, they, the managers, help advise and manage the company. When the company is sold, they should be taxed the same as their investors are.
The debate comes down to whether carried interest is more like labor earnings or capital gains, said Garrett Watson, a senior policy analyst at the Tax Foundation, a Washington-based think tank.
“And the tricky part is that it can be hard,” Watson said. “It’s a legit gray area.”
How much money is at stake?
Taxing carried interest as if it were ordinary income would bring in $13 billion over 10 years to the Treasury, according to an estimate from the Congressional Budget Office published in December 2024.
In comparison, total government revenues are projected to be around $70 trillion over the next decade.
Victor Fleischer, a tax law professor who has worked for Senate Democrats, has argued that the CBO’s estimates of revenues from raising taxes on carried interest are an order of magnitude too low.
Why didn’t Trump tax carried interest in his first term?
In fact, Trump did sort of raise taxes on carried interest as part of the 2017 Tax Cuts and Jobs Act, otherwise known as the Trump tax cuts.
The law required that investment funds hold assets for at least three years to qualify for the long-term capital gains tax rate. Usually, assets must be held for just one year before they qualify for the long-term capital gains tax rate of 20%, versus the 37% top rate for short-term gains.
That change, though, likely didn’t affect many private equity firms, which tend to hold on to investments for well over three years.
The change was reportedly included by former Treasury Secretary Steven Mnuchin, who did not want to tax carried interest as ordinary income, as a way to allow Trump to claim victory. Industry lobbyists, though, felt like they escaped unscathed.
Will Republicans go along with this tax hike?
Republicans have generally fought off Democratic efforts to raise taxes on carried interest over the past decade or so. In general, Republicans do not like tax hikes.
But it is conceivable that Trump could sway congressional Republicans to include carried interest reform in the sweeping tax overhaul they are pursuing as one of a number of measures to raise revenues to offset tax cuts elsewhere.
As a group, Republicans are more populist than they were in 2017, especially in the House.
On the other hand, key GOP senators, especially Majority Leader John Thune (R-SD) and Finance Committee Chairman Mike Crapo (R-ID) have historically opposed efforts to tax private equity. Crapo declined to comment when asked about the possibility by the Washington Examiner.
Others, though, have opened the door to the change.
“I’ve talked to a number of individuals who take advantage of carried interest, and I always ask them, ‘So explain to me how this is not ordinary income,’” Sen. Ron Johnson (R-WI) said. “Except that it has a different name, they really can’t explain it. So I wouldn’t be opposed to it.”
GOLDMAN SACHS SURVEY FINDS TOP CONCERN FOR SMALL BUSINESSES IN RURAL AMERICA
Sen. Lindsey Graham (R-SC) said he thinks Senate Republicans would have an appetite for getting rid of carried interest.
“Yeah, I’d be OK with it,” Graham said when asked about his view.
