A "Carried Interest" is . . .
A fund manager’s share of distributions from a private equity or hedge fund. Typically, the fund manager’s entitlement to distributions arises after the fund distributes to the investors amounts sufficient to return invested capital plus provide some return on invested capital. This structure intends to provide incentive to the fund manager to achieve gains on fund investments, because the manager’s economics from the fund is dependent on the fund’s making distributions in excess of investments. This structure also permits the fund manager to receive an economic interest in fund profits greater than its proportionate capital contribution.
The receipt of a carried interest by a fund manager is typically not a taxable event under current law, unlike many other forms of equity compensation. The primary rationale for this result is that the carried interest has no value on the date of its issuance, because a liquidation of the fund would yield only distributions to the investors returning their capital contributed.
In addition, the fund manager’s share of fund profits is taxed at the same character as the profits earned by the fund. Because many funds earn profits characterized as long-term capital gains, fund managers are often taxed at favorable capital gains rates (15% Federal rate) on the returns earned on account of their services to the funds.
This favorable tax treatment has led Congress to consider changing the rules for taxing carried interests. While no proposals have emerged from this process, many in the private equity and hedge fund world worry that Congress will find increasing their tax bill to be a politically convenient way to raise revenue to pay for other needs of the Federal government.