CNBC Explains

CNBC Explains: Carried Interest

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One of the reasons elite private fund managers can make millions or even billions of dollars in a single year is because they often pay relatively low taxes due to something called carried interest. Critics call it a tax loophole that allows the rich to get richer, but proponents say it's necessary to spur long-term investment. But what is carried interest, and why is it so controversial?

What is carried interest?

Carried interest is a rule in the tax code that lets the managers of some types of private investment funds—hedge, private equity, venture capital, real estate and other types of vehicles—pay a lower rate than most individuals.

More specifically, the "general partner" who manages money on behalf of "limited partner" clients receives a share of profits from any investment gain on stocks, bonds, real estate or other securities held for more than a year. A hedge fund manager, for example, usually takes 20 percent of all gains on the fund's investments.

The tax code treats that income as a "long-term capital gain," which is taxed at a lower rate than ordinary income (currently maximums of 20 percent versus 39.6 percent).

Fund managers sometimes also earn a flat management fee (typically 2 percent in the hedge fund industry), which is taxed at the higher ordinary income tax rate.

What's behind the idea?

Carried interest has been U.S. law for more than 50 years as an incentive for long-term investment. The idea is that putting up a building, starting a small business or investing in company stock carries risk.

The thinking goes that entrepreneurs should be rewarded when they sell something they helped build through early vision and money, as opposed to someone who just bought and sold something quickly, and didn't take the risk inherent with a start-up.

Proponents also contend that carried interest aligns the interests of money managers and their clients. The general partner makes far less or even no money when their fund performs poorly; they're proportionally rewarded when their investments gain in value.

Why is it so controversial?

Investment managers of private funds—often individuals, but sometimes a group that makes up the "general partner"—are some of the wealthiest people in the country in part because of the cut they take on investment gains. Most money managers are paid based on their performance rather than a regular salary, which makes their annual income taxed at a much lower rate that most other people.

It angers some that such high earners should be taxed at a lower rate than those who make far less. Some critics of carried interest believe it should be done away with all together and all fund managers should see the investment gains they pocket taxed like a regular salary.

Others say carried interest should apply only to the personal funds money managers have in their own fund—not the gains on the investments managed for clients such as pensions, endowments and foundations.

The carried interest earned from other people's money constitute the manager's "labor" or work and not capital risk, and therefor should be taxed like ordinary income. Another proposed fix is to make the carried interest tax discount proportional with the amount of money the investment manager puts in up front.

Politicians have long threatened to change carried interest rules, but the effort has never succeeded. Trade groups for private equity, hedge fund and other effected industries have fought to keep carried interest as is.

—By CNBC's Lawrence Delevingne. Follow him on Twitter @ldelevingne.