Carried Interest Under Fire: The Controversial Tax Break Trump Wants to Eliminate

A controversial tax break is under fire. Again.

Last month, President Trump told Republican lawmakers he wanted to change the tax treatment of carried interest from a preferential tax rate that allows venture capital, private equity and hedge-fund managers to pay a lower tax rate on the gains their receive from their investments.

That same day, U.S. Sen. Tammy Baldwin (D-Wis.) led 13 of her colleagues in introducing the Carried Interest Fairness Act.

Why all the fuss? The carried interest rule allows investment managers to pay the long-term capital gains rate of 20% on the retained portion of the gains generated from their investments rather than the ordinary income tax rate, which is currently a maximum of 37%. The retained gains fund managers receive can be a substantial portion of their overall compensation.

If this sounds familiar, it’s because it’s not the first time the carried interest rule has been in the headlines: The past three presidents, including Trump, have all tried to eliminate the favorable tax treatment for carried interest. All failed, although Democrats in Congress came close to eliminating the tax benefit in 2022. Their plan stalled after Sen. Kyrsten Sinema (D-Ariz.) came to its defense.

Supporters of carried interest are again rallying to protect the provision, arguing that paying the lower tax rate affords an incentive to take investment risks that drive capital into early-stage businesses and benefits the broader economy.

According to the National Venture Capital Association (NVCA), carried interest “encourages smart, high-risk investments in innovative high-growth startups” in areas such as artificial intelligence, crypto, life sciences and national defense.

“A change now will disrupt that progress and disproportionately harm small investors, especially in middle America,” said Bobby Franklin, NVCA’s president and CEO. 

Carried interest, it seems, is hard to kill. So much so, it’s earned the moniker of “the tax break with nine lives.”

So, what, exactly, is carried interest? Why is there a debate over how it is taxed? And will it survive its latest brush with death?

To break it all down, ITA spoke with University of Virginia Darden School of Business Professor Les Alexander who teaches courses and educates policy makers in Washington, D.C., on venture capital.

Q: Why is it called “carried” interest?

Carried interest dates back to 16th century maritime commerce, where ships would transport (“carry”) cargo to international ports and captains would retain a 20% share of the profit from the goods they delivered.

Q: How does it work?

A private equity firm (broadly defined including venture capital) makes its money from two components. The first is by charging a management fee, typically 2%, on the size of the fund they are managing and investing. So, for example, a $100 million fund will charge investors $2 million each year in management fees. Management fees are used to cover the operating costs of the fund including paying salaries, office rent, etc.

The second component is by retaining a portion of the gains from the fund investments — also called the “carry.” Most private equity firms receive a 20% carry on the gains from the investments. The other 80% goes to the fund’s limited partners who put up the majority of the capital for the fund.

Q: Have there been changes to the tax break?

While the selection of the appropriate tax treatment category, capital gains or ordinary income, has not been modified, the Tax Cuts and Jobs Act of 2017, which Trump signed into law, was the most recent change. It modified the measurement period for gains related to carried interest — extending the number of years an asset must be held before it is considered a long-term capital gain from one year to three. 

Q: Why is there interest again in Washington about changing the taxation of carried interest?

One of the current goals of Republican lawmakers is to reduce taxes, but they are looking for offsetting areas for either savings or creation of additional revenue. This proposed change to carried interest would generate revenue that could be used to offset some of the proposed tax reductions.

Some members of Congress see private equity fund managers as very wealthy individuals who should be paying more of their share in taxes, but what many of them don’t understand is that the median venture capital fund size is less than $40 million, and a 2% management fee would generate only $800,000 per year to cover all the operating expenses of the fund including paying salaries, office rent, travel, etc. The opportunity to generate additional compensation through their carried interest motivates fund managers to form a fund and invest in those risky deals that few other capital providers will finance.

Q: Why should the current carried interest tax rate be left alone?

Carried interest is created from the gains on the investments the fund manager makes. For the limited partners, these gains are treated as capital gains and taxed at that rate, but the proposed change would modify the tax treatment on the portion of the gains retained by the fund mangers and tax it as ordinary income. This would treat the gains differently depending upon the party receiving the gain and would be inconsistent.

One way to look at it is that the fund managers are “investing” a portion of their compensation in their portfolio companies that they hope to receive many years later and to be consistent should be taxed as capital gains. There is no guarantee that the fund manager will receive any value from their carried interest because if their portfolio company investments fail to return value, they will never receive a benefit.

Additionally, it is common for tax incentives to be put in place to encourage the investment of risk capital. For example, many states have enacted angel tax credits to stimulate investment from wealthy individuals, called “angels,” into risky startup businesses. Venture capital could be viewed similarly in that fund managers are incentivized to raise pools of risk capital and invest in these early-stage companies because a significant portion of their future compensation, which is tied to the performance of those investments, receives a beneficial tax treatment.

Q: How likely is it that this tax break will be closed this time around?

It can often be difficult to handicap proposed legislation in Washington, D.C., but this latest effort to change the taxation of carried interest has support from the executive branch as well as members on both sides of the aisle in Congress, so it has a reasonable chance of being passed. A related question to be asked is, if this legislation is passed, will it be applied to all categories of private equity (buyout, growth equity and venture capital) and to all sized funds and firms?

Q: What would a change to the rule mean for private equity and venture capital?

I believe that a change to carried interest taxation would reduce the number of new private capital funds raised (particularly venture capital) and amount of private capital being invested.

The greatest impact would be felt at the lower end of the market by fund managers who manage small funds. The larger funds at the upper end of the market could afford to hire lawyers and tax advisors to navigate through the change but the smaller funds that are not able to afford those resources would be impacted the most. It would reduce the incentive they have to raise these small funds, often in markets with limited access to capital to begin with. Large fund managers in Boston, New York and Silicon Valley may weather the storm just fine, but the small fund managers in cities like Austin, Columbus, Nashville and elsewhere will be hurt the most.