How VC Funds Work
What is carried interest and how is it taxed?
Carried interest (carry) is the share of profits that GPs earn from a fund — typically 20% of returns above the hurdle rate. It's taxed as long-term capital gains (not ordinary income), which is controversial since it effectively taxes GP compensation at a lower rate.
Carried interest is the economic engine of venture capital. When a VC fund exits an investment at a profit, the general partners keep 20% of the gains (the standard carry percentage) before returning the rest to LPs.
Example: Fund returns $500M on a $100M fund. The profit is $400M. GPs keep 20% of the profit = $80M in carry. LPs receive the remaining $320M plus their $100M principal back.
Most funds also have a preferred return or hurdle rate — a minimum return (typically 8% per year) that LPs must receive before carry kicks in. This aligns GP incentives with delivering real performance.
The tax treatment is the controversy. Carry is taxed as long-term capital gains (currently 20% federal + 3.8% net investment income tax) rather than as ordinary income (up to 37% federal). Critics argue this is a massive tax break for already-wealthy fund managers. Defenders argue carry is a performance-based return on the GP's investment of human capital and risk, not just compensation.
The "carried interest loophole" has been debated in Congress for 15+ years. The 2017 Tax Cuts and Jobs Act added a 3-year holding requirement, but the core structure remains unchanged as of 2024.