In layman’s terms, which is as deep as I go, a carried interest is a share in the profits of a partnership that the general, or managing, partner receives without having to pay any of the costs involved in earning those profits. The GP’s notional share of expenses is “carried” by the limited partners.
In an oil and gas partnership, for example, the managing partner may receive 20% of the revenue from producing wells without having to pay a penny of the land acquisition, exploration and drilling costs. The GP justifies this special treatment because of his entrepreneurial flair, deal-making ability and specialized knowledge of the oil and gas industry. My experience in the oil and gas world has been that these are sweet deals for the GP but not so much for anyone else.
One of the rough equivalents of this structure in today’s world is the SPAC.
Another is the private equity or hedge fund partnership, where the private equity fund/hedge fund acts as GP for, say, an equity portfolio managed for pension fund clients. The bulk of the GP’s compensation in these partnerships is the 20% or so carried interest in the partnerships’ profits it receives and redistributes to the GP’s employees, i.e., the portfolio managers.
The twist in the private equity/hedge fund cases is that profits from holdings retained in the partnership for three years before sale are classified as long-term capital gains for income tax purposes. In contrast to the case of a mutual fund/ETF that liquidates holdings to pay its investment managers, who are taxed at ordinary income rates for the money they receive, identical payments to a hedge fund manager (who would be crazy not to sell holdings older than three years) are taxed as capital gains. The Congressional Research Service estimates the loss to the Treasury from this loophole at $1.2 billion a year.
As part of his “Drain the Swamp” campaign, Trump pledged to eliminate special interest tax breaks like carried interest or the special deals given to natural resource companies. None of that happened in the 2018 tax bill, which lowered taxes for the wealthy instead.
My take on the Biden proposal is that the the control of Congress by recipients of the carried interest tax break is so strong there’s no chance that Congress will eliminate it. Therefore, the only way to close the loophole is to raise the capital gains rate for the wealthy.