The carried interest rule is one of the major reasons why hedge fund managers and other wealthy investors pay much lower tax rates than many American families.
I think an example will make this clearer. Tom creates a million-dollar hedge fund. Tom invests 100 thousand dollars, 10 percent of its value, in the hedge fund. Instead of a salary, Tom is given 25 percent of the profits. Under the carried interest rule, the 15 percent difference between the amount Tom originally contributed to the partnership and the percentage of the profits he was paid is taxed at the 23.8 percent capital gains rate.
Let’s put this to numbers. Tom’s hedge fund earned 100 million dollars. Tom is paid 25 million dollars. For tax purposes, the first one0 million dollars paid to Tom is taxed as ordinary income and would clearly put him in the 39.6 percent tax bracket. The remaining 15 million dollars of Tom’s income would be taxed at the 23.8 percent capital gains tax rate.
Here’s a description of carried interest from the Tax Policy Center.