Why Wall Street’s favorite tax break traces back to 16th-century sailing ships
In short: Investment managers in private equity and hedge funds earn a share of profits known as carried interest. While modern critics call it a massive tax loophole, the mechanism began with maritime captains risking their lives to transport goods across the Atlantic and to Asia.
The concept of carried interest—or 'carry'—is a performance fee paid to investment managers in alternative investments. Historically, 16th-century ship captains would take a 20% share of profits from carried goods to compensate for the immense risks of ocean voyages. Today, this structure persists in private equity and hedge funds, where managers receive a portion of profits exceeding their own capital contributions.
In the United States, the controversy lies in how these profits are taxed. Unlike the 1% to 2% annual management fee, which is taxed as ordinary income, carried interest is often taxed at the much lower long-term capital gains rate. As of 2026, the maximum rate for long-term capital gains, including the net investment income tax, is 23.8%. In contrast, the maximum ordinary income rate is 37%. This disparity has led critics to label the practice 'Wall Street's favorite tax break.'
The tax logic for treating 'sweat equity' as capital gains originated in the early 20th-century American oil and gas industry. Explorers took significant risks, and their profits were treated similarly to investors' returns. Modern distribution often follows a 'waterfall' structure: first, investors receive their initial capital; second, they receive a 'hurdle rate' (customarily 7% to 9% per annum); third, a 'catch-up' phase occurs; and finally, the remaining profits are split, often with the manager taking a 20% share.
Legislative attempts to close this gap have been frequent but often unsuccessful. Notable efforts include the 2015 Carried Interest Fairness Act and various proposals by lawmakers like Sander M. Levin. Even as recently as 2022, a proposal to narrow the loophole was removed from the Inflation Reduction Act following intervention by Senator Kyrsten Sinema.
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Sources
- Summary by Intellect · source: Carried interest
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