The carried interest loophole is just one of many ways the U.S. tax code offers preferential treatment to some Americans.

The U.S. tax code treats earned income from labor and investment income from dividends and capital gains differently.

If you are paid for performing a service (such as managing a company), your compensation is subject to ordinary income tax rates.

If you make an investment (such as buying the stock of a company), any profits you earn when selling that stock are subject to the lower capital gains tax rates.

Carried interest loophole allows people who manage investment funds, such as private equity funds and hedge funds managers, convert their compensation as if it were into lower-taxed capital gains, when it is actually derived from the labor and skill involved in managing other people’s investments.

Essentially, the partners in businesses that manage pools of money on behalf of investors are paid in two ways. One part of their income is a “management fee” for managing the investments. This fee is generally taxed as ordinary income.  The other part of the fund managers’ income is their cut of the fund’s profits. The fund managers treat their part of the fund’s earnings as a capital gain, subject only to the lower-taxed capital gains tax rate.

Investment managers typically take a management fee equal to just 2 percent of the assets they manage—plus a 20 percent cut of their investors’ profits. In doing so, they are able to shield the bulk of their income from ordinary tax rates.  As a result, theses wealthy fund managers have experienced disproportionately large income and wealth growth compared to everyone else.

Source:  Seth Hanlon and Gadi Dechter, “Congress Should Close the Carried Interest Loophole”, (Washington:  Center for American Progress, posted December 18, 2012), available at  https://www.americanprogress.org/issues/economy/news/2012/12/18/48469/congress-should-close-the-carried-interest-loophole/