A startup employee spends 4 years earning below-market salary, exercises options, pays AMT on shares they can’t sell, and when the company finally exits… pays ordinary income tax on whatever’s left.
The VC who funded that company? Pays 20%.
First, what is carried interest?
When a VC fund closes a successful investment, the fund managers take a cut of the profits.
Typically 20%.
That 20% is called “carried interest” or just “carry”.
It’s how VCs make “real” money.
Not from their management fee (the 2% they charge LPs annually to run the fund).
The tax treatment
Under U.S. tax law, carried interest is taxed as long-term capital gains.
Not ordinary income.
That means VCs pay a top federal rate of 20% on their carry.
Compare that to:
The startup employee exercising ISOs who may hit 37% federal income tax rates plus AMT
The engineer earning $200K in salary paying 32-35% marginal rates
The founder paying self-employment taxes on top of income taxes
The argument for this treatment is that carry represents a return on investment risk.
The argument against it: VCs don’t actually invest their own money to earn carry.
They invest other people’s money (LP capital) and earn 20% of the upside.
They’re being compensated for their labor (sourcing deals, advising companies, sitting on boards) and that labor is being taxed at investment rates instead of wage rates.
That’s the loophole.
Who benefits?
The top 25 U.S. venture firms.
The partners at those firms.
Private equity managers, who use the same structure.
Hedge fund managers who’ve structured the same way.
The Economic Policy Institute estimated in 2021 that closing the carried interest loophole would generate approximately $180 billion in tax revenue over 10 years.
That’s $180B that currently doesn't exist because fund managers pay capital gains rates on what is, substantively, their compensation.
Who doesn't benefit?
The employees at the portfolio companies.
The limited partners (pension funds, university endowments, family offices) who actually put up the capital.
Anyone earning a W-2.
Here’s the irony: a teacher whose pension fund is an LP in a top VC fund pays more in taxes on their salary than the fund manager pays on their multi-million dollar carry check.
Why hasn’t it been closed?
It's been tried. Multiple times.
The Carried Interest Fairness Act has been introduced and re-introduced in Congress for nearly two decades.
In 2022, the Inflation Reduction Act included a provision that extended the required holding period from 3 to 5 years before carry qualifies for long-term capital gains treatment.
That was the compromise.
A longer hold requirement.
The private equity and venture lobbying machine is one of the best-funded in Washington.
The argument they make: taxing carry as ordinary income would reduce investment activity, hurt LP returns, and slow economic growth.
The counterargument: there is no empirical evidence that this is true, and GPs in other countries operate under less favorable tax treatment without those consequences materializing.
Why this matters for founders and employees specifically
You built the product.
You stayed through the hard years on below-market comp.
You exercised options and paid a tax bill on shares you couldn’t sell.
You waited for an exit that might never come.
When it does come, you pay full freight.
The person who wrote a check from a fund (a check that came from university endowments and pension funds, not from their personal savings) pays 20%.
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