Carry in private equity is the share of a fund’s investment profits — usually 20% — that the fund’s managers (the General Partner, or GP) keep as performance pay, after the outside investors (the Limited Partners, or LPs) have gotten their money back plus a minimum return. It is the main way GPs get rich, and it only pays out if the fund’s investments actually make money.
The 2 and 20 Structure
Most private equity funds run on a “2 and 20” model. The GP collects a 2% annual management fee on committed capital to cover salaries, overhead, deal sourcing, and administration. On top of that, the GP takes 20% of the fund’s net profits. That 20% is the carry.
The profit split only starts after the fund has returned all of the LPs’ original contributions. Say a fund invests $100 million and eventually exits every position for $200 million. The $100 million of net profit is the base for carry. The GP takes $20 million, and the LPs split the other $80 million. Losses and fund expenses come out of the profit pool first, so carry is calculated on genuine net gains.
When the GP Actually Gets Paid
Two things decide whether and when carry gets distributed: the hurdle rate and the waterfall.
Hurdle Rates and the Catch-Up
Before the GP sees a dollar of carry, the fund usually has to deliver a minimum annual return to LPs. This is the hurdle rate, or preferred return, and it’s commonly set around 8% per year, compounded annually. Miss it and the GP earns nothing beyond management fees, no matter how much work went in.
Hurdles come in two flavors. A hard hurdle means the GP only earns carry on returns above the threshold: if the hurdle is 8% and the fund returns 12%, carry is calculated on the 4% above the line. A soft hurdle is more GP-friendly: once the fund clears 8%, carry is calculated on the entire profit pool, including everything below the hurdle. The distinction matters a lot in negotiation.
Funds with a soft hurdle usually include a “catch-up” provision that restores the 80/20 split after LPs get their preferred return. If the LPs have received $8 million in preferred returns, the catch-up sends the next $2 million entirely to the GP, bringing the GP up to $2 million of $10 million distributed, or 20%. From there, every additional dollar goes back to the standard 80/20 split.
European vs. American Waterfalls
The waterfall controls the timing. It is one of the most heavily negotiated terms in a fund agreement.
Under a European, or whole-fund, waterfall, the GP gets no carry until LPs have recovered all of their capital contributions plus the preferred return across the entire portfolio. A profitable exit on one deal cannot trigger carry if other investments are still underwater. This is the more common structure globally, and it protects LPs from paying performance fees on early wins that later losses might wipe out.
Under an American, or deal-by-deal, waterfall, the GP collects carry on each individual investment as it is sold at a profit. Each exit stands on its own. The management team gets cash faster, but there is a risk: if later deals lose money, the GP may have already collected more carry than the fund’s overall performance justifies.
Clawbacks and Vesting
Deal-by-deal waterfalls come with clawback provisions to fix the overpayment problem. A clawback forces the GP to return previously distributed carry if the fund’s final overall performance doesn’t support the amount already paid. The idea is that the GP ends up with no more than 20% of the fund’s total lifetime profit.
Funds typically require 20% to 30% of each carry distribution to sit in an escrow account as security. If that escrow isn’t enough to cover the shortfall, individual GP members are generally personally liable, though the specifics vary. Clawbacks are usually calculated net of tax, so the GP only has to give back what it kept after paying income tax on the earlier distributions.
Carry itself does not vest all at once. Vesting schedules typically run three to ten years, with seven years being a common standard, and most include a one-year cliff — anyone who leaves in the first year forfeits everything. After the cliff, carry usually vests in equal annual increments. What happens to unvested carry on departure depends on whether the fund treats the person as a “good leaver” (retirement, disability) or a “bad leaver” (terminated for cause, going to a competitor). Good leavers generally keep their vested carry; bad leavers may lose some or all of it.
How Carry Is Taxed
Because carry is structured as a share of partnership profits rather than a salary, it can qualify for the long-term capital gains rate instead of ordinary income rates. That’s the reason the tax treatment of carry gets so much political attention.
The Three-Year Holding Period Under Section 1061
Under Section 1061 of the Internal Revenue Code, any net long-term capital gain from an “applicable partnership interest” — which covers carry received in exchange for investment management services — gets recharacterized as short-term capital gain unless the underlying assets were held for more than three years.1Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services The three-year rule came in with the Tax Cuts and Jobs Act, extending the one-year threshold that applies to ordinary capital gains.
Clear the three years, and carry is taxed at the long-term capital gains rate, which reaches up to 20% for high earners in 2026.2Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Miss it, and the carry from that deal is taxed at ordinary income rates, with the top federal rate at 37%. That can nearly double the tax bill on that portion.
The 3.8% Net Investment Income Tax
On top of the capital gains or ordinary income rate, fund managers typically owe the 3.8% Net Investment Income Tax. The NIIT applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.3Internal Revenue Service. Net Investment Income Tax For most people earning meaningful carry, the surtax applies to the full distribution, so the effective top federal rate on qualifying long-term gains comes to 23.8%.
No Self-Employment Tax
Carry is generally not subject to the 15.3% self-employment tax that hits wage-like income from partnerships.4Congressional Budget Office. Tax Carried Interest as Ordinary Income The exemption traces back to a statutory provision excluding a limited partner’s distributive share of partnership income from the self-employment tax base, except for guaranteed payments for services.5Internal Revenue Service. Self-Employment Tax and Partners The exact boundaries of the exclusion are unsettled — the IRS has never finalized regulations defining “limited partner” for this purpose — but in practice carry is structured to fall outside self-employment tax.
Management Fee Waivers
Some funds let the GP voluntarily give up part of the 2% management fee in exchange for a larger share of future profits. Because management fees are taxed as ordinary income and carry can qualify for capital gains rates, this converts higher-taxed income into lower-taxed income. The IRS has signaled skepticism and proposed regulations that would recharacterize waived fees as ordinary income. The agency treats the proposed rules as reflecting current law and may apply them during audits before they are finalized.
State Taxes
Federal treatment is only part of the picture. Most states tax capital gains as ordinary income. Top state rates run from 0% in the eight states with no personal income tax to over 13% in the highest-tax states. In a high-tax state, the combined federal and state rate on carry can approach 37% even when the three-year holding period is met, which narrows the gap between capital gains treatment and ordinary income considerably.
The GP’s Own Capital Is Separate
Most fund agreements require the GP to invest its own money alongside the LPs, commonly called “skin in the game.” This commitment usually runs 1% to 5% of total fund commitments, averaging around 3.5% for buyout funds. LPs want to know the managers face real downside risk on the same investments they run.
That capital commitment and the carried interest are separate for tax purposes. Section 1061 explicitly excludes from the definition of an “applicable partnership interest” a capital interest that just reflects the money the GP contributed and pays a return proportional to it.1Office of the Law Revision Counsel. 26 USC 1061 – Partnership Interests Held in Connection With Performance of Services Returns on the GP’s own invested capital are taxed under the normal one-year holding period rules. The carry — the performance-based profit share earned for services — is what gets the three-year rule.
Reporting on the K-1
A fund that holds applicable partnership interests has to give each partner the numbers needed for Section 1061 reporting. The partnership attaches Worksheet A to each Schedule K-1, breaking gains into two buckets: gains from assets held at least one year and gains from assets held more than three years.6Internal Revenue Service. Section 1061 Reporting Guidance FAQs Section 1061 information appears in Box 20 of the Schedule K-1 on Form 1065.7Internal Revenue Service. Partners Instructions for Schedule K-1 Form 1065 The partner uses those figures to work out how much of the carry qualifies for long-term capital gains treatment on the individual return. Because the three-year rule is unusual, careful recordkeeping over the fund’s life is what supports the tax position if the IRS asks.