Carried Interest in 2026: Congress's Favorite Loophole Still Hasn't Closed (Here's Why It Matters for LPs)
Carried Interest Tax 2026: PE Loophole Survives Carried Interest in 2026: Congress's Favorite Loophole Still Hasn't Closed (Here's Why It Matters for LPs) By Jeff Barnes, MBA | Angel Investors Network
Carried Interest in 2026: Congress's Favorite Loophole Still Hasn't Closed (Here's Why It Matters for LPs)
TL;DR: Two bills introduced in 2026 would tax carried interest as ordinary income at rates up to 40.8%, up from the current 20% long-term capital gains rate: S.4330 in the Senate and the Carried Interest Fairness Act in the House. Neither has cleared committee, and the PE industry's lobbying record suggests they won't without a major political shift.
On April 16, 2026, Senators Ron Wyden, Sheldon Whitehouse, and Angus King formally introduced S.4330, the Ending the Carried Interest Loophole Act, marking the latest salvo in a legislative fight that has been running since 2007. If you manage capital or invest in private equity funds as a limited partner, this debate shapes how your managers get paid, and by extension, how fund economics are structured around you.
What Carried Interest Actually Is (Plain English)
Carried interest is the share of profits that a general partner receives from a private equity, venture, or hedge fund after investors get their capital back plus a preferred return. The GP is typically entitled to 20% of profits above a hurdle rate, often set at 8%.
The GP usually puts up little or none of its own capital to earn this. The carry is, in plain terms, a performance fee for managing other people's money. But the IRS has historically treated it not as compensation for services, but as a return on a partnership interest. That distinction is everything. Compensation is taxed as ordinary income. A return on a partnership interest can qualify as long-term capital gains.
The rate gap tells the story clearly. Long-term capital gains are currently taxed at 20%. Ordinary income for high earners is taxed at 37%, and once you add the 3.8% net investment income tax, the effective rate reaches 40.8%. That 17-to-20.8 percentage point spread is what makes carried interest one of the most valuable tax treatments in American finance. And it's what Congress has been arguing about for nearly two decades.
How Carried Interest Is Currently Taxed
Before the Tax Cuts and Jobs Act of 2017, the only requirement to qualify for long-term capital gains treatment on carried interest was that the underlying fund assets had to be held for more than one year. The TCJA changed that. Under Section 1061, GPs now must hold fund assets for at least three years for carry to qualify for capital gains rates.
In practice, that reform barely moved the needle. Typical PE fund holding periods run five to seven years. Most GPs already cleared the one-year bar with room to spare, and they clear the TCJA's three-year bar just as easily. The Congressional Research Service noted this directly in its analysis: the TCJA change had limited practical impact on PE funds because their investment horizons already exceeded the new threshold.
The arithmetic is not subtle. A PE fund manager earning $10 million in carried interest in 2026 pays roughly $2 million in federal tax. Under proposed legislation taxing that same income as ordinary income, the bill rises to $3.7 million to $4.08 million. That's a real difference. It changes the compensation math for fund managers and ripples through to fund structure decisions across the industry.
The Joint Committee on Taxation estimates S.4330 would raise $63.1 billion in federal revenue over ten years. A parallel House bill introduced June 1, 2026 by Rep. Marie Gluesenkamp Perez and Rep. Don Beyer, called the Carried Interest Fairness Act, carries a Treasury estimate of $6.5 billion over the same period. The gap between those two numbers reflects different scope and enforcement mechanisms in each bill, not a disagreement about the basic policy direction.
The 2026 Legislative Push
S.4330 is the most aggressive version of carried interest reform yet introduced. Wyden, Whitehouse, and King are targeting what they call "investment services partnership interests," a category designed to capture the economic reality of GP compensation without relying on the outdated legal distinction between capital and services. The bill would recharacterize carry as ordinary income regardless of how long the underlying assets are held.
On the House side, Gluesenkamp Perez and Beyer introduced their companion legislation on June 1, 2026. Their bill takes a similar position: if you are being compensated for managing a fund, that income should be taxed like other compensation. The framing from both chambers is consistent. Carried interest is a tax preference for a narrow class of highly compensated professionals, and it should be eliminated.
The political environment in 2026 is more charged than it was in 2022, when the Inflation Reduction Act came within a single Senate vote of including a carried interest provision. Sen. Kyrsten Sinema blocked that language in exchange for other concessions. Sinema is no longer in the Senate. But Senate arithmetic still requires 60 votes to overcome a filibuster, and that math has not become more favorable for reform.
Why It Keeps Surviving
I've tracked this issue for years. The carried interest debate has been alive since 2007. Every time it nearly passes, PE lobbying buries it. Understanding why it keeps surviving tells you a lot about how the industry protects GP economics.
The PE and venture capital industry's primary argument has three parts. First, carried interest represents risk-bearing. GPs claim their partnership interest aligns them with investors by putting their "sweat equity" at stake alongside LP capital. Second, eliminating the preference would discourage long-term investment by raising the effective tax rate on patient capital. Third, the revenue gain is modest relative to federal scale: $63.1 billion over ten years is real money, but small against annual deficits running into the trillions.
None of these arguments are new. They've been road-tested in front of Congressional committees since the Obama era. What makes them effective is not their intellectual force but the institutional apparatus behind them. The American Investment Council, which represents major PE firms, spends aggressively on lobbying. Individual fund managers give to candidates on both sides of the aisle. Key committee chairs have historically received significant campaign contributions from the financial sector.
There's also a structural problem: reforming carried interest requires clear definitions of what counts as a "services" interest versus a genuine "capital" interest. Drawing that line is technically complicated. Courts and the IRS have struggled with it. Opponents use that complexity to argue the reform would create uncertainty and litigation risk. That argument has repeatedly given fence-sitting legislators a policy excuse for a political choice.
You can read more about how regulatory enforcement shapes LP exposure in our piece on SEC enforcement and LP protections in 2026.
What Would Actually Change If a Bill Passed
The immediate effect would be a tax rate increase on GP compensation of 17 to 20.8 percentage points, depending on the manager's total income and state of residence. A New York-based fund manager would face state and city taxes on top of federal rates, pushing the combined marginal rate above 50% in some scenarios.
That changes the economics of starting and running a PE fund. The carry model exists because it defers compensation and taxes it favorably on exit. If the tax advantage disappears, GPs have less incentive to structure compensation as carry rather than management fees. Management fees are deductible by the fund; carry is not. Shifting more compensation toward fees would reduce the fund's net returns to LPs. It would also weaken the performance alignment that carry creates, since a GP earning mostly fees has less financial stake in fund outcomes.
For GPs at large established funds, the change is painful but survivable. They have diversified income streams, scale, and the ability to adjust fee structures over time. For emerging managers — first and second fund GPs who rely on the prospect of future carry to attract talent and defer near-term compensation — the calculus changes more sharply. Raising the tax cost of carry could reduce new fund formation, which affects LP access to the early-stage funds that often generate the highest returns.
Our analysis of PE return benchmarks for 2025-2026 shows that vintage-year spread is wide. LP returns depend heavily on manager selection. If tax reform concentrates capital with established managers and reduces new entrants, that selection universe narrows.
Impact on Fund Economics: What LPs Need to Think About
If you are an accredited investor in a PE fund or considering an LP commitment, the carried interest debate is not an abstract tax policy question. It touches the incentive structure of every fund you invest in.
The standard 2-and-20 model, meaning a 2% management fee and 20% carry, has already been under pressure from large institutional LPs who have negotiated lower carry percentages and higher hurdle rates. A 20% gross carry at a 20% tax rate produces a different net-of-tax outcome for the GP than a 20% gross carry at a 37% tax rate. If GPs need to maintain the same after-tax income, carry percentages would need to rise to roughly 25-28%, or other compensation structures would emerge entirely.
Neither outcome is clearly bad for LPs. Higher carry percentage with a higher hurdle rate still aligns the GP with performance. What matters is the structure of the agreement you sign, not the tax treatment the GP applies to their own proceeds. Before you commit to any fund, you should understand the waterfall, the preferred return, and how carry is calculated and distributed. Our breakdown of LP agreement red flags is a practical starting point for that review.
There is also a second-order question about fund-of-funds. If the underlying GPs face higher tax costs and adjust their structures, the fee compression in fund-of-fund arrangements becomes even more acute. Two layers of carry, one at the GP level and one at the fund-of-funds level, taxed at ordinary income rates rather than capital gains rates, would significantly erode net returns. We've covered this in our analysis of when fund-of-fund fee structures are actually worth the cost.
A Timeline of Reform Attempts
| Year | Bill / Event | Outcome |
|---|---|---|
| 2007 | Rep. Levin (D-MI) first introduces carried interest reform legislation in the House | Did not advance in Senate |
| 2010 | House passes carried interest reform as part of broader tax package | Stripped in Senate conference |
| 2012 | Mitt Romney's carried interest income disclosure elevates public debate during presidential campaign | No legislation advanced |
| 2015 | Obama administration budget repeatedly proposes carried interest reform | Congress does not act |
| 2017 | TCJA (P.L. 115-97) extends holding period from 1 year to 3 years under Section 1061 | Enacted; minimal practical impact on PE funds |
| 2021 | Build Back Better Act includes carried interest reform | Bill stalled in Senate; provision removed |
| 2022 | Inflation Reduction Act draft includes 5-year holding period extension; Sen. Sinema objects | Provision dropped; bill enacted without it |
| 2025 | Sen. Wyden introduces early version of S.4330; companion House discussion drafts circulate | No floor vote; carried over to 2026 |
| April 2026 | S.4330 (Wyden, Whitehouse, King) formally introduced; JCT scores at $63.1B over 10 years | In committee as of June 2026 |
| June 2026 | Carried Interest Fairness Act introduced by Gluesenkamp Perez and Beyer; Treasury estimates $6.5B | In committee as of publication date |
What Accredited Investor LPs Should Understand Right Now
The current legislative status: no carried interest reform bill has passed committee in 2026. Senate floor math does not favor the 60-vote threshold required to advance the bill. The House bill faces a similarly narrow path. Neither is close to enactment.
What you should take away from this debate is not a prediction about which way Congress will vote. Tax legislation is too politically unpredictable for confident forecasting. What the 2026 legislative push reveals is a structural tension in how PE fund compensation is designed. That tension shapes every new fund formation decision, every carry negotiation, and every LP side letter discussion happening right now.
If you are negotiating LP terms or evaluating a fund commitment, ask your GP directly: how would your compensation structure change if carried interest were taxed as ordinary income? The quality of that answer tells you something real about their approach to long-term fund economics. A GP who has modeled it and discussed it with tax counsel is a different counterparty than one who hasn't thought past the current rules.
For primary sources: the Congressional Research Service report R46447 covers the history and mechanics thoroughly. The Senate Finance Committee press release on S.4330 lays out the sponsors' framing directly. The Gluesenkamp Perez press release on the Carried Interest Fairness Act covers the House bill's scope. The American Investment Council publishes the industry's counterarguments. For Section 1061 mechanics, the Tax Foundation's carried interest explainer is a reliable reference.
Carried interest reform has been declared imminent at least a dozen times since 2007. It has never passed in full. The industry has survived every push. But the arguments against it have not gotten stronger, and the political coalition in favor of reform has not gotten smaller. If you are building a portfolio strategy around PE allocations, model both scenarios. The tax treatment of your GPs' compensation is a real variable, not a constant.
Author Disclosure: Jeff Barnes, MBA has no personal position in any company, fund, or platform named in this article. Angel Investors Network has no current commercial relationship with any party mentioned. AIN provides marketing and education services, not investment advice. Past performance does not guarantee future results. All investments involve risk, including loss of principal.
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About the Author
Jeff Barnes, MBA