How VCs Should Think About Carried Interest Tax Planning

Key Takeaways

• Carried interest (your share of fund profits) is taxed as long-term capital gains (20% max rate) instead of ordinary income (37% max rate)
• The 2017 Tax Cuts and Jobs Act added a 3-year holding period requirement for investments made after 2017
• Clawback provisions can create unexpected tax bills if you have to return carried interest
• State taxes on carried interest vary widely (California charges 13.3%, Texas charges zero)
• Charitable giving strategies (DAFs, private foundations) can offset high carry income years

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Business Insider just published their "Rising Stars of VC 2026" list. 37 young investors (associates, principals, founding partners) making big moves. If you're on that list (or aspire to be), you need to understand how carried interest is taxed.

I work with VCs, and the most common question I get is: "Why is my tax bill so confusing?" The answer usually comes down to carried interest, clawback provisions, and the 3-year holding rule that most people don't fully understand. For related tax planning, see our guide on fintech founder tax mistakes.

Let me break it down.

What Is Carried Interest and Why Does It Get Special Tax Treatment?

Carried interest (also called "carry") is the share of fund profits that goes to the general partners (GPs) of a venture fund. Typically, GPs get 20% of profits after returning capital to limited partners (LPs). For founders considering similar tax planning, check out our QSBS guide for founders.

Example: A $100M fund returns $300M to LPs. After returning the original $100M, there's $200M in profit. The GP gets 20% of that profit = $40M in carried interest.

Here's the tax advantage: Even though you didn't put up the capital (the LPs did), your carried interest is taxed as long-term capital gains (max 20% federal rate) instead of ordinary income (max 37% federal rate).

Why does this special treatment exist? The argument is that GPs are taking risk (their time, reputation, opportunity cost) and should be rewarded like investors, not employees. Critics argue it's a loophole that lets wealthy VCs pay lower tax rates than teachers and firefighters. Either way, it's the law.

How Did the 2017 Tax Cuts and Jobs Act Change Carried Interest Rules?

Before 2018, carried interest qualified for long-term capital gains treatment if the underlying investment was held for 1 year. The 2017 Tax Cuts and Jobs Act (TCJA) changed that.

Now, for investments made after December 31, 2017, you must hold the investment for 3 years to get long-term capital gains treatment on carried interest.

If you hold for less than 3 years, the carried interest is taxed as short-term capital gains (same rate as ordinary income, up to 37%).

Why this matters for VCs:

Most venture funds hold investments for 5-10 years, so the 3-year rule isn't usually a problem. But if your fund does a quick flip (invests in a company, sells 2 years later), your carry gets hit with the higher short-term rate.

Example: You're a GP at a growth-stage fund. You invest in a company in 2024, and it gets acquired in 2026 (2-year hold). You make $5M in carried interest. Under the old rules, that would be taxed at 20% long-term capital gains = $1M in tax. Under the new rules, it's taxed at 37% short-term = $1.85M in tax. The 3-year rule just cost you $850K.

What to do: Track holding periods carefully. If you're close to the 3-year mark on an exit, it might be worth negotiating with the acquirer to delay closing by a few months. An $850K tax savings is a strong incentive.

What Are Clawback Provisions and How Do They Affect Taxes?

Most VC fund agreements include a clawback provision. This means if the GP receives carried interest early in the fund's life (based on early exits), but later investments lose money, the GP has to return some of the carry to make LPs whole.

Example: Your fund has 10 investments. The first 3 exits return $150M, and you take $10M in carried interest. But the remaining 7 investments go to zero. The fund ends up returning less than the original capital to LPs. You owe a clawback to repay part of that $10M.

Tax problem: You already paid tax on the $10M (at 20% long-term capital gains = $2M in tax). Now you have to give back, say, $4M. Do you get your $800K in taxes refunded?

Answer: Sort of, but not immediately. You can deduct the clawback as a loss in the year you repay it. But that loss might not fully offset the gain you recognized earlier, especially if your income is lower in the clawback year.

What to do: Set aside cash from early carry distributions to cover potential clawbacks AND the tax on the clawback. Some GPs set up a separate escrow account for this. Don't spend all your carry assuming it's permanent.

How Do State Taxes Affect Carried Interest?

Carried interest is taxed at the state level too, and state rates vary wildly.

High-tax states:

• California: 13.3% on capital gains (same as ordinary income)
• New York: 10.9% (combined state + NYC tax)
• New Jersey: 10.75%

No-income-tax states:

• Texas, Florida, Nevada, Washington: 0%

Example: You make $10M in carried interest. Federal tax (20% long-term capital gains) = $2M. California state tax = $1.33M. Total tax = $3.33M. For similar equity comp tax planning, see RSU tax mistakes tech founders make.

If you lived in Texas? Total tax = $2M. Moving to Texas saves you $1.33M on that one carry distribution.

Strategy: Some VCs move to no-income-tax states before a big liquidity event. But (like with QSBS), you need to establish residency BEFORE the carry is realized. California will audit you if they think you moved just for taxes. You need documentation: lease, utility bills, time tracking (spend 183+ days/year in the new state).

I've worked with VCs who saved over $1M by moving to Austin or Miami a year before their fund had a major exit. But I've also seen California claw back taxes from people who didn't do it right.

What Charitable Giving Strategies Work for VCs with High Carry Years?

If you have a big carry distribution (say, $10M), your tax bill will be around $3M+ depending on your state. One way to reduce that: donate appreciated assets (stock, carried interest units) to charity.

Two main strategies:

1. Donor-Advised Funds (DAFs)

You contribute appreciated stock or cash to a DAF (Fidelity Charitable, Schwab Charitable, etc.). You get an immediate tax deduction for the full fair market value, even though the charity doesn't receive the money right away. You then recommend grants from the DAF to charities over time.

Tax benefit: If you donate $2M of appreciated stock to a DAF, you can deduct $2M from your income (subject to AGI limits). At a 37% marginal rate, that saves you $740K in federal taxes.

Why VCs like DAFs: You can bunch donations into high-income years (when you realize carry) and then distribute to charities over many years.

2. Private Foundations

If you want more control (and have significant wealth), you can set up a private foundation. You contribute assets, get a tax deduction, and the foundation makes grants to charities you choose.

Downside: More administrative burden (990-PF tax filings, excise taxes, minimum distribution requirements). Only makes sense if you're donating $5M+ over your lifetime.

What to do: If you're expecting a big carry distribution, talk to your CPA in the year BEFORE the distribution. Set up a DAF or foundation in advance so you can donate appreciated stock before you sell it. This is way more tax-efficient than selling stock, paying capital gains tax, and then donating cash.

What About Management Fees vs Carried Interest?

VCs earn income from two sources:

1. Management fees: Usually 2% of committed capital per year. This is ordinary income (taxed at up to 37%).
2. Carried interest: 20% of fund profits. This is long-term capital gains (taxed at 20%, assuming 3-year hold).

Common mistake: Young VCs think their entire compensation is carry. In reality, most of your income early in your career is management fees (ordinary income). As you become a senior GP and the fund has exits, carry becomes a bigger part of your comp.

Tax planning tip: Max out retirement accounts (401(k), backdoor Roth IRA) with your management fee income. You can't contribute carried interest to a 401(k) (it's not W-2 income), so use your salary/management fees to max out tax-advantaged accounts.

Summary

Carried interest is one of the most tax-efficient forms of compensation, but it comes with complexity. Here's what VCs need to remember:

• Carried interest is taxed at 20% long-term capital gains (vs 37% ordinary income), but you must hold investments for 3+ years
• Clawback provisions can create unexpected tax bills, so set aside cash for potential repayments
• State taxes vary massively (California charges 13.3%, Texas charges 0%)
• Charitable giving (DAFs, private foundations) can offset high carry years
• Track holding periods carefully to avoid short-term capital gains treatment

If you're a VC with a big carry distribution coming, don't wait until April to think about taxes. Plan in advance. The difference between good tax planning and no planning is hundreds of thousands (or millions) of dollars.

Sources:

• 2017 Tax Cuts and Jobs Act (Section 1061)
• IRS Publication 541 (Partnerships)
• Business Insider Rising Stars of VC 2026