How Private Equity Returns Are Actually Taxed
Carry, deemed disposals, returns of capital, and the difference between distribution and accrual — how PE returns reach you after tax.
Distributions vs. accruals
A PE fund's NAV may rise every quarter, but in most jurisdictions you are not taxed on unrealised gains. Tax is triggered by actual distributions, deemed disposals (in jurisdictions like the UK's offshore-fund rules), or — for tax-transparent vehicles — your share of the underlying gains regardless of distribution.
Understanding which regime applies to your fund vehicle is the difference between modelling cash tax and modelling phantom tax.
Return of capital is not income
Early PE distributions are often a return of capital, not income or gain. They reduce your cost basis rather than triggering tax. Later distributions become gain once basis is fully recovered. Misclassifying these is a common error that leads to overpaying tax in the early years and underpaying later.
A clean investor statement should split each distribution into 'return of capital' and 'gain' so the tax treatment is obvious.
Carry, hurdle and how the GP gets paid
Most PE economics include a preferred return (e.g. 8%) to investors, a catch-up to the GP, and then a split of profits (typically 80/20). The GP's share is carried interest. Its tax treatment varies — capital gains in the US (a long-standing political debate), ordinary income in some EU jurisdictions, mixed in others.
For investors, the relevance is simpler: model the post-carry return, not the gross return. A 20% gross IRR can become a 14% net IRR after fees and carry. Always run the math on the waterfall, not the headline.
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