The Carried Interest Fairness Act of 2025 aims to significantly alter the tax treatment of income earned by partners providing investment management services in pass-through entities. Its central purpose is to reclassify much of what is currently taxed as long-term capital gains, often referred to as "carried interest," as ordinary income, which is generally subject to higher tax rates. This change applies to income derived from "investment services partnership interests" and other "disqualified interests" in investment entities.

A key provision of the bill is the creation of new Internal Revenue Code Section 710, which mandates that net capital gain attributable to an investment services partnership interest be treated as ordinary income. Similarly, any gain recognized upon the disposition of such an interest would also be recharacterized as ordinary income. These rules are designed to ensure that compensation for investment management services is taxed at ordinary income rates, aligning with how other forms of service income are treated.

The bill defines an "investment services partnership interest" as an interest in an "investment partnership" held in connection with providing services like advising, managing, or acquiring assets. An investment partnership is generally one where substantially all assets are "specified assets" (e.g., securities, real estate) and less than 75% of its capital comes from qualified capital interests. However, the legislation includes an important exception for "qualified capital interests," allowing income attributable to a partner's actual capital contributions to retain its character if certain conditions are met, such as comparable allocations to non-service providers.

Beyond direct partnership interests, the bill extends its reach to other forms of compensation. It stipulates that income or gain from a "disqualified interest" in an investment entity or special purpose acquisition company, where the value is tied to investment management services, will also be treated as ordinary income. This aims to prevent recharacterization through alternative structures. Domestic C corporations, excluding special purpose acquisition companies, are generally exempt from these new rules.

Furthermore, the legislation subjects this recharacterized income to self-employment taxes, meaning it would be included in net earnings from self-employment for Social Security and Medicare purposes. It also amends Section 751 to treat investment services partnership interests as "hot assets," triggering ordinary income on certain partnership interest transfers or distributions. To deter non-compliance, the bill introduces a substantial 40% penalty for underpayments related to avoiding these new rules, with stricter requirements for demonstrating reasonable cause.

The bill also modifies Section 7704, which governs publicly traded partnerships, by specifying that "specified carried interest income" will not be considered qualifying income. This could impact the tax status of some publicly traded partnerships, though a 10-year transitional rule is provided for this particular change. The Secretary of the Treasury is granted broad authority to issue regulations to prevent avoidance and ensure the proper implementation and coordination of these new provisions.