Is carried interest taxed as capital gain or ordinary income for a US citizen working at a UK fund?

It can be both in the same year. Under IRC section 1061, long-term capital gain allocated in respect of an applicable partnership interest keeps long-term treatment only to the extent it derives from assets held more than three years. The remainder is recharacterised as short-term capital gain and taxed at ordinary rates. The test applies asset by asset, so a single carry allocation is routinely split between the two characters. Section 1231 gains, section 1256 gains and qualified dividends fall outside section 1061 entirely.

Does section 1061 apply if the fund and the carry vehicle are both outside the United States?

Yes. Section 1061 governs the character of gain allocated to a US taxpayer and does not depend on where the fund, the general partner, the carry vehicle or the portfolio companies are established. A US citizen or green card holder at a London fund holding carry through a UK, Scottish, Jersey or Guernsey partnership is fully within the rule. What changes is not whether section 1061 applies but who performs the computation, because a non-US carry vehicle typically issues no Schedule K-1 and no Section 1061 Worksheet A.

What do I do if my UK carry vehicle never issues a Schedule K-1?

The computation still has to be made on your Form 1040, using the fund's own records. In practice that means the audited financial statements, the realisation schedule with acquisition and disposal dates for each position, and partner capital account statements that separate carry from co-invest. From that you build the API One Year Distributive Share Amount and the API Three Year Distributive Share Amount yourself, complete Section 1061 Worksheet B with Tables 1 and 2, and document the method used where the fund cannot supply asset-level data. You should also test whether Form 8865 is required for the vehicle.

Which box on the Schedule K-1 carries the section 1061 information, and how does it reach Form 8949?

Where a US passthrough entity is involved, Section 1061 Worksheet A is attached to the Schedule K-1 and referenced at box 20 code AH on Schedule K-1 (Form 1065), or box 17 code AD on Schedule K-1 (Form 1120-S). You then complete Worksheet B and post a Section 1061 Adjustment to Form 8949: in Part I the Recharacterization Amount is entered as short-term proceeds with zero basis, and in Part II as basis with zero proceeds. Net gain is unchanged; only the character moves, and the result carries to Schedule D.

Does passing the UK 36 to 40 month average holding period test mean I pass the US three-year test?

No, and assuming otherwise is one of the most expensive mistakes in this area. The UK test under the regime effective 6 April 2026 is a single value-weighted average across the whole investment scheme, determining what proportion of carry is qualifying and therefore subject to the 72.5 percent multiplier. The US section 1061 test is applied separately to each asset generating gain allocated to your applicable partnership interest in that year. A fund can be 100 percent qualifying in the UK while most of your US allocation is recharacterised as short-term, or the reverse.

Can I claim a full foreign tax credit for UK tax on carry against the US tax on the same carry?

Often not in full, because of timing and category. The US charge generally arises when the fund allocates the gain to you, while the UK charge arises when carry is received, which can be years later. Foreign tax credits are claimed on Form 1116 within separate limitation categories, and under section 904(c) unused credits carry back only one year and forward ten. Credits arising in the UK payment year cannot reach a US liability from several years earlier. HMRC's elective accruals basis for carried interest, available from the 2022-23 tax year and stated on GOV.UK to be aimed at aligning the UK tax point with other jurisdictions, is one lever worth modelling. The 3.8 percent net investment income tax cannot be reduced by foreign tax credits at all.

Carried Interest US Tax UK: Section 1061 Rules

Carried interest US tax UK treatment begins and ends with one provision on the American side: IRC section 1061. Section 1061 requires an asset to have been held for more than three years before long-term capital gain allocated in respect of an applicable partnership interest keeps its long-term character on your Form 1040. Anything inside that window is recharacterised as short-term capital gain and taxed at ordinary rates. If you are a US citizen, green card holder or dual US/UK national holding carry at a London private equity, private credit or hedge fund, that single sentence governs the largest number on your US return, and it is measured entirely independently of whatever HMRC concludes about the same distribution.

This page is written for the US preparation and compliance side of that position. It is deliberately not a walkthrough of the UK income tax charge on carry, which we cover separately. What follows is the section 1061 machinery, the Schedule K-1 and Schedule K-3 information a UK-based principal actually receives, what is almost always missing from it, how the recharacterisation lands on Form 8949 and Schedule D, and where the UK regime that took effect on 6 April 2026 collides with the US calculation for foreign tax credit purposes.

What is an applicable partnership interest under section 1061?

An applicable partnership interest, or API, is a partnership interest transferred to or held by a person in connection with the performance of substantial services by that person or a related person in an applicable trade or business. That is the statutory definition in section 1061(c), and it is broad by design. A standard carry allocation held through a general partner vehicle, a special limited partner, a carry partnership, or a chain of two or three such vehicles is an API, and the character flows through every tier.

An applicable trade or business is an activity conducted on a regular, continuous and substantial basis that consists of raising or returning capital and either investing in, disposing of, or developing specified assets. Specified assets are the ordinary furniture of a fund: securities, commodities, real estate held for rental or investment, cash and cash equivalents, options and derivatives on any of those, and interests in partnerships to the extent of the partnership's own specified assets. A UK buyout fund, a credit fund and a long/short equity fund all sit comfortably inside the definition.

Two structural points matter for UK principals in particular. First, section 1061 is a rule about the character of gain allocated to a US taxpayer. It does not care where the fund, the carry vehicle, the general partner or the portfolio companies are established. A Jersey limited partnership feeding a Scottish limited partnership feeding a UK LLP produces the same section 1061 answer as a Delaware stack. Second, section 1061 does not apply to a partnership interest held by a corporation, but the final regulations pull that carve-out back for an S corporation and for a passive foreign investment company with a qualified electing fund election in place. Interposing a company is therefore not the simple fix it looks like, and for a US taxpayer sitting in the UK it usually creates a far larger set of problems than it solves.

Which gains does section 1061 leave alone?

Section 1231 gains and losses, which is why a fund with genuine operating real property can produce carry allocations that escape recharacterisation entirely
Section 1256 gains and losses, relevant to funds trading regulated futures and certain foreign currency contracts
Qualified dividends, which retain their preferential rate regardless of the three-year test
Gain properly allocable to a capital interest that satisfies the capital interest exception in section 1061(c)(4)(B) and Treas. Reg. 1.1061-3
Gain allocated in respect of an interest held by a C corporation that is not an S corporation and not a PFIC with a QEF election

In preparation terms, these carve-outs are the difference between a routine return and a very expensive one. They are also the items most often lost in translation when the fund's accounting is prepared to UK GAAP or IFRS and never mapped to US character categories. If nobody has asked the administrator to split the year's realisations into section 1231, section 1256, qualified dividend and ordinary capital gain buckets, nobody can apply the carve-outs, and the conservative default is that the whole allocation goes into the section 1061 computation.

The capital interest exception, and why UK principals lose it on paperwork

Most fund principals invest their own money alongside the fund, frequently a meaningful multiple of their salary. Gain on that genuine capital is not carry and is not caught by section 1061. But the exception is conditional. Treas. Reg. 1.1061-3 requires that the allocations to the capital interest be determined and reported in a manner reasonably similar to the allocations made to significant unrelated non-service partners, meaning investors holding 5 percent or more of aggregate capital contributions. Treas. Reg. 1.1061-3(c)(3)(ii)(B) then requires the partnership to identify those allocations clearly through contemporaneous books and records.

The word that does the damage is contemporaneous. A UK fund whose partnership agreement lumps a principal's co-invest and carry into a single capital account, and whose administrator produces one blended capital account statement per partner per quarter, has not made the identification. Reconstructing the split three years later during a US return preparation cycle is not the same thing. The downside is not marginal: if the API and the capital interest cannot be separated on the fund's own records, the safe filing position treats the entire allocation, co-invest returns included, as subject to recharacterisation. There is one helpful rule in the other direction. Under Treas. Reg. 1.1061-3(c)(3)(iii), API gain that is actually distributed and reinvested, or simply retained in the partnership, is treated thereafter as a capital interest, so carry that has already been through the section 1061 filter does not get taxed as carry a second time on its subsequent growth.

How does carried interest US tax UK reporting actually work on a Form 1040?

The reporting architecture comes from Treas. Reg. 1.1061-6 and the IRS section 1061 reporting guidance FAQs published on IRS.gov. It runs in two halves: what the passthrough entity is supposed to give you, and what you are supposed to do with it.

The passthrough entity completes Section 1061 Worksheet A and attaches it to your Schedule K-1, referenced at box 20 code AH on Schedule K-1 (Form 1065), or box 17 code AD on Schedule K-1 (Form 1120-S)
Worksheet A reports two figures: the API One Year Distributive Share Amount, being long-term capital gain computed on a more-than-one-year holding period, and the API Three Year Distributive Share Amount, computed on a more-than-three-year holding period
As the owner taxpayer you complete Section 1061 Worksheet B, with Tables 1 and 2, and attach it to your own return
The excess of the One Year Amount over the Three Year Amount, after the adjustments on Worksheet B, is the Recharacterization Amount
On Form 8949 you make a Section 1061 Adjustment: in Part I you enter the Recharacterization Amount as short-term proceeds with zero basis, and in Part II you enter zero proceeds with the Recharacterization Amount as basis, so the net gain is unchanged and only the character moves
The result carries to Schedule D, and collectibles gain and unrecaptured section 1250 gain are tracked separately on Worksheet B lines 10 and 11 using a reasonable method
A section 1061(d) transfer to a related person, including a transfer that would otherwise be non-recognition, is picked up on Worksheet B line 8

Two further rules sit behind the arithmetic. The Lookthrough Rule can recharacterise gain on the disposal of the API itself, even where you have held the API for more than three years, where substantially all of the underlying partnership assets have a short holding period. And section 1061(d) means that moving carry to a spouse, a child or a related vehicle can accelerate short-term gain rather than defer anything. Both are the sort of provision that a principal encounters exactly once, at the worst possible moment, having already signed the transfer documents.

What the Schedule K-1 and Schedule K-3 do not tell a UK-based principal

Here is the practical reality that almost no published commentary addresses. The reporting regime above assumes there is a US passthrough entity filing a Form 1065 and issuing a Schedule K-1 with a Worksheet A attached. A very large proportion of UK fund principals hold their carry through a vehicle that does no such thing. A UK, Scottish, Jersey or Guernsey limited partnership with no US investors, no US trade or business and no US-source income files no Form 1065. It issues no Schedule K-1, no Schedule K-3, and no Section 1061 Worksheet A. The general partner's finance team has never heard of box 20 code AH and has no obligation to have heard of it.

That does not switch off section 1061. It transfers the entire computational burden to your US return preparation. In practice the file has to be built from the fund's own records:

The fund's audited financial statements and the realisation schedule showing acquisition and disposal dates for every portfolio investment realised in the period
Partner capital account statements separating the principal's carry allocation from any co-invest or commitment capital, ideally as issued at the time rather than reconstructed
A character analysis mapping each realisation to US categories, so that section 1231, section 1256 and qualified dividend items can be carved out
Holding period data at the level of each disposed asset, since the three-year test is applied asset by asset and not to the fund as a whole
Documentation of the reasonable method adopted where the fund genuinely cannot supply asset-level data, retained with the return

Alongside the section 1061 computation sits the information return overlay. A US person holding an interest in a foreign partnership may be a Category 1, 2 or 3 filer of Form 8865, Return of US Persons With Respect to Certain Foreign Partnerships, with Schedules K-2 and K-3 completed by reference to the Form 1065 instructions. Control and acquisition thresholds are tested at the carry vehicle level, and a promotion that increases your percentage interest can itself be a reportable acquisition. Penalties on Form 8865 are per form, per year, and are assessed without regard to whether any US tax was underpaid. In our experience this is where a UK fund principal's exposure most often turns out to be procedural rather than substantive.

Worked example: a UK fund principal's section 1061 year

Take a fictional principal, James, a dual US/UK national and a partner at a London mid-market buyout fund. He is UK resident and files a Form 1040 as a US citizen. In the year, the fund realises three positions and allocates 900,000 USD of long-term capital gain to the carry partnership, of which James's share is 300,000 USD. Asset one, held 55 months, produced 40 percent of the gain. Asset two, held 29 months, produced 45 percent. Asset three, a bolt-on disposed 14 months after acquisition, produced the remaining 15 percent. James also holds a 500,000 USD co-invest, separately documented, which returns 60,000 USD of gain on a position held six years.

For the carry, the API One Year Distributive Share Amount is 300,000 USD, because every asset was held more than one year. The API Three Year Distributive Share Amount is 120,000 USD, being only the asset held 55 months. The Recharacterization Amount is 180,000 USD, which moves from long-term to short-term on Form 8949 and is taxed at ordinary rates. The 60,000 USD of co-invest gain sits outside section 1061 under the capital interest exception, provided the fund's contemporaneous records identify it properly, and retains long-term treatment. Note what has happened: nothing about James's economics changed, and 60 percent of his carry gain has been converted into ordinary income by a holding period test he does not control. Note also what would have happened if the co-invest and carry had shared one blended capital account: the 60,000 USD would have been dragged into the computation as well.

The UK regime from 6 April 2026 and the foreign tax credit collision

The UK changed its treatment of carried interest with effect from 6 April 2026. Under the revised regime described in HM Treasury's policy paper Revised tax regime for carried interest on GOV.UK, carried interest is treated as trading profits and charged to Income Tax and Class 4 National Insurance contributions. Where carried interest is qualifying, the amount treated as trading profits is 72.5 percent of the qualifying profits. Whether carry is qualifying depends on the average holding period of the relevant investment scheme, and the draft legislation published on GOV.UK sets a sliding scale: nil qualifying below 36 months, then 20 percent at 36 to 37 months, 40 percent at 37 to 38 months, 60 percent at 38 to 39 months, 80 percent at 39 to 40 months, and 100 percent at 40 months or more. The average is value-weighted, calculated by multiplying the value invested in each relevant investment by the time held, summing, and dividing by total value invested. The effective UK rate that results depends on the individual's marginal income tax position and Class 4 NIC position for the relevant tax year, and should be confirmed against the enacted legislation for the year in question rather than assumed from pre-enactment commentary.

This is where the second and larger trap sits. The UK 36 to 40 month scale and the US 36 month test look like the same idea. They are not. The UK test is a single value-weighted average across the whole scheme, applied to the carry as a block. The US test is applied asset by asset, gain by gain, to the specific allocations made to your API. A fund can pass the UK average holding period condition at 100 percent qualifying while the majority of the gain allocated to you in that particular year came from assets held under three years, producing heavy US recharacterisation. The reverse is equally possible. Passing one test tells you nothing about the other, and any planning that assumes symmetry is planning on a false premise.

Character and timing then compound the problem for the foreign tax credit. The UK charge is an income tax charge arising when carry is received. The US charge arises when the fund allocates the gain, which for a partner in a flow-through structure can be years earlier, and the US character may be capital gain, short-term capital gain, or a mixture. Foreign tax credits are claimed on Form 1116 within separate limitation categories under section 904(d), and unused credits carry back one year and forward ten years under section 904(c). A credit generated in the year the UK tax is paid cannot be carried back more than one year to meet a US liability that arose three years earlier. That is the structural reason so many UK fund principals accumulate a large and permanently unusable excess credit pool while still writing a real cheque to the IRS.

Two levers are worth knowing about at the preparation stage. HMRC's elective accruals basis for the carried interest rules, introduced with effect from the 2022-23 tax year, allows a voluntary and irrevocable election for carried interest to be taxed in the UK on an accruals basis, and GOV.UK states its purpose expressly as aligning the UK tax point with that of other jurisdictions to make double taxation relief claimable. Separately, sourcing matters: section 865 sources gain on the sale of personal property by residence, and section 865(g)(2) will not treat a US citizen as a non-resident for that purpose unless foreign income tax of at least 10 percent of the gain is actually paid to the foreign country on that gain. Whether your carry gain is foreign source, and therefore capable of absorbing UK credits at all, is a question that has to be answered before the Form 1116 is populated, not after.

Self-employment tax, the net investment income tax and the other US charges

Section 1061 is a character rule, not the whole charge. Two further layers apply. The net investment income tax under section 1411 applies at 3.8 percent to net investment income above the statutory threshold, and those thresholds are not indexed for inflation. Critically, the NIIT applies whether the gain is long-term or short-term, so section 1061 recharacterisation does not remove it. It also cannot be reduced by foreign tax credits claimed on Form 1116, which is a recurring and unwelcome discovery for UK-resident principals who assume UK tax will cover the whole US bill.

Self-employment tax is the second layer, and it has moved. Management fee income and guaranteed payments allocated to a principal through a management vehicle have long been exposed. The limited partner exception in section 1402(a)(13) was widely relied on to shelter distributive shares, but in Soroban Capital Partners LP v. Commissioner, T.C. Memo 2025-52, decided 28 May 2025, the Tax Court applied a functional analysis and held that partners who were active in the business were not limited partners as such for that purpose. For a UK-based principal the analysis then runs into the US/UK social security agreement and the question of which country's system covers you, which has to be resolved with a certificate of coverage rather than assumed. Where a principal is paying UK National Insurance, including the Class 4 NIC now attaching to carry from 6 April 2026, the coverage position needs to be documented before any US self-employment tax conclusion is reached.

A US filing checklist for a UK fund principal

Obtain the fund's realisation schedule with acquisition and disposal dates for every position realised, not just the net gain figure
Confirm in writing whether any entity in the carry chain files a Form 1065 and will issue a Schedule K-1 with Section 1061 Worksheet A attached
Check that carry and co-invest are separately identified in contemporaneous partnership books and records, and fix the record-keeping prospectively if they are not
Carve out section 1231, section 1256 and qualified dividend items before running the section 1061 computation
Prepare Worksheet B with Tables 1 and 2, and post the Section 1061 Adjustment to Form 8949 Parts I and II
Test Form 8865 filing categories for every non-US partnership in the chain, including changes in percentage interest from promotions
Model the Form 1116 position by category and year before the UK tax point is fixed, and consider whether the HMRC elective accruals basis improves alignment
Confirm the section 865 sourcing conclusion, including the section 865(g)(2) 10 percent test, before claiming foreign source treatment
Document the net investment income tax and self-employment tax positions separately from the income tax computation
Retain the reasonable method memorandum where fund data is incomplete, and keep it with the return

Carried interest is the point where a UK fund principal's US filing stops being an administrative formality and starts being the largest single number on the return. Section 1061 is unforgiving, the data needed to apply it correctly is almost never delivered to a London-based principal in usable form, and the UK's revised regime from 6 April 2026 has moved the UK charge further away from the US charge in both character and timing rather than closer to it. The work is preparation work: assemble the asset-level data, apply the carve-outs before the recharacterisation, document the capital interest separation contemporaneously, and model the credit position across years rather than one return at a time.