US UK Cross-Border Tax Specialist Carried Interest Guide |

US UK Cross-Border Tax Specialist Carried Interest Guide |

US UK Cross-Border Tax Specialist: Carried Interest Guide

US UK Cross-Border Tax Specialist on Carried Interest

Carried interest is one of the most contested and most frequently misunderstood areas of compensation taxation in the fund management industry — and for US-citizen fund managers working in London, the divergence between the US and UK tax treatment of the same carry payment creates one of the most complex cross-border tax problems that a US-UK cross-border tax specialist encounters in private equity and hedge fund practice. Furthermore, the UK's favourable carried interest regime — which taxes qualifying carry as a capital gain at 28% for higher-rate taxpayers — does not correspond to any equivalent US treatment, since the IRS taxes the same payment under a combination of the partnership income flow-through rules, the Section 1061 three-year holding period rules for certain carried interest arrangements, and the GILTI and Subpart F regimes where the carry vehicle is an offshore entity. Consequently, a US-citizen fund manager in London who receives £2 million of carried interest and pays UK CGT at 28% can simultaneously face US federal tax on the same payment at rates between 20% and 37%, with only partial foreign tax credit relief available in most structures.

This article is written for US citizens who are UK residents working in private equity, venture capital, or hedge fund management, and who receive or anticipate receiving carried interest payments from fund structures. By the end of this guide, you will understand how the US and UK tax systems treat carried interest differently, where the foreign tax credit mechanism helps and where it fails to prevent double taxation, and what a US-UK cross-border tax specialist does to manage the combined tax exposure across both systems.

What Is Carried Interest and How Is It Structured?

Carried interest is the fund manager's share of profits generated by the fund's investments above a specified hurdle rate — typically 8% per annum — allocated to the manager as a performance fee in recognition of value added through investment selection and portfolio management. Furthermore, the economic substance of carried interest is that the manager receives a share of the fund's profits — typically 20% of returns above the hurdle — without having contributed the equivalent proportion of capital to the fund, since the manager's capital commitment to the fund is typically 1% to 2% of total fund capital rather than 20%. Consequently, the legal question that both the IRS and HMRC must answer — how to characterize the manager's profit share for tax purposes when the economic substance is a performance fee but the legal form is a capital allocation — produces different answers under US and UK law, with significant financial consequences for US-citizen managers who are within the scope of both systems.

For UK fund managers, carry is typically received through a carried interest vehicle — a limited partnership or other transparent entity established in the Cayman Islands, Luxembourg, or the UK — that allocates the carry to the individual manager as a partner's share of the vehicle's profits. Furthermore, the UK's carried interest regime under Chapter 5D of the Taxation of Chargeable Gains Act 1992 determines whether the carry is taxed as employment income, miscellaneous income, or a capital gain, with the capital gain treatment applying where the manager's average holding period in the fund's investments exceeds 40 months. The HMRC guidance on the UK carried interest regime is at https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg37500.

Why Carried Interest Tax Planning Matters More in 2026

The October 2024 Budget and UK Carried Interest Reform

The UK Autumn Budget of October 2024 announced a fundamental reform of the UK carried interest regime, replacing the existing regime from 6 April 2026 with a new approach that treats qualifying carried interest as employment income at a headline rate of 32.5% rather than at the current CGT rate of 28%. Furthermore, transitional rules apply to carry entitlements accrued before April 2026, with pre-April 2026 accruals continuing to be taxed at the current CGT rates in most cases. Consequently, for US-citizen fund managers who will receive carry distributions after April 2026, the combined US and UK effective tax rate on carried interest will change materially — the increase in the UK rate from 28% to 32.5% generates a larger UK foreign tax credit. Still, it may also produce a different income character for US foreign tax credit basket purposes, since employment income and capital gains are treated differently in the passive and general limitation baskets.

Section 1061 and the Three-Year Holding Period Rule

IRC Section 1061 — introduced by the Tax Cuts and Jobs Act of 2017 — imposes a three-year holding period requirement for certain carried interest arrangements to qualify for long-term capital gain treatment, replacing the standard one-year holding period that applies to most partnership capital allocations. Furthermore, where the underlying fund investments are not held for more than three years before the carry is allocated, the gain attributable to the carry is recharacterized as short-term capital gain taxable at ordinary income rates — up to 37% plus 3.8% NIIT — rather than long-term capital gain rates of 20% plus 3.8% NIIT. Consequently, US-citizen fund managers in private equity — where fund investment hold periods typically exceed three years — are generally less affected by Section 1061 than managers in hedge funds or venture funds with shorter investment hold periods. According to the https://www.aicpa.org, Section 1061 has been one of the most complex new provisions affecting investment fund managers since its introduction, with significant uncertainty remaining about its interaction with offshore fund structures.

The 2025 Estate Tax Sunset and Carry Vehicle Ownership

The anticipated reduction in the US unified credit after 31 December 2025 affects not just the fund manager's personal estate planning but also the estate tax treatment of their carried interest entitlement. Specifically, unvested or contingent carry that is included in the US taxable estate at fair market value at the date of death — as discussed in our estate planning guidance — is particularly relevant for fund managers whose carry vehicle holds interests in active funds where the carry is contingent on future investment performance. Furthermore, the carry vehicle's ownership structure — whether held personally, through a UK LLP, or through a Cayman LP — affects both the GILTI and Form 8865 treatment of the carry during the manager's lifetime and the estate tax treatment of the carry interest at death. Consequently, the estate planning review for carry must be coordinated with the annual income tax and compliance review rather than addressed as a separate exercise.

UK and US Carry Treatment: The Key Divergences

The UK Carried Interest Regime Pre and Post April 2026

Under the current UK carried interest regime — which applies to carry entitlements accruing before 6 April 2026 — the gain is taxed as a capital gain where the average holding period of the fund's investments at the time of the carry payment exceeds 40 months. Furthermore, carry payments with an average holding period between 36 and 40 months are taxed on a blended basis — partly as income and partly as capital — and carry with an average holding period below 36 months is taxed as income at the income tax rate applicable to the manager's total income. Additionally, the annual 20% investment return test requires that the manager's entitlement to carry be economically justified by the fund's investment performance exceeding a 20% annualized return threshold, with carry below this threshold potentially subject to the disguised investment management fee rules rather than the carried interest regime. The HMRC guidance on the disguised investment management fees rules is at https://www.gov.uk/hmrc-internal-manuals/investment-management-special-annual-tax-return.

Under the new UK carried interest regime from April 2026, qualifying carried interest is taxed as employment income at 32.5%, subject to National Insurance contributions and without the 40-month holding period test, representing a significant increase in the UK tax cost for fund managers who previously received carry at 28% CGT. Furthermore, the transition from a capital gains regime to an employment income regime changes the interaction with the US foreign tax credit calculation — employment income taxes generally fall into the general limitation basket rather than the passive income basket, which may allow the UK tax to be credited more efficiently against US ordinary income tax on the same payment in certain fund structures.

The US Treatment of Carried Interest Through a Partnership

For US federal income tax purposes, carried interest allocated through a partnership is generally treated as a distributive share of partnership income, which retains the character of the income at the partnership level — meaning long-term capital gains allocated as carry are long-term capital gains for the manager. Ordinary income allocated as carry is ordinary income for the manager. Furthermore, Section 1061 imposes the three-year holding period rule on applicable partnership interests — which includes most carried interest arrangements — requiring that the underlying investment be held for more than three years for the allocated gain to qualify as long-term capital gain. Consequently, the US character of carried interest depends on both the nature of the fund's investments and the holding period of those investments at the time the carry is allocated, and this analysis must be conducted on an investment-by-investment and fund-by-fund basis rather than at the aggregate level. The IRS guidance on Section 1061 is at https://www.irs.gov/pub/irs-drop/rr-2021-13.pdf.

The Foreign Tax Credit on UK Carry Tax

The UK tax paid on carried interest — whether at the 28% CGT rate under the current regime or at the 32.5% employment income rate under the new regime — is a foreign tax potentially creditable against the US tax on the same income, subject to the foreign tax credit limitation rules. Furthermore, the basket in which the carry income falls for foreign tax credit purposes depends on the income character of the underlying investment gains — capital gains from the sale of stock or securities fall into the passive income basket. In contrast, ordinary income from trading operations or management fees falls into the general limitation basket. Consequently, the foreign tax credit for UK carry tax must be allocated across baskets in proportion to the character of the underlying income, which requires a fund-level income analysis rather than a simple application of the foreign tax credit against the total US tax on the total carry payment. Additionally, the excess credit position — where the UK tax exceeds the US tax on the same income — can be carried back one year and forward ten years, making multi-year carry credit planning an essential element of the annual US tax strategy for fund managers with large UK carry positions.

Managing Cross-Border Carry Tax: A Practical Framework

Step 1 — Classify the carry vehicle for US tax purposes.

Confirm the US tax classification of the carry vehicle — typically a UK LLP, a Cayman LP, or a UK limited company — since the classification determines whether the carry is reported on Form 8865 (foreign partnership), Form 5471 (foreign corporation), or directly on Schedule E as a pass-through income. Furthermore, a UK LLP is typically treated as a foreign partnership for US purposes, making every US partner in the LLP a Form 8865 filer for each year of partnership membership. Additionally, a Cayman LP used as a carry vehicle is also a foreign partnership, requiring the same Form 8865 treatment — making the combined Form 8865 filing obligation for a manager with carry through both a UK LLP and a Cayman LP a significant annual compliance exercise.

Step 2 — Determine the income character of each carry allocation.

For each carry payment, analyse the character of the underlying fund income that generates the carry — distinguishing between long-term capital gains (held more than three years under Section 1061), short-term capital gains, ordinary income from trading, and interest or dividend income. Furthermore, apply the Section 1061 three-year test to each investment whose gain is attributable to the carry allocation and identify any investments that fail the test, since those gains are recharacterized as short-term capital gains for US purposes — even where the UK treats the entire carry payment as a long-term capital gain. Additionally, document the character analysis in a detailed schedule that supports the US tax return positions for each carry allocation year, since the IRS may examine the Section 1061 analysis in detail for fund managers with large carry positions.

Step 3 — Calculate the foreign tax credit allocation across baskets.

Allocate the UK tax paid on the carry payment across the passive income and general limitation baskets in proportion to the income character of the underlying carry, with capital gains allocations falling into the passive income basket and ordinary income allocations falling into the general limitation basket. Furthermore, model the foreign tax credit utilization in the current year and project the excess credit carryforward position for subsequent years, since large UK carry tax payments may exceed the available US tax on the same income in years of lower US income. Additionally, assess whether the income character allocation between baskets can be optimized by managing the timing of carry payments or the character of fund income to maximize the credit utilisation in years when the manager has sufficient US passive or general limitation income to absorb the excess credit.

Step 4 — Assess the GILTI and Subpart F position for offshore carry vehicles.

Where the carry vehicle is an offshore corporation — such as a Cayman Islands exempted company — assess whether the vehicle is a PFIC or a CFC for US tax purposes, since the GILTI and Subpart F rules may cause the carry to be taxed at the US shareholder level on a current basis rather than on a deferred basis when distributed. Furthermore, for a Cayman carry vehicle that pays no local tax, the GILTI high-tax exclusion will not be available, meaning any tested income allocated to the US manager through the vehicle is subject to GILTI without any foreign tax credit to offset it. Additionally, the PFIC classification of Cayman carry vehicles is a specific issue that requires analysis of the vehicle's income and asset composition — particularly in years when the vehicle holds no unrealized gain and its assets consist predominantly of cash awaiting distribution. The IRS guidance on GILTI and offshore fund managers is at https://www.irs.gov/forms-pubs/about-form-8992.

Step 5 — Review the UK employment income treatment from April 2026.

For carry entitlements that will be taxed under the new UK regime from April 2026, assess the change in the US foreign tax credit basket position — since UK employment income taxes generally fall into the general limitation basket rather than the passive income basket. Furthermore, confirm whether the transitional rules for pre-April 2026 carry-forward accruals apply to the specific fund structure and carry mechanism, as the transitional provisions may allow pre-2026 accruals to continue to be taxed under the old capital gains regime even after the new regime takes effect. Additionally, model the combined US and UK effective tax rate on the same carry payment under the new regime and compare it with the rate under the pre-April 2026 regime to determine whether the regime change increases or decreases the combined tax cost for each US-citizen manager. The HMRC guidance on the April 2026 carried interest reform is at https://www.gov.uk/hmrc-internal-manuals/capital-gains-manual/cg37500.

Step 6 — Establish the annual compliance program for carry reporting.

Establish an annual compliance programme covering Form 8865 for each foreign partnership carry vehicle, Form 5471 for any foreign corporation carry vehicle, Form 8992 for GILTI analysis, Form 1116 for the foreign tax credit allocation, and Schedule K-1 equivalent reporting for any UK LLP carry income. Furthermore, coordinate the annual US compliance with the UK self-assessment return for the same carry payment to ensure that the foreign tax credit basis reconciles between the US and UK returns. Additionally, maintain detailed records of the Section 1061 three-year holding-period analysis for each investment in each fund, as the IRS may require this documentation in any examination of the Section 1061 position.

Case Study: US Citizen in London, Private Equity Carry

Our team was engaged by a US citizen who had been a partner at a London-based private equity fund for seven years and received a carried interest allocation of approximately £3.8 million from the fund's third realization — the sale of a UK manufacturing company that the fund had held for four years and two months. The carrying vehicle was a UK LLP in which the manager was a 15% partner. The manager had paid UK CGT at 28% on the full £3.8 million carry allocation — approximately £1.064 million — having met the 40-month average holding period test under the current UK regime. The manager had filed US tax returns for all years but had not reported the carry income on his US return for the allocation year, assuming that the UK CGT payment discharged any US obligation.

After conducting the full US analysis, we confirmed that the UK LLP was a foreign partnership for US purposes and that the manager was a Category 2 Form 8865 filer — holding a 15% interest in a foreign partnership with sufficient US ownership to fall within the controlled partnership rules. Furthermore, the carry allocation from the fund's UK manufacturing company sale was a long-term capital gain that satisfied the Section 1061 three-year holding period requirement — the fund's investment had been held for more than three years — meaning the full carry allocation was eligible for long-term capital gains treatment at the 20% US rate plus 3.8% NIIT. Consequently, the total US federal tax before foreign tax credit was approximately $912,000 on the $4.79 million carry allocation (converted at the exchange rate on the distribution date).

The foreign tax credit calculation placed the entire carry allocation in the passive income basket — since the underlying income was a long-term capital gain from the sale of shares — and the UK CGT of approximately $1.34 million (converted) exceeded the US tax of approximately $912,000, producing an excess credit carryforward of approximately $428,000. Consequently, after applying the foreign tax credit, the net US federal tax on the carry allocation was zero — the UK CGT fully covered the US tax liability — with a $428,000 passive income credit carryforward available to offset future US passive income tax. Furthermore, we prepared Form 8865 for the allocation year with the Section 1061 analysis documented in a supporting schedule. We confirmed that the GILTI analysis was not applicable since the UK LLP was treated as a partnership rather than a corporation for US purposes. The total correction involved one year of amended Form 1040, including carryover income, one Form 8865 catch-up filing, and a Form 1116 recalculation to establish the credit carryforward.

Common Mistakes US Fund Managers Make with Carry Tax

Mistake 1 — Treating UK CGT on Carry as a Complete Discharge of US Tax

The most common mistake — and the one our case study illustrates — is assuming that paying UK capital gains tax on the carry allocation discharges the US tax obligation through the foreign tax credit, without actually filing the US return that claims the credit. Furthermore, the foreign tax credit is claimed on Form 1116 as part of a filed US income tax return — it is not automatically applied by the IRS when UK tax is paid. The correct approach is to file the US return for the carry allocation year with the carry income reported, and the foreign tax credit formally claimed, regardless of whether the expected net US tax after the credit is zero.

Mistake 2 — Not Completing the Section 1061 Analysis for Each Investment

Many fund managers and their advisers assume that carried interest from a private equity fund is automatically eligible for long-term capital gains treatment, without completing the investment-by-investment Section 1061 three-year holding period analysis. Furthermore, where the fund held any investment for fewer than three years at the time of the carry allocation — including investments that were written off at a loss before reaching the three-year mark — the gain attributable to those investments may be recharacterised as short-term capital gain. The correct approach requires a fund-level investment schedule that shows the holding period of each investment contributing to the carry allocation, along with the Section 1061 test result for each. The IRS Section 1061 guidance is at https://www.irs.gov/pub/irs-drop/rr-2021-13.pdf.

Mistake 3 — Missing the Form 8865 Filing Obligation for the Carry LLP

US partners in a UK LLP carry vehicle who hold 10% or more of the partnership must file Form 8865 annually, and the automatic penalty for a missing Form 8865 is $10,000 per year per partnership. Furthermore, many fund managers who receive their carry through a UK LLP are entirely unaware of the Form 8865 obligation, since their UK tax adviser manages the LLP's UK partnership return and assumes that satisfies any reporting requirement. The correct approach is to identify every US person who is a partner in the carry LLP at any point during the year and confirm that their Form 8865 is filed annually, with the carry allocation reported as partnership income in the character determined by the Section 1061 analysis.

Mistake 4 — Applying the Foreign Tax Credit in the Wrong Basket

The foreign tax credit for UK carry tax must be allocated between the passive income and general limitation baskets in proportion to the character of the carry income — with capital gain carry in the passive basket and ordinary income carry in the general basket. Furthermore, misallocating the entire UK carry tax to the passive basket when a portion of the carry has ordinary income character — for example, where Section 1061 recharacterizes part of the carry as short-term capital gain — produces an incorrect credit claim that understates the general limitation basket credit and overstates the passive basket credit. The correct approach requires a character-by-character basket allocation of the UK tax paid on each component of the carry allocation.

Mistake 5 — Not Assessing the Impact of the April 2026 Regime Change in Advance

Many US-citizen fund managers are aware that the UK carried interest regime changes take effect from April 2026, but have not modeled the impact on their combined US and UK effective tax rate under the new regime. Furthermore, the change from a 28% CGT rate to a 32.5% employment income rate changes the foreign tax credit basket allocation, the net US tax after credit, and the excess credit carryforward position — all of which must be remodeled before the first carry distribution under the new regime is received. The correct approach is to conduct a pre-April 2026 modeling exercise as part of the annual tax planning review, assessing the impact of the regime change on the manager's specific carry-vehicle structure and income character.

Mistake 6 — Ignoring the Estate Tax Treatment of Unvested Carry

Unvested or contingent carry is included in the US taxable estate at fair market value as of the date of the fund manager's death, even where the carry has not yet vested or been paid. Furthermore, the valuation of unvested carry for estate tax purposes requires a formal qualified independent appraisal using the Black-Scholes model or a similar option pricing methodology, and the value can be substantial even for carry that is contingent on future fund performance. The correct approach requires an annual review of the carry's estate tax inclusion as part of the overall estate planning review, with a qualified appraisal prepared for estate tax return purposes in any year where the manager's total estate approaches the unified credit threshold. The IRS estate tax guidance is at https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.

Get in Touch

At US-UK Tax, our team of Chartered Tax Advisers (CTA), Enrolled Agents (EA), and Certified Public Accountants (CPA) — members of the Chartered Institute of Taxation (CIOT) and the American Institute of CPAs (AICPA) — provides comprehensive carried interest planning and compliance advice as a dedicated US UK cross-border tax specialist practice for fund managers in London. Furthermore, we conduct the full annual compliance engagement for US-citizen fund managers — Section 1061 analysis, Form 8865 preparation, GILTI assessment for offshore carry vehicles, Form 1116 foreign tax credit allocation, and coordination with the UK self-assessment return — as a coordinated annual service that ensures the combined US and UK tax position on each carry allocation is correctly reported and optimised. We have direct experience managing carry allocations from UK LLPs, Cayman LPs, Luxembourg carry vehicles, and US co-investment vehicles across private equity, venture capital, and hedge fund structures.

Contact our team today to begin a confidential review of your carried interest tax position. Email hello@us-uktax.com, call 0333-8807974, or visit https://www.us-uktax.com/contact/ to book a consultation.

Conclusion

Carried interest is one of the most complex areas of cross-border compensation taxation precisely because the US and UK systems treat the same payment under different analytical frameworks, with different income character determinations, rate structures, and foreign tax credit basket allocations. Furthermore, the April 2026 UK regime change — from a capital gains treatment at 28% to an employment income treatment at 32.5% — introduces a new layer of complexity for US-citizen fund managers in London that must be planned for in advance rather than managed retrospectively. Moreover, the combination of Section 1061, Form 8865, GILTI, and the carry estate tax valuation requirement makes this an area where engaging a dedicated US UK cross-border tax specialist practice — rather than a UK-only fund tax adviser or a generalist US expat preparer — is the only way to ensure that the full scope of the compliance and planning obligation is correctly addressed each year.

The three most important actions for any US-citizen fund manager in London are: first, confirm that Form 8865 is being filed annually for every foreign partnership carry vehicle in which you hold a 10% or more interest; second, complete the Section 1061 three-year holding period analysis for every carry allocation before the US return for the allocation year is filed; and third, model the impact of the April 2026 UK regime change on your combined US and UK effective tax rate before the first carry distribution under the new regime is received. Contact US-UK Tax at hello@us-uktax.com or call 0333-8807974 to begin a confidential carried interest review today.

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FAQs

Q: How is carried interest taxed in the UK for fund managers?

Under the current regime, qualifying carry is taxed as capital gain at 28% where the average fund investment holding period exceeds 40 months. From April 2026, it is taxed as employment income at 32.5% under the new HMRC regime.

Q: How does the US tax carried interest for fund managers?

The IRS treats carry as a distributive share of partnership income, retaining the character of the underlying fund income. Section 1061 requires a three-year holding period for long-term capital gains treatment — otherwise, gains are short-term and taxed at up to 40.8%.

Q: What is Section 1061 and how does it affect carried interest?

Section 1061 imposes a three-year holding period test on applicable partnership interests. Carry allocable to investments held fewer than three years is recharacterized as short-term capital gain taxed at ordinary income rates — up to 37% plus 3.8% NIIT.

Q: Can UK capital gains tax on carry be credited against the US federal tax?

Yes, subject to the foreign tax credit basket allocation. Long-term capital gains fall under the passive income basket. For many PE managers, the UK tax exceeds the US liability, resulting in an excess credit carryforward rather than a net US tax liability.

Q: Must a Form 8865 be filed for a UK LLP carry vehicle?

Yes, if the US partner holds 10% or more of the LLP, Form 8865 is required annually, with an automatic $10,000 penalty for each missed year. The carry allocation must be reported as partnership income in the character determined by the Section 1061 analysis.

Q: How does the April 2026 UK carried interest regime change affect US citizens?

The shift from 28% CGT to 32.5% employment income changes the foreign tax credit basket allocation from passive to general limitation. This changes the net US tax position and the excess credit carryforward, requiring pre-2026 adjustments to the combined tax rate.

Q: Is unvested carried interest included in the US taxable estate at death?

Yes, at fair market value at the date of death, even where the carry is contingent on future performance. A formal, qualified, independent appraisal using an option-pricing methodology is required for estate tax return purposes in most cases.

Q: Do offshore carry vehicles trigger GILTI for US fund managers?

If the vehicle is a for, e.g., Ora Cayman-exemptedpted company) Rather than a partnership, GILTI may apply. Cayman vehicles paying no local tax cannot use the high-tax exclusion, meaning tested income is subject to GILTI without a foreign tax credit offset.