By Gabriela Mandiuc, CPA
We are often asked: What is a foreign partnership, or what is a foreign partner?
“A foreign partner is any partner who is not a U.S. person. As such, a foreign person includes a nonresident alien individual (NRA), foreign corporation, foreign partnership, foreign trust or estate, or a foreign organization described in section 501(c).”
SEC. 1446: WITHHOLDING TAX ON FOREIGN PARTNERS’ SHARE OF EFFECTIVELY CONNECTED INCOME (ECI)
A domestic partnership that has ECI allocable to a foreign partner must pay a withholding tax on that partner’s distributive share of income equal to the maximum rate for individuals (39.6% as of 2014) and corporations (35% as of 2014). In certain circumstances, the partnership is allowed to use the highest rate of tax applicable to a particular type of income or gain allocable to a foreign non-corporate partner, such as 20% rate for long-term capital gains, 25% rate for uncaptured section 1250 gains, and 28% for collectibles gains.3 There are also certain deductions allowed for state and local taxes paid by the partnership on ECI on behalf of its partners and the tax rates mentioned above must be used unless a lower percentage can be supported by a certification process initiated by the foreign partner. The rather complex certification process allows certain losses to be considered for the specific foreign partner (see Reg. 1.1446-6 regarding this).
Example: Medical Practice Management LP (MPM), a Texas partnership, has two partners, Dr. Munoz, a U.S. citizen, a 50% partner, and International Management Co., a foreign corporation that owns 50% of MPM. MPM has taxable income of $120,000 for the year. The ECTI allocable to International Management Co. is $60,000 ($120,000*50%). MPM must withhold 35% of $60,000 under section 1446, or $21,000 (35% is the highest tax rate for corporations).
The partnership must file the following forms:
- Form 8804, “Annual Return for Partnership Withholding Tax (Section 1446)” to Report the total liability under section 1446
- Form 8805, “Foreign Partner’s Information Statement of Section 1446” Withholding Tax
- Form 8813, “Partnership Withholding Tax Payment Voucher (Section 1446)” to pay the withholding tax (see estimated tax payments explained below).
When applying Section 1446 rules the partnership must be aware of the following:
- The partnership must determine if any partner is a foreign partner subject to section
- A partnership may determine a partner’s foreign or non-foreign status by relying on a W-8 Form, Form W-9, an “acceptable substitute form, or by other means”. If a certification is not provided, the partnership may presume the partner is foreign and will be required to withhold tax under section 1446.
- Form 8805 is attached to the foreign partner’s Schedule K-1 and is also required to attach to the foreign partner’s US income tax return in order to claim a withholding credit.
- The amount of section 1446 tax paid by the partnership for a foreign partner will be treated as a distribution made to that partner.
- Estimated tax payments must be paid in 4 equal installments using Form 8813 on or before the 15th day of the 4th, 6th, 9th and 12th months of the partnership’s tax year.
- The partnership should notify its foreign partners as soon as possible to obtain a U.S. taxpayer identification number by using Form W-7, since this is needed in order to ensure proper crediting of the tax withheld reported to the IRS on Form 8805.
- Generally, an NRA or corporation is considered involved in a US trade or business if the NRA or corporation are partners in a partnership involved in a U.S. trade or business. However, this also applies to indirect participation in a U.S. trade or business, such as when a foreign person is a partner in a foreign partnership which, in turn, is a partner in a domestic partnership, as illustrated in the example below.
Example: “Rizzo Cheese (RC), an Italian partnership, produces fine Italian cheeses. In order to establish a U.S. market for its products RC teams up with Indiana, Inc., a U.S. distributor of gourmet food items. RC and Indiana form a U.S. partnership, Cheers & Cheese, LLP that sells and distributes unique cheese products to upscale delis across the U.S. As a result of the activities of Cheers & Cheese, the partners in RC are engaged in a U.S. trade or business. Any NRA partner of RC will treat his or her share of Cheers & Cheese’s profit or loss as effectively connected income on a U.S. tax return.”
SEC. 1445: WITHHOLDING OF TAX ON DISPOSITIONS OF UNITED STATES REAL PROPERTY INTERESTS (USRPI)
In general, if a partnership acquires a U.S. real property interest from a foreign person, the partnership may have to withhold tax of 10% under IRC section 1445 on the amount it pays for the property. Domestic partnerships should be aware that the 10% tax under this section also applies to taxable partnership distributions to a foreign partner, as illustrated in the example below:
Example: “Jordan Enterprises (JE), an Indiana partnership, distributes land to Barry Lird, a NRA partner, in a taxable distribution. The land is located in Terre Haute, Indiana and has a FMV of $23,000 at the time of the distribution. JE will have to withhold a tax of $2,300 from Lird when the taxable distribution occurs.”
Under Section 1445(e), a tax rate of 35% applies for gains on dispositions of USRPI by a domestic partnership, allocable to a foreign partner. For example, a disposition of USRPI would be the gain allocable to a foreign partner due to the sale of land by a domestic partnership.
The partnership must file the following forms for tax withheld under section 1445:
Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests
Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests
Coordination with Section 1446: “A domestic partnership’s compliance with the requirement to pay a withholding tax under Section 1446 satisfies the requirements under Section 1445 for dispositions of U.S. real property interests”.
SEC. 1441.WITHHOLDING OF TAX ON FIXED OR DETERMINABLE ANNUAL OR PERIODICAL GAINS AND INCOME (FDAP)
A partnership may have to withhold tax on a foreign partner’s distributive share of fixed or determinable annual or periodical gains and income (FDAP income) not effectively connected with a U.S. trade or business. “Thus, any portion of a U.S. partnership’s distributive share labeled as a fixed or determinable annual or periodic (FDAP) gain will have 30 percent withheld.” FDAP income includes interest, rents, and royalties, to name a few. The example below shows how FDAP income is distinguished from effectively connected income.
Example: “Kate Kindle is a citizen of Kenya and an NRA partner holding a 25-percent interest in the U.S. entity, Nairobi Organization, which reports the following transactions during the current year:
- $120,000—Gain on the sale of land located in Baton Rouge, Louisiana (…) [ECI]
- $6,000—Interest on bonds acquired with the above funds while the partners determine their next course of action. This is FDAP gain.
The required withholdings applicable to Kindle amount to $12,330:
- 25% (Kindle’s interest) × $120,000 = $30,000 × 39.6% = $11,880 [ECI]
- 25% × $6,000 = 1,500 × 30% = 450 [FDAP]
- Total: $ 12,330″
The following forms must be filed to report tax related to FDAP income:
- Form 1042, “Annual Withholding Tax Return for U.S. Source Income of Foreign Persons”
- Form 1042-S, “Foreign Person’s US Source Income Subject to Withholding”
TAX PLANNING AND COMPLIANCE
The article “Texas joins national coalition to attract more foreign investment to US” published in the San Antonio Business Journal (March 25th, 2015) indicates that Texas is focused on attracting foreign direct investment into the state. Thus, more and more domestic partnerships in Texas will face the tax issues related to Sections 1446, 1445 and 1441 discussed above. For more information, contact Sol Schwartz and Associates PC at (210) 384-8000 which can help not only with the tax compliance associated with these rules, but also with the tax planning related to foreign partners and domestic partnerships.
The professionals at Sol Schwartz & Associates are ready to help. Contact Gabriela Mandiuc, CPA at 210.384.8000 or gam@ssacpa.com.
FURTHER READING:
[1] Code Sec. 1446(c)
[1] 2014 IRS Instructions for Form 8804, 8805, 8813
[1] Reg. 1.1446-3(a)(2)(ii)
[1] Code Sec. 875(1)
[1] Journal: TAXES-The Tax Magazine, Focus on Foreign Partnerships and Foreign Partners-An Update (Sept. 19, 2014)
[1] www.IRS.gov
[1] 2015 IRS Instructions for Form 1042-S
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