Foreign investment in the United States continues to rise. The investment vehicle of choice, especially in the case of real estate, is generally a tax-transparent entity such as a limited partnership, limited liability company, or similar foreign transparent entity that is treated as a partnership for U.S. tax purposes. Consequently, tax practitioners need to be aware of the special withholding rules applicable to partnerships with foreign partners.
A foreign or domestic partnership that has U.S. effectively connected taxable income (ECTI) allocated to a foreign partner must withhold and pay U.S. tax under Sec. 1446. To comply with this requirement, the partnership must determine whether it has any foreign partners, determine the partnership’s ECTI allocable to each foreign partner, compute the Sec. 1446 tax with respect to each foreign partner, determine when the tax should be paid, and report the amounts paid.
Determining Whether a Partnership Has a Foreign Partner
The Sec. 1446 tax
applies only if the partnership has at least one foreign partner
during the partnership’s tax year. Therefore, the partnership must
first determine whether or not it has a foreign partner, which is
generally the case if the partner is a nonresident alien, foreign
partnership, foreign corporation, foreign estate or trust, or
other foreign person. A partner treated as a U.S. person for all
income tax purposes is not a foreign partner. (See Regs. Sec.
1.1446-1(c)(1).)
A partnership must generally
determine whether a partner is a foreign partner, and the
partner’s tax classification (e.g., corporate or noncorporate), by
obtaining a withholding certificate from the partner. A partner
that is a U.S. person must provide a valid Form W-9, Request for
Taxpayer Identification Number and Certification. A partner that
is not a U.S. person must provide a valid Form W-8 (e.g., Form
W-8BEN, Certificate of Foreign Status of Beneficial Owner for
United States Tax Withholding). An entity that is disregarded as
an entity separate from its owner does not submit Forms W-8 or
W-9. Instead, the owner of such entity for federal tax purposes
must submit appropriate documentation.
A
partnership may rely on a valid Form W-8 or Form W-9 from a
partner to determine whether that person is a foreign or
nonforeign partner for purposes of computing the Sec. 1446 tax. A
partnership may not rely on Form W-8 or Form W-9 if it has actual
knowledge or reason to know that any information on the
withholding certificate is incorrect or unreliable and if, based
on such knowledge, the partnership should pay the Sec. 1446 tax. A
partnership has reason to know this if its knowledge of relevant
facts or statements contained on the form is such that a
reasonably prudent person would question the claims made. (See
Regs. Sec. 1.1446-1(c)(2)(iii).)
If the
partnership does not have actual knowledge or reason to know that
a Form W-8 or Form W-9 contains incorrect or unreliable
information, but it subsequently determines that this is the case,
and based on such knowledge the partnership should pay Sec. 1446
tax in an amount greater than would be the case if it relied on
the certificate, the partnership will not be subject to penalties
for its failure to pay the Sec. 1446 tax prior to the date that
the determination is made.
Determining a Partnership’s ECTI
A partnership’s ECTI is generally its taxable income as computed under Sec. 703 and with consideration of only those partnership items effectively connected with the conduct of a trade or business in the United States. A foreign partner’s allocable share of partnership ECTI for the partnership’s tax year is equal to that foreign partner’s distributive share of partnership gross income and gain effectively connected and properly allocable to the partner under Sec. 704, reduced by the foreign partner’s share of partnership deductions connected with such income.A partnership’s items of gross income effectively connected include any income treated as effectively connected income. A foreign partner’s share of partnership ECTI does not include income or gain exempt from U.S. tax by reason of a Code provision. A foreign partner’s allocable share also does not include income or gain exempt from U.S. tax by the operation of any U.S. income tax treaty or reciprocal agreement (Rev. Proc. 89-31).
In computing a foreign partner’s allocable share of partnership ECTI, certain rules apply with respect to deductions and losses. No deduction for charitable contributions is allowed. The net operating loss deduction of any foreign partner is not to be taken into account. Losses from the sale or exchange of capital assets are allowed only to the extent of gains from the sale or exchange of capital assets. No deduction is allowed for personal exemptions or the additional itemized deductions for individuals. Any limitations on losses or deductions that apply at the partner level are not be taken into account. Final and temporary regulations provide exceptions to the general rule in certain cases (TD 9200).
Calculating and Paying the Sec. 1446 Tax
The applicable percentage of tax to be used is the highest rate of tax specified in Sec. 11(b)(1) for a corporation and in Sec. 1 for a noncorporate entity. In certain cases, a partnership is permitted to consider as the applicable percentage the highest rate of tax applicable to a particular type of income or gain allocable to a partner to the extent of a partner’s allocable share of such income or gain.A partnership must pay its Sec. 1446 tax by making installment payments based on the amount of partnership ECTI allocable to its foreign partners. A partnership may estimate its Sec. 1446 tax and pay its installments under one of the annualization methods under Sec. 6655 or the safe-harbor method under Regs. Sec. 1.1446-3(b)(3). The installment payments generally must be made on or before the 15th day of the fourth, sixth, ninth, and twelfth months of the partnership’s tax year. Form 8813, Partnership Withholding Tax Payment Voucher, should be submitted with each installment payment, although it is not required if the payments are made electronically via the Electronic Federal Tax Payment System.
If the safe-harbor method under Regs. Sec. 1.1446-3(b)(3) is used, no penalties or interest will apply to a partnership with respect to a current installment of Sec. 1446 tax if (1) the average of the current installment and prior installments during the tax year is at least 25% of the total Sec. 1446 tax that would be payable on the amount of the partnership’s ECTI, (2) the prior tax year consisted of 12 months, (3) the partnership timely files (including extensions) an information return for the prior year, and (4) the amount of ECTI for the prior tax year is not less than 50% of the ECTI shown on the annual return of Sec. 1446 withholding tax that is timely filed for the current year.
Every partnership that has effectively connected gross income for the partnership’s tax year to one or more of its foreign partners must file Form 8804, Annual Return for Partnership Withholding Tax. Every partnership required to file Form 8804 also must file Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax, for each of its foreign partners on whose behalf it paid Sec. 1446 tax. Forms 8804 and 8805 are filed separately from Form 1065, U.S. Return of Partnership Income, but are due on or before the due date for filing Form 1065.
A partnership’s payment of Sec. 1446 tax generally relates to its U.S. income tax liability for the partner’s tax year. A foreign partner may claim, as a credit under Sec. 33, the Sec. 1446 tax paid by the partnership allocable to that partner. A foreign partner must attach proof of payment (Form 8805) to its U.S. income tax return. The partner may not claim an early refund of these amounts under the estimated tax rules.
Although the rules of Sec. 1446 are not overly complicated, tax practitioners should advise their clients early and often of the foreign partner withholding requirements to avoid unnecessary penalties and interest.
EditorsNotes
Joel E. Ackerman, CPA, MST is with Holtz Rubenstein Reminick LLP, DFK International/USA Melville, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
If you would like additional information about these items, contact Mr. Ackerman at (631) 752-7400 x262 or jackerman@hrrllp.com.
