Partnership reporting of contributions to foreign entities

Editor: Jeffrey N. Bilsky, CPA

Investors looking for greater diversification and opportunity often invest in partnerships to access private equity and other investments unavailable to the public. Further, these partnerships often invest in foreign entities. Many partners, especially limited partners, have no ability to direct the partnership’s operations and investment choices. Since foreign entities fall out of the reach of the jurisdiction of the United States, their activity usually escapes the tax information reporting requirements, such as Form 1099 or Schedule K–1, Partner’s Share of Income, Deductions, Credits, etc., filings that aid the IRS in enforcing U.S. tax laws.

Congress has imposed reporting requirements on U.S. persons with interests in foreign assets, and substantial penalties can be imposed for not complying with the reporting requirements. Many of these reporting requirements only apply to U.S. persons who meet certain ownership or control thresholds, which often means the U.S. person will have enough influence over the foreign entity to obtain the required information. However, Sec. 6038B imposes reporting requirements on U.S. persons when the value of transfers to foreign entities exceeds dollar amount thresholds, regardless of the ownership percentage in the foreign entity.

Domestic partners in partnerships that invest in foreign entities rely on information provided on Schedule K–3, Partner’s Share of Income, Deductions, Credits, etc. — International, to determine if they have a reporting requirement under Sec. 6038B. Since many partners might not have intended to invest in a foreign entity, they could be surprised if the IRS tries to assess a penalty against them.

Reporting contributions to foreign partnerships and corporations

Sec. 6038B requires reporting contributions to foreign corporations and partnerships if the U.S. person owns 10% or more of the entity, directly or indirectly, or if the total transfers in the preceding 12–month period exceed $100,000. Regs. Secs. 1.6038B–1 and 1.6038B–2 define how transfers to corporations and partnerships are to be reported. For contributions made by partnerships, domestic partners are deemed to have made a proportionate contribution to the foreign entity. Domestic partners report contributions to foreign partnerships by filing Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, with their income tax returns, as Category 3 filers. Regs. Sec. 1.6038B–2 permits a domestic partnership to report its transfer to a foreign partnership, so its partners will not be required to report the transfer.

Regs. Sec. 1.6038B–1 requires U.S. persons to report transfers to foreign corporations on Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, attached to their income tax return. Unlike Regs. Sec. 1.6038B–2, which allows domestic partnerships to file Form 8865 for their contributions to a foreign partnership, Regs. Sec. 1.6038B–1 does not allow a partnership to file Form 926 for its partners. If a partnership contributes property to a foreign corporation, the domestic partners are responsible for any Form 926 filing if their proportionate share of contributions meets the filing threshold.

Penalties on partners required to report contributions

A U.S. person failing to report a contribution under Sec. 6038B could be charged a penalty equal to 10% of the fair market value of the property transferred. The penalty is capped at $100,000, except in cases of intentional disregard. Further, Sec. 6501 extends the statute of limitation on assessment to three years after the IRS receives the required Form 8865 or Form 926, so taxpayers face the risk that the IRS will continue to assess additional tax on any part of their income tax return until the required form is filed. When a domestic partnership does not report a contribution to a foreign partnership by filing Form 8865, each partner must file Form 8865 themselves if their proportionate share of the contributions exceeds the dollar amount threshold or if the partner is deemed to own 10% or more of the foreign partnership.

Partnership reporting of transfers

Partnerships are not required to report transfers on Form 8865 or Form 926 as they pass the information to their partners. Partnerships report transfers to foreign partnerships and corporations on Schedule K–2, Partner’s Distributive Share Items — International, and Schedule K–3 informs their partners of any possible Form 8865 or Form 926 filing requirement.

A partnership failing to report all required information on Schedules K–2 could be penalized for failure to file a complete return under Sec. 6698. The penalties under Sec. 6698 are indexed for inflation, and for partnership returns required to be filed in 2025, the penalty is $245 per month per partner during the tax year while the failure to provide required information occurs. The penalty can be charged for up to 12 months. If a partnership fails to provide all required information on Schedule K–3 or to provide the statements to its partners, Sec. 6721 and 6722 penalties may be charged for failing to file correct information returns or failing to provide the statements to partners. For returns required to be filed in 2025 (and not corrected by Aug. 1), under Secs. 6721 and 6722, a penalty of $330 per Schedule K–3 may be charged, up to a maximum of $3,987,000. If the partnership’s average annual gross receipts are $5 million or less, a lower maximum penalty of $1,329,000 is applied. Penalties under Secs. 6038B, 6698, 6721, and 6722 may be waived due to reasonable cause, which could include situations where a Schedule K–3 omits required information.

Upper–tier partnerships often face delays in obtaining Schedules K–1 and K–3 from lower–tier entities, and the IRS does not require partnerships to provide Schedules K–1 and K–3 before the due date of the tax return, which is frequently the same due date of the upper–tier partnership. Partnership agreements sometimes include provisions requiring a lower–tier partnership to provide Schedule K–1 information by an earlier date so that upper–tier entities have sufficient time to complete their tax returns and provide Schedules K–1 to their partners.

To allow upper–tier partnerships time to complete their own returns, however, some partnerships will rely on estimates provided by the lower–tier partnership rather than the actual Schedules K–1 and K–3. These estimates often omit international items, including transfers to foreign entities reportable under Sec. 6038B. The IRS has not approved the use of estimated Schedule K–1 amounts, so the partnership must carefully consider its risk of penalties for providing inaccurate information, as well as the needs of upper–tier partnerships to complete their returns and provide Schedules K–1 to their partners in a timely manner. If an estimate must be used, the partnership should determine whether any disclosure is required. Financial information for each lower–tier partnership should be obtained to determine if there could be an indirect interest in a foreign entity and if any reporting is needed on Schedules K–2 and K–3.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.