Partnerships with Foreign Partners – IRS Tax & Partner Reporting Basics
Anybody that practices tax law will tell you that while corporate taxation can be complex, the tax laws involving partnerships are some of the most complex tax laws on the planet.
Moreover, when partnerships involve either a foreign partnership with U.S. partners, and/or U.S. partnerships with foreign partners, the tax related issues can become even more complex.
- 1 Foreign Partnerships
- 2 Partnerships in General
- 3 Partnership Withholding
- 4 Reporting Ownership in a Foreign Partnership
- 5 Form 8865 – The Basics
- 6 Do I File an 8865 or 8938?
- 7 Why Do I Not File 8938?
- 8 Similar to Form 5471, but…
- 9 Who Has to File Form 8865?
- 10 What are the Four (4) Categories of Filers?
- 11 How do I File Form 8865?
- 12 But I am Not Required to File a Tax Return?
- 13 Key Definitions of Terms Used in the 8865.
- 14 Penalties for Not Filing Form 8865
- 15 How to Get Into Compliance
- 16 Golding & Golding: About Our International Tax Law Firm
The Internal Revenue Service is aware that when foreign partners are involved in a partnership, the partnership may be more prone to tax fraud.
The reason is because it would not be unlike a partnership – or any business entity for that matter – to try to avoid US tax by transferring money overseas to a foreign partner in an effort to keep the partnership earnings below the US radar. (or keep foreign partnership earnings outside of the country, if not ‘hidden’ from U.S. tax reporting requirements).
What complicates this matter even further is the ability of partnerships to essentially develop whichever type of distribution they want to the partners – which does not necessarily need to coincide with the specific investment or ownership by the individual partner.
The IRS has provided the following summary on Partnership and Foreign Interests:
Partnerships in General
A partnership (foreign or domestic) that has income effectively connected with a U.S. trade or business (or income treated as effectively connected) must pay a withholding tax on the effectively connected taxable income that is allocable to its foreign partners. Note: The withholding tax rate for effectively connected income allocable to non-corporate foreign partners is 39.6%, but remains at 35% for corporate foreign partners, for tax years beginning after December 3, 2012.
A publicly traded partnership must withhold tax on actual distributions of effectively connected income, unless it chooses to withhold under special Rules Applicable to Publicly Traded Partnerships.
This withholding tax regime under IRC section 1446 does not apply to income that is not effectively connected with the partnership’s U.S. trade or business (i.e., it does not apply to FDAP income). FDAP income is subject to the NRA withholding tax regime, Forms 1042/1042-S, under which withholding is required under Internal Revenue Code Chapter 3 sections 1441, 1442, and 1443 (NRA Withholding). This withholding tax regime requires 30% withholding on a payment of U.S. source income to a foreign person.
Treasury Regulation section 1.1446-6 allows foreign partners to certify to the partnership prior year deductions and losses that carry over to the current year. Under these regulations a nonresident alien partner is also permitted to certify to the partnership that the partnership investment is (and will be) the only activity of the partner for the partner’s taxable year that gives rise to effectively connected income, gain, deduction, or loss. In that case, the partnership is not required to pay IRC section 1446 tax with respect to the foreign partner if the partnership estimates that the annualized or actual IRC section 1446 tax due is less than $1,000.
A foreign partner is required to file a U.S. income tax return even if there is no U.S. tax due. A valid Taxpayer Identification Number (TIN) is required.
It is important to note that if during a partnership’s tax year the partnership has taxable income effectively connected with the conduct of a trade or business within the United States that is allocable to a foreign partner, the Internal Revenue Code requires the partnership to report and pay a withholding tax under IRC Section 1446to the IRS.
The partnership must pay the IRC section 1446 withholding tax regardless of the amount of foreign partners’ ultimate U.S. tax liability and regardless of whether the partnership makes any distributions during its tax year. Revenue Procedure 92-66, and Treasury Regulation section 1.1446-3 set forth the time and manner for paying the withholding tax, as well as the general reporting obligations with respect to the tax. Refer to Forms 8804, Annual Return for Partnership Withholding Tax (Section 1446), 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax, and 8813, Partnership Withholding Tax Payment Voucher (Section 1446), for further guidance on reporting and paying the IRC section 1446 withholding tax.
A partnership that fails to comply with IRC section 1446 reporting and withholding requirements may be subject to penalties and interest.
The partnership may reduce the foreign partner’s share of the partnership’s gross effectively connected income by certain partner level deductions and losses if the foreign partner certifies these losses on Form 8804-C (see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, for additional information).
Special rules apply to publicly traded partnerships. Publicly traded partnerships (within the meaning of Rev. Proc. 89-31) must file Forms 8804(PDF), 8805 (PDF), and 8813 (PDF) only if they have elected to pay IRC section 1446 withholding tax based on effectively connected taxable income allocable to its foreign partners. For more information about the rules applicable to publicly traded partnerships see Revenue Procedure 92-66.
Reporting Ownership in a Foreign Partnership
The following is a brief summary of IRS Form 8865, which is used to report certain ownership interest in a foreign partnership.
Form 8865 – The Basics
When a person has a qualifying interest in a Foreign Partnership, the information is reported on this form and it is filed along with their tax return (or separately if no tax return is required)
Do I File an 8865 or 8938?
Typically, a person will file a form 8938 (Reporting Specified Foreign Financial Assets) if they have an interest in an offshore investment, which does not meet the threshold requirement of an 8865 or 5471, and/or it is not the year of acquisition. But, if the ownership is in the year of acquisition and/or the the value/percentage of the ownership increases, the person may have to file a form 8865 instead of the 8938 for the particular asset. This is especially true when it involves a foreign partnership.(a person does not file the same form 8938 and 8865 for the same interest...although if accounts are involved, an FBAR may be required)
Why Do I Not File 8938?
The form 8938 is used to report specified foreign assets. Typically, the scenario will include a foreign bank account or foreign stock ownership. When a person owns a percentage of a foreign partnership, they may also need to report it on a form 8938… unless they meet the threshold requirement of having to file form 8865. In that case, individual will file a form 8865 instead of a form 8938 as to that particular interest in the foreign partnership.
Similar to Form 5471, but…
While the form is similar to a form 5471 involving foreign corporations, and the 5471 is more common (for the simple fact that more individuals have interests in foreign corporations than they do in foreign partnerships), there are important distinctions regarding these two forms.
Who Has to File Form 8865?
A person will file form 8865 when they qualify as one of the four (4) categories of filers indicated in the instructions. There are four categories of filers, and depending on which category a person falls into, it may be required to file form 8865 along with certain schedules detailing more information about the foreign partnership.
What are the Four (4) Categories of Filers?
Category 1 (aka Control)
When a person has control of a foreign partnership, which typically means ownership of more than 50% of the partnership, then they will qualify as a category 1 Filer.
Category 2 (U.S. Controlled Partnership)
This category of filing requires an individual to have at least 10% interest in the foreign partnership when the foreign partnership is controlled by US persons each have at least 10% ownership. If this sounds familiar you, it is similar to a controlled foreign corporation in which more than 50% ownership must be had by US persons each have at least 10% ownership (attribution rules apply).
Category 3 (Contributing Property)
When a U.S. person contributes property during the individuals tax year to foreign partnership, and in exchange receives an interest in the partnership, they will also have to file this form when the person either owns 10% or more immediately following the contribution or when the value of the property (along with any other property attributed by the individual or related person during the 12 month period ending on the transfer) exceeds more than $100,000.00
Category 4 (General Catchall)
This is the most common scenario for most individuals. Why? Because often times the foreign partnership will not be owned by at least 50% of US persons who each own 10%, the individual will not control the Partnership, nor contribute any property. That brings us to the fourth category in which a person acquires at least 10% or greater interest in the foreign partnership. A typical example would be when the individual purchases a 15% share or inherits a 12.5 percent share.
How do I File Form 8865?
Form 8865 is generally not the type of form that you will find included in tax software used by non-tax professionals such as TurboTax or TaxAct. Rather, if you are not utilizing a tax professional, you would have to download the PDF form and complete the form yourself. Thereafter, you would attach the form 8865 to your income tax return when you submitted to the IRS.
But I am Not Required to File a Tax Return?
Unfortunately, the Internal Revenue Service does not let you off the hook that easily. Rather, you will still have the complete and submit the form separately to the location you would otherwise have to submit a tax return — in order to make sure you are in compliance. In other words, if you are the only US person in the Foreign Partnership, and the only person filing this form on behalf of the partnership — even if you do not have to file a tax return, you still have the file this form.
Key Definitions of Terms Used in the 8865.
The IRS provides the following summary of the different key terms used in preparing form 8865:
A partnership is the relationship between two or more persons who join to carry on a trade or business, with each person contributing money, property, labor, or skill and each expecting to share in the profits and losses of the business
whether or not a formal partnership agreement is made. The term “partnership” includes a limited partnership, syndicate, group, pool, joint venture, or other unincorporated organization, through or by which any business, financial operation, or venture is carried on, that is not, within the meaning of the regulations under section 7701, a corporation, trust, estate, or sole proprietorship. A joint undertaking merely to share expenses is not a partnership. Mere co-ownership of property that is maintained and leased or rented is not a partnership. However, if the co-owners provide services to the tenants, a partnership exists.
A foreign partnership is a partnership that is not created or organized in the United States or under the law of the United States or of any state or the District of Columbia.
A 50% interest in a partnership is an interest equal to: 50% of the capital, 50% of the profits, or 50% of the deductions or losses. For purposes of determining a 50% interest, the constructive ownership rules described below apply.
A 10% interest in a partnership is an interest equal to: 10% of the capital, 10% of the profits, or 10% of the deductions or losses. For purposes of determining a 10% interest, the constructive ownership rules described below apply.
For purposes of determining an interest in a partnership, the constructive ownership rules of section 267(c) (excluding section 267(c)(3)) apply, taking into account that such rules refer to corporations and not to partnerships. Generally, an interest owned directly or indirectly by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by its owners, partners, or beneficiaries. Also, an individual is considered to own an interest owned directly or indirectly by or for his or her family. The family of an individual includes only that individual’s spouse, brothers, sisters, ancestors, and lineal descendants. An interest will be attributed from a nonresident alien individual under the family attribution rules only if the person to whom the interest is attributed owns a direct or indirect interest in the foreign partnership under section 267(c)(1) or (5)
Penalties for Not Filing Form 8865
The penalties for failing to file form are intense, and vary depending on which category a person would have to file:
Failure to timely submit all information required of Category 1 and 2 filers.
A $10,000 penalty is imposed for each tax year of each foreign partnership for failure to furnish the required information within the time prescribed. If the information is not filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign partnership) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired.
The additional penalty is limited to a maximum of $50,000 for each failure. Any person who fails to furnish all of the information required within the time prescribed will be subject to a reduction of 10% of the foreign taxes available for credit under sections 901, 902, and 960. If the failure continues 90 days or more after the date the IRS mails notice of the failure, an additional 5% reduction is made for each 3-month period, or fraction thereof, during which the failure continues after the 90-day period has expired. See section 6038 (and the underlying regulations) for the maximum reduction, the exception due to reasonable cause, and for limits on the amount of these penalties.
Criminal penalties under sections 7203, 7206, and 7207 may apply for failure to file or for filing false or fraudulent information. Additionally, any person that files under the constructive owners exception may be subject to these penalties if all the requirements of the exception are not met. Any person required to file Form 8865 who does not file under the multiple Category 1 filers exception may be subject to the above penalties if the other person does not file a correctly completed form and schedules. See Exceptions to Filing, earlier.
Failure to file information required of Category 3 filers.
Any person that fails to properly report a contribution to a foreign partnership that is required to be reported under section 6038B and the regulations under that section is subject to a penalty equal to 10% of the fair market value (FMV) of the property at the time of the contribution. This penalty is subject to a $100,000 limit, unless the failure is due to intentional disregard. In addition, the transferor must recognize gain on the contribution as if the contributed property had been sold for its FMV. See section 6038B for the exception due to reasonable cause.
Failure to file information required of Category 4 filers.
Any person who fails to properly report all the information requested by section 6046A is subject to a $10,000 penalty, in addition to the section 7203 criminal penalty, unless it is shown that such failure is due to reasonable cause. If the failure continues for more than 90 days after the IRS mails notice of the failure, an additional $10,000 penalty will apply for each 30-day period (or fraction thereof) during which the failure continues after the 90-day period has expired. The additional penalty shall not exceed $50,000.
Penalties may be imposed for underpayment attributable to undisclosed foreign financial asset understatements. The term “undisclosed foreign financial asset” with respect to any tax year includes any asset with respect to which required information was not provided. An “undisclosed foreign financial asset understatement” means for any tax year, the portion of the understatement for that tax year which is attributable to any transaction involving an undisclosed foreign financial asset. No penalty will be imposed with respect to any portion of an underpayment if the taxpayer can demonstrate that the failure to comply was due to reasonable cause with respect to such portion of the underpayment and the taxpayer acted in good faith with respect to such portion of the underpayment. See sections 6662(j) and 6664(c) for additional information.
How to Get Into Compliance
If you are out of compliance, for not filing form 8865, one of the best ways to get back into compliance is by entering the IRS offshore voluntary disclosure program. Programs to seek means getting to compliance while reducing or forewarning penalties.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.