Here at Cadesky U.S. Tax Ltd., we receive a lot of inquiries in regards to how to structure a non-resident’s investment into the United States. Many of these investments involve U.S. real property or marketable securities. In addition, we also receive a lot of questions from Canadian advisors and new clients who have held these investments for a number of years but who have never filed any U.S. tax returns, primarily because these investments have not generated any revenue until the underlying investments are being sold.
If the investment entity is being formed in the United States it will most likely be, or has been, formed as a limited liability company (LLC) under state law. For most private company entities, this is now the default structure. For U.S. tax purposes, a multi-member LLC is taxed as a partnership unless there is an election, under the check the box rules, to tax the LLC as a corporation. For purposes of this U.S. Tax Tip we are assuming that the LLC will remain a partnership for U.S. tax purposes.
We will be looking at U.S. investment in an LLC as a three-part series. Part 1 will look at the filing of the partnership return itself. Part 2 will look at the withholding requirements when foreign partners receive allocations of income and gain from the partnership. Part 3 will look at the U.S. tax implications when the partnership interest has been sold or redeemed.
Another question, which these U.S. Tax Tips will not be addressing, is how Canada may treat a U.S. LLC. That is whether the LLC is a foreign affiliate or controlled foreign affiliate, for Canadian tax purposes, and be subject to the foreign accrual property income (FAPI) rules, etc. Readers will need to consult with their Canadian advisors on these issues.
What needs to be filed?
Every partnership that is doing “business” in the United States is required to file Form 1065, “U.S. Return of Partnership Income”. The partnership, however, does not pay any U.S. tax on its own account. The partnership will issue, to each partner, Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.”
A foreign partnership that has gross income effectively connected (ECI) with the conduct of a trade or business within the United States or has gross income derived from sources in the United States must file Form 1065. This is true even if its principal place of business is outside the United States or all its members are foreign persons. A foreign partnership required to file a return must generally report all of its foreign and U.S. source income. There are, however, limited exceptions that may apply.
Foreign partners are deemed to be doing business in the U.S. via their interest in the partnership. As such, it is the partners who must pay any U.S. federal or state taxes. Partners who are non-resident individuals or non-resident trusts would file Form 1040-NR, “U.S. Nonresident Alien Income Tax Return”. Partners who are foreign corporations would file Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation”.
When is the partnership return due?
The due date for a partnership is the 15th day of the 3rd month following the end of the fiscal year. For a calendar year partnership, the due date would be March 15th. A 6 month extension can be obtained by timely filing Form 7004, “Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns”.
Late filing penalties
Since the partnership is not required to pay any U.S. tax there is no “late filing penalty” with respect to the late filing of Form 1065 itself. Rather the penalty is for the late filing of the associated Schedule K-1 (Form 1065).
A penalty is assessed, against the partnership, if it
(a) fails to file the return by the due date, including extensions, or
(b) files a return that fails to show all the information required, unless such failure is due to reasonable cause.
The penalty is $205 for each month or part of a month (for a maximum of 12 months) the failure continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due.
This is where the issue becomes problematic and is not understood by many investors or advisors. Because the partnership is not generating any taxable income, in many cases partnership returns are not being timely filed.
Let’s assume that a partnership was formed in 2015 with 50 partners. The partnership invested in U.S. real property, an apartment complex. The objective was to generate a long term capital gain on the renovation, rental and eventual sale of the apartment complex.
There was no current year income generated in any year (primarily because of U.S. tax depreciation). The apartment complex was sold in 2019 for a considerable gain such that all the partners will have a taxable gain.
Since the 2015 through 2018 partnership returns were not timely filed (the 2019 partnership return is not due until March 15th, 2020), the partnership is subject to penalties for not timely issuing the Schedule K-1 forms.
In this example, there would be a substantial penalty. We would have 4 years (2015 through 2018) times 50 partners times 12 months times $205 per month times 4 years. That is a potential penalty of US $492,000!! Unfortunately, this is not an unusual situation that we have come across.
Who we are
Cadesky U.S. Tax Ltd. is a full service advisory and compliance firm. We monitor U.S. tax news that may be of interest to our readers and share our thoughts in U.S. Tax Tips.
If you require our assistance please do not hesitate to reach out to us.