Investing in the U.S. via partnerships or limited liability companies (LLCs) – Part 2
Volume No. US-20-03
This Cadesky U.S. Tax Tip is the second of three that deal with non-residents investing in the United States via partnerships or limited liability companies (LLCs). Part 1 looked at the U.S. implications of the partnership or LLC not timely filing a U.S. partnership return nor timely filing Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.” In this U.S. Tax Tip we look at the withholding obligations the partnership has with respect to distributions to non-resident partners.
As discussed in Part 1, a partner is deemed to be doing business in the U.S. via their interest in the partnership. Partnerships, in general, do not pay tax, the partners do. As such, with respect to a foreign partner the U.S. Congress was (and still is) concerned that once funds leave the United States that the U.S. Internal Revenue Service (IRS) may be unable to enforce payment of the non-resident’s U.S. tax liability. As such, the Internal Revenue Code imposes a withholding obligation on the partnership itself. IRC §1446 states
“SEC. 1446. WITHHOLDING OF TAX ON FOREIGN PARTNER’S SHARE OF EFFECTIVELY CONNECTED INCOME.
- GENERAL RULE – If
- A partnership has effectively connected taxable income for any taxable year, and
- Any portion of such income is allocable…to a foreign partner,
such partnership shall pay a withholding tax under this section at such time and in such manner as the Secretary shall by regulations prescribe.”
Some observations; remember effectively connected income is NOT subject to a flat U.S. non-resident withholding tax. A U.S. income tax return must be filed, by the partner, to report any ECI (per the partner’s Schedule K-1 (Form 1065)) and the foreign partner is liable for any U.S. tax if their U.S tax return reflects net taxable income. In addition, the partnership may have earned and distributed non-ECI investment income such as interest, dividends, etc. (also known as FDAP – fixed, determinable, annual or periodical). These too may be reported on the K-1. These amounts, however, would not be subject to withholding under IRC §1446 as they would be subject to a final U.S. non-resident withholding tax. In many instances, where the partner is a foreign person, they may have also received Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding”.
IRC §1446, however, imposes a withholding obligation on the partnership where the partnership has effectively connected taxable income (ECTI) and where any portion is allocable to a foreign partner. Note that the withholding is on effectively connected income ALLOCATED to a foreign partner. That income does not necessarily have to be distributed to the foreign partner. As such there could be cash flow implications where income is allocated but not distributed.
The amount that is required to be withheld depends on the type of taxpayer the partner is. In general, the tax required to be withheld is equal to the taxpayer’s top marginal tax rate for the year. For individual and trusts, the rate is 37% on ordinary income and 20% on long term capital gains. For corporations, the rate is 21%. This is NOT a final tax, only a withholding obligation on the payor partnership. The foreign partner receives credit on their U.S. tax return for any amounts withheld and remitted on their behalf. Since individuals and trusts are taxed at graduated rates in many instances they would be entitled to a refund when they actually file their U.S. non-resident income tax return.
Reporting of withholdings
The partnership is required to file Form 8804, “Annual Information for Partnership Withholding Tax (Section 1446)” with the IRS. Each foreign partner would receive Form 8805, “Foreign Partner’s Information Statement of Section 1446 Withholding Tax” indicating the amount of U.S. federal tax withheld and remitted on their behalf. These returns are due to be filed with the IRS on or before the 15th day of the third month following the close of the partnerships’ tax year. For partnerships that keep their books and records out of the United States and Puerto Rico, the due date is the 15th day of the sixth month following the close of the partnerships’ tax year. The partnership may also file an extension, Form 7004, “Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns” to request more time to file the information returns. An extension, however, does not extend the time for the payment of the withheld tax.
If these information returns are not timely filed (including extensions), the IRS will impose late filing penalties. A partnership that fails to file Form 8804 on a timely basis will be subject to a late filing penalty of 5% (0.05) of the unpaid tax for each month (including a part month) the return is late. The maximum late filing penalty is 25%. If, however, Form 8804 is filed more than 60 days late, the minimum penalty will be $330, or the amount of any tax owed, whichever is smaller. The IRS can also impose late payment penalties. This penalty is imposed at the rate of ½ of 1% (0.005) of the unpaid tax per month. The maximum late payment penalty if 25%.
The late filing of Form 8805 could result in a penalty of $270 for each Form 8805. It may be possible to have penalties abated, but that usually requires additional time and fees.
Where partnerships have foreign partners, not only must the partnership (ultimately) withhold and remit (per above) but the partnership will also be required to make quarterly estimated instalment payments in anticipation of those final withholdings. These quarterly payments are reported on Form 8813, “Partnership Withholding Tax Payment Voucher (Section 1446)”. These must be filed, and payments made, by the 15th day of the 4th, 6th, 9th and 12th months of the partnership’s tax year. Failure to timely make the required payments will result in interest costs and late under instalment penalties.
Where a foreign partner has losses that have been carried forward, there may not be a cumulative taxable position even though the partnership may have generated current year ECTI. The partnership is still required to withhold and remit based on current year ECTI. The foreign partner, however, may request a reduction in the current year withholding by filing, with the IRS, Form 8804-C, “Certificate of Partner-Level Items to Reduce Section 1446 Withholding”. Once approved this form should be submitted to the partnership to allow them to reduce the required withholding.
Whenever a foreign partner invests in the United States, numerous and varying filing obligations will arise. The partnership (or its agent) needs to review the types of income the partnership earned (ECTI or FDAP), the type of partner involved (individual, trust or corporation), the tax residence of the partners (U.S. or foreign), etc. as these will impact what and when different information returns needs to be filed. Failure to consider these differences will result in penalties to the partnership. Cadesky U.S. Tax Ltd. is well versed in assisting clients with the preparation of all required partnership filings.
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The material provided in this U.S. Tax Tip is believed to be accurate and reliable as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither Cadesky Tax nor Cadesky U.S. Tax can accept any liability for the tax consequences that may result from acting based on the contents hereof.
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