Partnerships Must Pay Tax on Income of Foreign Partners Or Face Big Penalties

Does your partnership have U.S. income and foreign partners? If so, you may be personally liable for making payments of U.S. taxes for the foreign partners.

Partnerships conducting a trade or business in the U.S. are required to make payments of Federal income tax ("1446 Payments") on behalf of foreign partners. These payments are due quarterly and are computed in a manner similar to corporate estimated tax payments. The payments are computed at the highest rate of tax (now 35%) for the type of partner. Special rules apply to reduce the amount of the payment for a particular partner for loss carry forwards and certain other items of that partner. Payments made on behalf of a partner are a refundable withholding tax credit for the partner upon filing a U.S. income tax return. If the partner owes no tax, there is a full refund to the partner.

1446 Payments are required be every partnership that has income from a U.S. trade or business, called effectively connected income or ECI, and has foreign partner(s). This applies to partnerships formed under U.S. law or under foreign law. The questions of whether a trade or business exists and whether the income is effectively connected with such trade or business are inherently factual. There are no bright line tests, though there are exceptions. Generally, if a revenue producing business is conducted in the U.S., then the income from the U.S. part of that business is ECI. However, if the activities in the U.S. are solely administrative, or if U.S. activities are only occasional, then the income may not be ECI. In addition, there are certain exceptions in IRS regulations, mostly related to securities and commodity traders.

In addition, partnerships must withhold 30% Federal income tax ("1441 Payments") on distributions to partners of their share of non-ECI interest, dividends, rents and royalties. The rate of tax may be reduced under a U.S. income tax treaty with the partner's home country. But to get this reduction, the partner must have provided the partnership with Form W-8BEN before the payment.

The 1441 and 1446 payments apply only to foreign partners. An individual is foreign if he or she is not a U.S. citizen AND not a U.S. resident. A corporation is foreign if it is incorporated outside the U.S. Where payments are to partnerships, the originating partnership must look through the receiving partnership to determine residence of corporate or individual partners. The payment requirement applies at EACH tier of partnerships.

Payments are due only on each foreign partner's share of the income. This share is determined under the partnership agreement. Payments of 35% of foreign partners' share of ECI are due quarterly on the corporate estimated payment dates. These are April 15, June 15, September 15, and December 15 for calendar year partnerships. A final payment is due on the un-extended due date of the partnership return (April 15 for calendar year). Payments of 30% (or treaty rate) for distributed passive income are due under normal withholding tax rules (often next business day). Where passive income remains undistributed, it is deemed distributed at year end, but tax payment is due on the un-extended due date of the partnership return.

A partner with prior U.S. tax losses on their returns can have the partnership reduce its 1446 Payment. To get this reduction, the partner must provide the partnership a statement indicating how much loss carryover the partner has available. The partnership will then reduce the partner's ECI subject to the payment by the amount of this loss until it is used up. Without the partner's sworn statement, the partnership must pay the full 35% tax.

Failing to make these payments can result in penalties. Payments must be deposited with a bank or made by electronic funds transfer to the IRS. If the payments paid are late, the IRS automatically imposes a penalty of similar to interest on the amount that is late, and may impose a late deposit penalty of up to 10%. In addition, the IRS may impose a $100 penalty on the partnership. If the payments are not paid, the IRS may impose a penalty of 100% on the partnership, in addition to collecting the tax from the partnership.

EACH AND EVERY general partner of the partnership is liable for the payments and penalties. Also, the person in charge of partnership funds (such as the controller or manager) could be subject to the 100% penalty.

The partnership must file IRS Forms 8813 at the quarterly due dates above to report aggregate 1446 Payments. It must file Forms 8804 and 8805 with its partnership return (Form 1065) after year end. The partnership also provides a copy of Form 8805 to the foreign partner as proof of payment of U.S. income tax. The partnership must also follow deposit rules and reporting, and file Forms 1042 and 1042-S at year end with respect to 1441 Payments.

Year end 1441 Payments and all 1446 Payments are considered distributions to partners under Federal tax law. However, unless the partnership agreement explicitly refers to these payments, the treatment under partnership law may be unresolved. Partnership agreements need to explicitly provide that these payments are considered distributions to the affected partners.

In addition to Federal requirements, many states require that partnerships make estimated and final tax payments for partners not resident in the state. Rules vary widely by state.

Is your partnership making the required payments on time? If not, you may be personally exposed to penalties. Getting the competent help you need can cost much less than IRS penalties.

Stephen C. Fox, CPA, has been helping mid-market companies reduce their international tax bills for over 30 years. He is a frequent speaker at international tax conferences, with articles published in major tax journals. Steve provides opportunities to save taxes through structuring, foreign tax credit planning, foreign tax reduction, and IC-DISC. Learn more about how to reduce your international tax bill by clicking Steve Fox, International Tax CPA or call Steve Fox today at 1(973) 610-5669.