Tax Implications of Foreign Partners in a Partnership

Owning a percentage of a partnership in the U.S. as a foreigner (non-resident alien individual or foreign entity) carries significant tax implications. The U.S. has a "pass-through" taxation system for partnerships, meaning the partnership itself generally doesn't pay income tax. Instead, the income, gains, losses, deductions, and credits "pass through" to the partners, who then report them on their own tax returns.

Here's a breakdown of the key tax implications for a foreign partner:

1. Effectively Connected Income (ECI) and Withholding Tax (Section 1446)

• What it is: If the U.S. partnership has income "effectively connected with a U.S. trade or business" (ECI), the foreign partner's share of this ECI is subject to U.S. income tax. This is the primary tax concern.

• Partnership's Withholding Obligation: The partnership is generally required to withhold tax on the foreign partner's allocable share of ECI. This withholding acts as an estimated tax payment.

  • Rates: The withholding tax rate is typically the highest individual income tax rate (currently 37%) for non-corporate foreign partners and the highest corporate tax rate (currently 21%) for corporate foreign partners.

  • Forms: The partnership uses Form 8813 (Payment Voucher) to make payments to the IRS and reports the withholding on Form 8804 (Annual Return) and Form 8805 (Foreign Partner's Information Statement).

  • Reduction of Withholding: A foreign partner can sometimes reduce the withholding by providing Form 8804-C, certifying partner-level deductions and losses that can offset their share of ECI.

• Foreign Partner's Filing Obligation: Even with withholding, the foreign partner is required to file a U.S. income tax return (Form 1040-NR for individuals, Form 1120-F for foreign corporations) to report their share of ECI and calculate their final U.S. tax liability. The withheld tax is a credit against this liability.

2. Fixed, Determinable, Annual, or Periodical (FDAP) Income

• What it is: FDAP income includes passive income like interest, dividends, rents, and royalties from U.S. sources that are not effectively connected with a U.S. trade or business.

• Withholding Tax: FDAP income paid to a foreign person (including a foreign partner's share) is generally subject to a 30% withholding tax. This tax is typically final, meaning the foreign partner might not need to file a U.S. tax return solely for this income if the tax has been fully withheld.

• Treaty Benefits: This 30% rate can often be reduced or eliminated under an applicable income tax treaty between the U.S. and the foreign partner's country of residence. To claim treaty benefits, the foreign partner generally needs to provide Form W-8BEN (for individuals) or W-8BEN-E (for entities) to the partnership.

• Forms: The partnership reports this withholding on Form 1042 and Form 1042-S.

3. Sale or Disposition of a Partnership Interest

• Section 1446(f) Withholding: If a foreign partner sells or disposes of their interest in a partnership that is engaged in a U.S. trade or business, the transferee (buyer) may be required to withhold 10% of the amount realized on the disposition. This withholding applies if any portion of the gain on the disposition would be treated as ECI.

• FIRPTA (Foreign Investment in Real Property Tax Act): If the partnership owns U.S. real property interests, the sale of the partnership interest could also be subject to FIRPTA rules. This generally means that gain from the disposition of a U.S. real property interest by a foreign person is treated as ECI and subject to U.S. tax. Withholding may be required under Section 1445.

4. U.S. Estate Tax (for individuals)

• For foreign individual partners, a U.S. partnership interest is considered a U.S. situs asset and may be subject to U.S. estate tax upon the individual's death. The U.S. estate tax can be as high as 40%. Some estate tax treaties may provide relief.

5. Reporting Requirements (for foreign partnerships and U.S. partners in foreign partnerships)

• Form 1065: A foreign partnership must file Form 1065, U.S. Return of Partnership Income, if it has gross income effectively connected with a U.S. trade or business or U.S.-source income. This is an informational return, as the partnership itself is not taxed.

• Form 8865: U.S. persons (including U.S. individuals or entities that are partners in a foreign partnership) may have a separate reporting obligation by filing Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. This form provides detailed information about their interest in and transactions with the foreign partnership. Penalties for non-filing can be substantial.

6. Branch Profits Tax (for foreign corporate partners)

• If a foreign corporation is a partner in a U.S. partnership that is engaged in a U.S. trade or business, the foreign corporation's share of the partnership's effectively connected earnings may be subject to an additional 30% "branch profits tax" (or a reduced treaty rate).

Important Considerations:

• Tax Treaties: U.S. income tax treaties with various countries can significantly impact the tax liability and withholding rates for foreign partners. Treaties often reduce or eliminate U.S. tax on certain types of income, prevent double taxation, and provide rules for determining whether a foreign person has a "permanent establishment" (which generally triggers ECI).

• Tax Characterization of Income: The classification of income as ECI or FDAP is crucial and can be complex, especially for businesses with various types of activities.

• State and Local Taxes: In addition to federal taxes, foreign partners may also be subject to state and local income taxes in the states where the partnership operates.