Caution: More than One Type of U.S. Federal Tax Withholding Could Be Required for Foreign Partners in a U.S. Partnership

It is very important for a U.S. partnership to determine the residence status of all partners in the partnership. A U.S. partnership is required to report whether a partner is a foreign partner on the Schedule K-1 filed with the Form 1065 federal partnership tax return. A partner is considered to be a foreign partner if the partner is a foreign company formed under the laws of a foreign country. A partner is considered to be a foreign partner if the partner is a foreign individual who is not a U.S. citizen, does not hold a U.S. green card or does not meet the substantial presence test to be treated as a U.S. resident for U.S. federal tax purposes. The U.S. partnership is also required to comply with certain types of U.S. federal tax withholding that are required for foreign partners. The applicable types of U.S. federal tax withholding include foreign partner withholding under I.R.C. Section 1446 and U.S. nonresident withholding under I.R.C. Sections 1441 and 1442.

A U.S. partnership is required to withhold federal income tax at the highest U.S. individual or corporate income tax rate (currently 35% for 2012) on a foreign partner’s distributive share of effectively connected taxable income (“ECTI”). ECTI is basically the U.S. partnership’s ordinary trade or business income. Quarterly estimated payments of Section 1446 foreign partner tax withholding are required with the voucher Form 8813. The U.S. partnership is required to file the Form 8804 Annual Return for Partnership Withholding Tax and Form 8805 Foreign Partner’s Withholding Tax Statement with the annual Form 1065 federal partnership tax return. The foreign partner is generally considered to be engaged in a U.S. trade or business based on its ownership of an interest in a U.S. partnership. A foreign partner that is a nonresident individual must file a U.S. tax return on the Form 1040NR to report the share of partnership income from the Schedule K-1. A foreign partner that is a foreign corporation must file a U.S. tax return on the Form 1120-F. The foreign partner may claim a credit on the U.S. tax return for the federal tax withholding paid by the U.S. partnership on behalf of the partner.

A U.S. partnership is also required to withhold federal income tax at a rate of 30% of the foreign partner’s share of the gross amount of certain types of the partnership’s income which are referred to as fixed or determinable annual or periodical (“FDAP”) income. FDAP income includes interest, dividends, rents, royalties and compensation for services performed by a foreign person in the United States as a consultant or independent contractor. The 30% U.S. nonresident withholding tax rate could be reduced under an applicable U.S. tax treaty provision. A U.S. partnership is required to report this type of U.S. nonresident tax withholding applicable to foreign partners on the Forms 1042 and 1042-S.

So, it is possible that a foreign partner in a U.S. partnership could be subject to both foreign partner tax withholding under Section 1446 and U.S. nonresident tax withholding under Section 1441 or 1442. Another thing to note is that if a U.S. partnership with a foreign partner sells U.S. real property, I.R.C. Section 1445 FIRPTA tax withholding is not required on the gross sale proceeds. However, the gain from the sale of the U.S. partnership’s U.S. real property is treated as ECTI and it is subject to Section 1446 foreign partner withholding. Section 1446 foreign partner withholding supersedes Section 1445 FIRPTA withholding.

Got questions? Connect with an experienced Aprio advisor today. Schedule a Consultation