If your partnership has foreign partners,
there are some special IRS requirements
that apply. Partnerships are generally considered to be “pass through” entities by the
IRS, which means that the partnership does
not have a separate existence from its partners for income tax purposes and is not
required to pay federal taxes on its income.
Instead, the tax liability is passed through to
the partners. The rules change, however, if
the partnership has foreign partners. The
partnership must then report and remit to the
IRS taxes withheld from its foreign partners.
Smart Business spoke with Desiree M.
Cuason, Esq., an attorney with Katz Barron
Squitero Faust, about federal tax requirements for partnerships with foreign partners.
When are partnerships with foreign partners
required to withhold taxes?
U.S. partnerships with foreign partners are
required to withhold taxes on income allocable to foreign partners and remit them if one
of the following applies: the partnership has
income from an active business in the U.S.;
the partnership receives periodic income
from passive investments, even if it does not
have an active business in the U.S.; or the
partnership sells a U.S. real property interest.
How much tax is required to be withheld from
income from an active business?
If the partnership receives income from an
active business in the U.S., it must withhold
taxes at the highest tax rate for individuals or
corporations on income that is allocated to
its foreign partners. The usual pass-through
entity rules apply to U.S. partners, so withholding requirements do not apply to them.
When does the tax withheld from the foreign
partners have to be reported and remitted?
There are both quarterly and year-end
requirements for reporting and remitting.
Quarterly withholding payments are made
on an estimated basis. If the estimated tax is
less than the actual tax due at the end of the
tax year, then the balance is remitted when
the partnership files its annual return. If the
estimated tax is greater, then the foreign partner would seek a refund from the IRS.
Foreign withholding can create a disparity
between the adjustments made to capital
accounts of foreign and domestic partners.
The capital account of a partner is increased
when income is allocated and is decreased
when a distribution is made. The withholding
of tax for a foreign partner has the effect of a
distribution and decreases the foreign partner’s capital account. This doesn’t happen
with a domestic partner’s capital account.
Partnership agreements can be drafted to
avoid this disparity, requiring the partnership
to distribute cash to all partners in amounts
that will cover the taxes due on allocated
income. Also, the partnership can be
required to distribute a pro rata equivalent of
the tax withheld for the foreign partners as
each quarterly installment comes due.
If the partnership borrows money to fund
the foreign withholding, then the partnership
agreement may provide that the foreign partners’ capital accounts will be reduced by the
loan repayment and other loan related costs.
This protects domestic partners from bearing
expenses that benefit the foreign partners.
What is passive income and how much tax
must be withheld from passive activities?
Interest, dividends, royalties and rents are
examples of passive income. The partnership
must withhold 30 percent of the income allocated to its foreign partners. The income
must be reported and the taxes withheld
must be remitted by March 15 of the year following the calendar year in which the income
was allocated to the foreign partner.
Keep in mind that what you think is passive
income might really be an active business in
the eyes of the IRS and therefore subject to
the higher tax rates. Each situation is judged
on its own facts. For example, interest payments from an account receivable are treated
as active business income by the IRS.
Likewise, assets that are acquired and held in
the ordinary course of business, such as a
residential developer’s real estate inventory,
are considered active business income.
Since tax rates are different for active and
passive income, the partnership’s tax adviser
must have a clear understanding of the passive income items and assess the risk of the
IRS treating them as active business income.
What is the withholding requirement for a
partnership with foreign partners when it
sells its U.S. real estate?
When a partnership with foreign partners
sells its U.S. real estate or certain other assets
(such as shares in a U.S. corporation), the
partnership will be treated as conducting an
active business in the U.S. and the foreign
withholding will be based on the highest tax
rates. On the other hand, if the partnership
distributes the asset to its partners instead of
selling, then the withholding will only be 10
percent of the asset’s fair market value.
Are there any consequences to the partnership for failing to withhold and remit tax on
income allocated to its foreign partners?
It is partnership’s responsibility, not the foreign partner’s, to withhold and pay the tax to
the IRS. If a partnership does not, or if it does
not withhold the right amount, it may be subject to penalties and interest on the unpaid
amounts. The partners should consult with
their tax advisers to determine their tax obligations and to reserve funds necessary to
protect interests of all concerned.
DESIREE M. CUASON, Esq., is an attorney with Katz Barron Squitero Faust. Reach her at (305) 856-2444 or [email protected].