Foreign Witholding Rules

From the Desk of Samuel Handwerger, CPA

BACKGROUND

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. This effectively causes the partnership to become a “withholding agent” for the foreign partner. A withholding agent has personal liability to administer the requirements of the law correctly. In other words, the withholding agent can be help responsible for paying any and all amounts that should have been paid along with any applicable penalties and interest.

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: (a) the partnership has income from an active business in the U.S.; (b) the partnership receives periodic income from passive investments, even if it does not have an active business in the U.S.; or (c) the partnership sells a U.S. real property interest.

Interest, dividends, and royalties are examples of passive income. Whether rents are included in this category of passive income is a matter of facts and circumstances. Triple net rent leases are clearly passive. Operations less passive are open to interpretation.

If the rents are nevertheless deemed passive, the partnership must withhold 30 percent of the income allocated to its foreign partners. The income in this case is defined as the “gross rent”, with no deduction for operating expenses let alone depreciation. One can easily see that this must be onerous on the foreign taxpayer in most situations. Since the partnership is in the position of a “withholding agent” and can be found to be personally liable for failure to withhold properly, the partnership should seriously consider withholding based on this onerous calculation in order to protect itself.

RECOMMENDED ACTION STEPS

To avoid this most unpleasant scenario completely, the foreign taxpayer should take some simple steps, many of which they are going to have to do anyway.

First, the foreign partner should secure a US Federal Identification Number by completing and filing Form W-7 with the IRS. The partnership is going to need that number both in its capacity of filing the annual tax return and in fulfilling its stewardship role as withholding agent.

Next, the partner should complete a Form W-8ECI and submit that to the partnership. This form will demonstrate to the partnership that the foreign partner has or intends to make the election that they are treating the income from this partnership as being “effectively connected income” to a trade or business. This election will allow the foreign partner to pay tax only on the net income of the partnership and avoid the 30% tax on gross rents. With this in hand, the partnership now can avoid the 30% withholding on gross rents for the foreign partner.

The foreign partner needs to follow that up by actively filing his US tax return, Form 1040-NR, along with the appropriate election, as outlined above. Note: That the foreign partner must annually file this US return or they can retroactively lose this election for up to 6 prior years. On this note, it is important that the partnership recognize that if there is any reason to doubt the effectiveness of the foreign partner’s election, the withholding agent (the partnership in this case) must immediately resort back to withholding on the 30% of gross rents. Given the severity of liability that the partnership may have in its role as withholding agent it is advisable for the partnership to require the foreign partner to submit a copy, annually, of their Form 1040-NR as filed with the IRS.

Further, the Form W-8ECI, described above, is good for three years. The foreign partner must re-submit another such form to the partnership upon the three year anniversary or the partnership will be forced to resort to once again withhold at the 30% of gross rent.

Notwithstanding this election, the partnership will still have to withhold taxes of the foreign person based on the calculated net income. The rate of withholding here will be at the highest individual tax rate under the US graduated rates, but here it is only on net income – meaning after deducting all operating expenses including depreciation. Finally, the foreign partner can give the partnership Form 8804-C to demonstrate either a lower rate of tax due to a tax treaty or because their circumstances warrants a lower rate.



Tax Due Dates