Being caught unaware of these tax obligations could mean an expensive tax bill for your partnership.
In the current global business environment, it’s become common for US entrepreneurs to team up with foreign business partners. In many cases, foreign investors bring valuable skillsets, resources, international networking, and expansion opportunities to US partnerships. However, business leaders should be aware of the complex tax laws that apply to US partnerships with foreign partners. These companies will need to meet additional tax withholding and reporting obligations that can mean admin headaches–or worse, an expensive tax bill–for those caught unaware.
US Tax Requirements for Foreign Partners
When one member of a US partnership is a foreign person, the IRS becomes concerned that the individual may skip out on paying the taxes that are due to the United States government. To encourage foreign partners to file and pay the full amount owed, the IRS imposes additional withholding and reporting requirements for these individuals. These requirements fall into three main categories:
1. Withholding on Effectively Connected Income (ECI)
ECI is defined as any income from sources connected with the conduct of trade or business within the United States. The IRS requires US partnerships to withhold taxes at the highest rate possible on foreign partners’ effectively connected income. For individuals, this rate is 37%; for corporations, the maximum rate is 21%. In most cases, this means that the amount withheld exceeds the taxes due. This motivates foreign partners to file to claim their tax refund.
2. Withholding Related to FIRPTA (Foreign Investment in Real Property Tax Act of 1980)
If a foreign partner sells their interest in US real property, the buyer must withhold 15% of the foreign seller’s net proceeds. Again, this withholding is intended to discourage tax evasion and urge foreign partners to file the proper forms with the IRS.
3. Withholding on FDAP (Fixed, Determinable, Annual, and Periodic) Income
FDAP income is defined as any income that is not effectively connected income or income gained from the sale of real or personal property. FDAP income, therefore, includes passive investments, such as interest, dividends, capital gains, and rents. Generally, FDAP income is subject to a 30% tax withholding for foreign partners. In some cases, this withholding may be reduced by a tax treaty between the foreign partner’s country of residence and the United States.
Consequences of Non-Compliance
Partnerships that fail to comply with these reporting and withholding requirements could wind up stuck with an expensive tax bill. Due to the tax rules that apply to foreign partners, both the foreign person and the US partnership are responsible for the taxes due. If the partnership fails to withhold and the foreign person becomes delinquent on their taxes, the IRS will come after the partnership for the missing tax payment–along with any penalties or interest charged due to non-payment.
How to Comply with Tax Rules for Foreign Partners
Partnerships with a foreign partner should use Form 8813 to pay quarterly installments of the required tax withholding on effectively connected income. Installments are due on the 15th day of the fourth, sixth, ninth, and twelfth months of the partnership’s tax year.
If a tax treaty is used to reduce the withholding amount on a foreign partner’s income, the partnership must document the treaty and proof of the foreign individual’s eligibility.
Before filing a US tax return, foreign partners must have the proper documentation. For individuals, this means having a Taxpayer Identification Number (TIN). Foreign corporate partners, on the other hand, will need an Employer Identification Number (EIN). Obtaining either can take time, so it’s best to encourage foreign partners to start the process early.
Get the Full Benefits of International Partnership
US partnerships with foreign partners face additional obligations and a more complex tax situation. Ultimately, the liability of withholding rests with the partnership. But with a little tax planning, US business leaders can enjoy the benefits of foreign partnerships without the headaches.
