Partnership Taxation Rules

Treas. Reg. § 301.7701–3(b)(1) defines an LLC that has more than one member as a partnership. (Unless the members choose to designate it for tax purposes as a corporation.)

Partnerships are “pass-through entities.” That means that a partnership’s income and expenses “pass through” to the individual partners, who must pay a tax on their proportionate shares of net gain or may claim a deduction for their shares of net loss.

IRC Section 701 states that a partnership is not liable for federal income taxes. Instead, persons carrying on business as partners are liable in their separate or individual capacities for the income taxes arising from partnership operations.

In United States v. Basye, 410 U.S. 441 (1973), the U.S. Supreme Court held that for taxation purposes, partnerships are conduits through which the tax obligation passes to the individual partners.

In Miller v. Comm’r of Internal Revenue, 52 T.C. 752,the United States Court of Appeals held that a foreign partner’s distributive share of a U.S domestic partnership is excludable only to the extent that it represents his share of the firm’s income from sources outside the United States.

Every year, a partnership must file an information return (Form 1065) to report items of income, deduction, and credit, when these items are allocated among the partners who bear the tax consequences for them.

U.S. Sourcing Rules

Under U.S. law, determining whether income earned by nonresident aliens or foreign corporations is subject to U.S. taxation depends on the source of that income.

It is also crucial for U.S.persons when figuring out their foreign earned income exclusion or foreign tax credit. This article deals specifically with foreign persons, and the discussion of U.S. persons’ taxation is out of scope.

The IRS taxes foreign persons (i.e., nonresident aliens and foreign corporations) on two types of income:

1. U.S.-source investment income (FDAP)
2. Income effectively connected with a U.S. trade or business (“USTB”).

Nonresident aliens are generally subject to U.S. taxation from income sourced within the United States. As a result, most foreign persons prefer to acquire foreign-source income rather than U.S.-source income.

(There are some rare exceptions, but we’ll worry about that another time.)

Now, partnership income retains its character whenever it flows through to the individuals’ personal tax return. If 100% of the partnership income is foreign source, then 100% of the partners’ distribution is foreign source.

So, based on this, let’s look at the various source of income earned by the partnership in the question above.

1. The Indian partners provided Software development and consulting services directly from India to various US customers.

   IRC 875 specifies that where a partnership is found to be engaged in a U.S. trade or business, the foreign partner will also bear the consequences of such attribution, meaning the foreign partner will also be treated as if he is engaged in a U.S. trade or business.

   Section 875 determines the taxable status of a nonresident partner in a partnership engaged in business in the United States (“USTB”). Section 871 determines the manner in which a nonresident partner in a partnership shall be taxed, and section 872 limits the income to be taxed.

   Since you indicated that the partnership does not have an office, employee, exclusive agent, or a partner residing in the United States, it’s fair to conclude that this partnership may not have a U.S. trade or business (USTB), therefore the income referenced above cannot be effectively connected to USTB.

   IRC 862(a)(3) states that the source of compensation for personal services is the country where the services are performed regardless of where the payor resides, the residence of the recipient of the service, time and place of payment, and the place of contracting.

   In summary, this partnership’s service income from sources outside the United States would be from services performed by its members and employees abroad. As explained earlier, foreign source income earned by a non-resident Alien will not be subject to U.S. taxes even though there is a U.S.LLC set up for this operation.

   The gross foreign earned income, and related foreign expenses of the partnership for all partners must be separately stated. Foreign income and expenses are generally reported in Box 16 of schedule K-1 Form 1065.

   The individual partners will not be required to file a Form 1040NR under these circumstances since the service income is a foreign source and not taxable to the non-resident partner.

   PLEASE NOTE that for tax year 2021 and beyond, additional Schedules namely K-2 (similar concept to Schedule K, see page 4), and K-3(similar concept to Schedule K-1) for Forms 1065 are required to be filed by partnerships with items of international tax relevance (generally foreign activities or foreign partners).

   The schedules are designed to provide greater clarity for partners on how to compute their U.S. income tax liability with respect to items of international tax relevance, including claiming deductions and credits.

   These schedules also replaces, supplements, and clarifies the reporting of certain amounts reported on Schedule K-1 (Form 1065), Part III, line 16. Click here for more information on these additional schedules.

2. The Partnership savings account at JPMorgan Chase earned 500 USD interest.

   Generally, interest income is determined by the residence of the payor. Therefore, interest received from U.S residents or corporations is U.S-source income. However, there is an exception.

   You see, nonresident aliens who receive interest income from deposits with a U.S. bank, savings & loan institution, credit union, or insurance company—or who receive portfolio interest—are exempt from taxation on such interest income as long as such interest income is not effectively connected with a USTB.

   Since the partnership in the above question is not engaged in USTB, the interest received from the savings deposit will not be taxable to the nonresident alien partners.

   Now, the partnership will report the interest income in Box 5 of schedule K-1 Form 1065. But the individual partners will not be required to file a Form 1040NR under these circumstances, since the interest income is not taxable.

3. The Partnership purchased publicly traded stocks when we opened a brokerage account with Wells Fargo. A total amount of 500 USD was distributed to the partnership as dividends from these publicly traded stocks.

   IRC 861(a)(2) provides that dividends from domestic corporations are U.S.-source income. Since all the partners are from India, Article 10(2)of the U.S – India Tax treaty provides for a 15% withholding rate for direct dividend, or 25% of the gross amount of the dividends in all cases.

   The Direct dividend withholding rate applies if the beneficial owner is an Indian company which owns at least 10 percent of the voting stock of the U.S company paying the dividends.

   If withholding is not done at the source—at the brokerage level—it is the duty of the partnership to withhold the taxes and remit directly to the IRS. (See IRC sections 1441, 1442, and 1443.)

   The partnership will also be required to report such withholding on Form 1042 and 1042-S.

   A partnership with such withholding obligation should register for an EFTPS account, where the withheld taxes will be remitted, and also obtain an Individual Taxpayer Identification Number(“ITIN”)from each foreign partner to make it easy for the IRS to reconcile these income and tax payments against each foreign partner’s account.

   The Partnership must retain a completed W8-BEN from each foreign partner – which certifies the country of tax residency and to establish their qualification for a reduced rate of withholding on such dividends.

   The partnership will file Form 1065 and report such dividends on each partner’s Schedule K-1 box 6a and “6b” if applicable.

   However, the individual partners will not be required to file a Form 1040NR if the tax due on the dividend was properly withheld at the US source.

4. The Partnership also traded some stocks within the brokerage account referenced above, so there are some capital gains reported by the brokerage.

   Stocks are intangible personal property, so disposition or sale of stock are generally taxed based on the residence of the person receiving the payment. (See IRC 865)

   Foreign persons can exclude U.S. source capital gains that are not effectively connected to USTB.

   Under IRC 871(a)(2), a nonresident alien is taxable on U.S. source capital gain only if he is present in the United States for 183 days or more during the taxable year.

   Since the partnership is not engaged in USTB, and if none of the foreign partners have been present in the United States for 183 days or more during the year, the capital gain from a stock sale will not be taxable to the nonresident alien partners.

   Depending on the type of capital gain, whether short- or long-term, the partnership will report the capital gain in either Box 8 or 9a of Schedule K-1 Form 1065.

   The individual partners will not be required to file a Form 1040NR under these circumstances, since the capital gain is not taxable.

5. The partnership generated royalty income from Amazon, Apple, Google, and Envato.

   The source of royalty is determined by where the property is used.

   Royalties paid for the use of, or for the privilege of using, in the U.S., patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like property are U.S.-source income.

   When a U.S resident downloads or views your content, the royalties received by the partnership will be deemed as U.S source income.

   Since all the partners are from India, Article 12(2)-(4) of the U.S India Tax treaty provides for a 15% withholding rate on U.S-source royalty income, with the exception of royalties received as consideration for the use of industrial, commercial, or scientific equipment’s – this is subject to a 10% withholding rate.

   If withholding is not done at the source—at the brokerage level—it is the duty of the partnership to withhold the taxes and remit directly to the IRS. (See IRC sections 1441, 1442, and 1443.)

   The partnership will also be required to report such withholding on Form 1042 and 1042-S.

   A partnership with such withholding obligation should register for an EFTPS account, where the withheld taxes will be remitted, and also obtain an Individual Taxpayer Identification Number(“ITIN”)from each foreign partner to make it easy for the IRS to reconcile these income and tax payments against each foreign partner’s account.

   The Partnership must retain a completed W8-BEN from each foreign partner – which certifies the country of tax residency and to establish their qualification for a reduced rate of withholding on such royalties.

   The individual partners will not be required to file a Form 1040NR if the tax due on the royalty was properly withheld at the US source.

Still With Me?

Okay. Let’s take a quick review of the four questions we’re hoping to answer with this article:

1. Is the partnership required to file Form 1065?
2. Should the partners file form 1040NR?
3. Is this foreign owned multi-member U.S. LLC required to file form 5472?
4. Is the partnership subject to section IRCSection 1446 withholding?”

So far, we’ve been able to answer the first two questions. Now let’s move on to 3 and 4.

Withholding Tax on Foreign Partners’ Share of Effectively Connected Income

A partnership (foreign or domestic) that has income effectively connected with a U.S. trade or business (or income treated as effectively connected) must pay a withholding tax on the effectively connected taxable income that is allocable to its foreign partners.

The current withholding tax rate for effectively connected income allocable to individual foreign partners is 37%—and 21% for corporate foreign partners.

If your U.S partnership is determined to be engaged in a U.S. trade or business effectively connected with the U.S. trade or business, it will be required to “withhold on effectively connected taxable income allocable to its foreign partners” under IRC Section 1446.

It is the duty of the partnership to withhold the taxes and remit directly to the IRS. The partnership will also be required to report such withholding on Forms 8804, 8805, and 8813.

A partnership with such withholding obligation should register for an EFTPS account, where the withheld taxes will be remitted, and also obtain an Individual Taxpayer Identification Number(“ITIN”)from each foreign partner to make it easy for the IRS to reconcile these income and tax payments against each foreign partner’s account.

The facts in your case do not support the determination that this partnership is engaged in USTB, therefore in the absence of USTB, the partnership will not be subject to IRC Section 1446 withholding with respect to the distributive share of income to the foreign partners.

Is This Foreign-Owned Multi-Member U.S LLC Required to File Form 5472?

Form 5472 is used to provide the information required under sections 6038A and 6038C when reportable transactions occur during the tax year of a reporting corporation with a foreign or domestic related party.

Reporting corporation. A reporting corporation is either:

1. a) A 25% foreign-owned U.S. corporation (including a foreign-owned U.S. disregarded entity, or
2. b) A foreign corporation engaged in a trade or business within the United States.

Per IRC 301.7701-2(a), if an entity with two members, including a multi-member LLC seeks to be treated as a corporation, it must check the appropriate box on IRS Form 8832. If it does not check this box, the entity is treated and taxed as a partnership.

The reporting of Form 5472 applies to foreign-owned U.S corporations and foreign-owned single U.S member LLCs. It does not apply to multiple-member LLCs because the multiple-member LLC is not a reporting corporation within the meaning of the law.

I hope this article helped you!

CAUTION: This explanation is oversimplified, and it should be noted that partnership taxation partnership taxation has always been a complicated field, full of traps and pitfalls, and becomes increasingly so each year. Your tax consequences will always depend on your specific facts and circumstances. The issue is even more complicated when the following factors are present…

• Having a U.S Citizen or resident as a partner
• Owning a U.S office, warehouse, or any other permanent structure where business is conducted.
• Partners traveling physically into the U.S to conduct business.
• Having U.S employees and exclusive agents or contractors who are not independent.

The list provided above is not exhaustive and you should always consult your tax attorney or CPA even when you think your tax obligation is simple.

If you need some assistance from a professional CPA—or just have more questions—just let me know, and I’ll be happy to help. I’ll review all the details of your unique situation and make sure you’re covering all your bases.

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