December 2001

Withholding Basics for Foreign Partners

By James Lynch, CPA

Sobel & Co. LLC CPAs

Under IRC section 1446, U.S. partnerships with foreign partners must generally withhold income tax on the foreign partners' effectively connected taxable income. U.S. partnerships are partnerships organized in one of the fifty states or the District of Columbia. Special rules, however, apply to publicly traded partnerships, which withhold tax on distributions rather than on effectively connected taxable income unless they elect otherwise. The mechanics of withholding income for foreign partners can entail certain requirements and pitfalls.

Withholding Basics

The withholding under IRC sections 7701(a) and 1446(e) applies to foreign partners: individuals that are not citizens or residents of the United States, or corporations, partnerships, and certain trusts or estates organized outside of the United States. A U.S. partnership's managing partner can determine which partners are foreign by any means; however, if the manager determines incorrectly, the partnership is subject to penalties for not withholding tax when it should have. Managers can protect themselves by obtaining a signed certificate of nonforeign status, or a Form 1041, W-8 or W-9, from each potential foreign partner. The certificate is a document, under penalty of perjury, in which the partner states that the partner is not a foreign person or entity. As long as the partnership's manager does not know that the certification is false, he may rely on it for three tax years without facing a withholding penalty (see Revenue procedure 89-31).

The withholding tax is assessed on the effectively connected taxable income allocated to foreign partners under IRC section 4446(a)(1). If a partner's income is not taxable due to the provisions of a tax treaty, the income is not subject to withholding. It is important to note that the tax is withheld on income, not on distributions (except in the case of publicly traded partnerships). In addition, partnerships may not take into account net operating losses from the partnership or other losses or deductions in computing the tax to be withheld for each partner. The withholding tax is on current year income only. Furthermore, effectively connected taxable income does not include interest, dividends, or gains on the sale of real property, which is subject to its own withholding regime under Revenue procedure 89-31.

Determining Quarterly Payments

The withholding tax is paid quarterly on the 15th day of the fourth, sixth, ninth, and twelfth months of the partnership's tax year. According to Revenue procedure 89-31, 1989-1, CB 895, any additional withholding tax is due on the original due date of the partnership's return. Taxes should be withheld at 35% for corporate partners and 39.6% for all other partners.

The amount of tax to be paid in a quarterly installment can be determined in two ways, described in Form 8804. In the first method, partnerships annualize their income using one of three options. The standard option uses the income from the first three months of the current tax year for the first two installments, from the first six months for the third installment, and from the first nine months for the fourth installment.The second option uses the first two months' income for the first installment, the first five months' income for the second installment, the first seven months' income for the third installment, and the first ten months' income for the fourth installment. The third option uses the first three months' income for the first installment, the first five months' income for the second installment, the first eight months' income for the third installment, and the first eleven months' income for the fourth installment. If options two or three are elected for a tax year, the partnership must file Form 8842 by the due date of the first installment.

Alternatively, the partnership can compute the tax owed based upon the prior year's income. This second method is permitted only if the partnership filed a Form 1065 for 12 months during the prior year and only if the effectively connected taxable income for the prior year is at least 50% of the effectively connected taxable income of the current year (Revenue procedure 89-31). Using this method can be risky for partnerships whose income fluctuates dramatically from year to year.

The quarterly payment is made with Form 8805; the annual report is done on Form 8804. Withholding is reported to each partner on Form 8813. The withheld tax is treated as a distribution to the partner in the tax year to which the distribution relates. Partnerships with foreign partners should carefully monitor their income and ensure that they are withholding the correct amounts. Substantial penalties can be imposed on partnerships not paying the tax or withholding too little.

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