Withholding on foreign partners - general tax limitations apply. (Federal Taxation)by Biondo, Gina
One interesting issue that has arisen is whether the partnership may take into account deduction or loss items that are currently limited to the amount of income in a particular classification (i.e., passive activity losses, capital losses, investment interest expense) to offset other items of partnership income for purposes of determining the amount of withholding tax due. The resolution of this issue is significant in light of Sec. 1461, which holds the partnership liable for the withholding tax. Also, the partnership may be held liable for any applicable interest and penalties. Thus, partnerships may be faced with the choice of withholding or the risk of an IRS determination of failure to withhold.
A partnership must make quarterly installment payments of withholding tax based on the amount of effectively connected taxable income allocable to its foreign partners (without regard to whether distributions are made to the partners during the partnership's taxable year). To determine this amount, the partnership's effectively connected income and deductions for each quarterly period are annualized by applying the principles of Sec. 6655(e) (the annualized income installment method for computing estimated tax payments).
The amount of withholding tax with respect to a foreign partner is the highest rate of tax, 31% for noncorporate foreign partners and 34% for corporate foreign partners, applied to the foreign partner's allocable share of such effectively connected taxable income. Accordingly, the threshold for withholding by the partnership is the foreign partner's effectively connected taxable income.
Effectively Connected Taxable Income
The term "effectively connected taxable income" means the "taxable income of the partnership that is effectively connected (or treated as effectively connected) with the conduct of a trade or business in the U.S.," computed with certain adjustments Sec. 1446(c). The legislative history to Sec. 1446 clarifies that the term "effectively connected taxable income" is the partnership's taxable income, as computed under subchapter K, with certain adjustments. Senate Finance Committee Report on P.L. 100647. Under Sec. 703, the taxable income of a partnership is computed in the same manner as an individual, except that the items described in Sec. 702 (separately stated items) are not taken into account and certain deductions are not allowed. However, Sec. 1446 modifies the definition of partnership taxable income as defined under Sec. 703.
One such adjustment is that items that are normally separately stated for subchapter K purposes are included in the computation of partnership taxable income, i.e., items described in Sec. 702(a) are included in the computation of partnership taxable income if they give rise to income that is effectively connected or deductions therefrom. Sec. 1446(c)(1). Sec. 702(a) items may include short- and long-term capital gains and losses; Sec. 1231 gains and losses; foreign taxes; and other items of income, gain, loss, deduction, or credit, as prescribed by regulations (i.e., passive income and losses, etc.).
In addition, the partnership does not take into account net operating loss carryovers and charitable contributions Rev. Proc. 89-31, Sec. 6.01.
Accordingly, most items of partnership income and expense, including net capital gains and losses, passive activity gains and losses, interest, dividends, investment interest expense, etc., to the extent effectively connected, would be netted for purposes of determining the amount of any withholding tax due. However, since partnership income is computed in the same manner as for an individual, it appears that general tax limitation principles would apply. Thus, based on a literal reading of the statute, the partnership would not be able to take into account deduction or loss items that are currently limited to the amount of income in a particular classification (i.e., passive activity losses and capital losses) or deduction items that are currently limited (i.e., investment interest expense, etc.) to offset other items of partnership income for purposes of determining the amount of any withholding tax due. In fact, PLR 8952006 further supports the above conclusion, even though it cannot be cited as a precedent.
In PLR 8952006, the IRS ruled that in computing the amount of withholding tax required to be paid by the partnership under Sec. 1446 with respect to a foreign partner, the gross amount of a deduction that is currently limited for federal income tax purposes to the amount of income in a particular classification (i.e., passive activity losses or capital losses), is not to be taken into account under Sec. 1446 to the extent it exceeds the amount of income in that classification attributable to the partnership for the current period. In addition, the excess of such deductions over such income may not be carried forward by the partnership under Sec. 1446. Thus, based on this ruling, partnerships would be required to apply federal income tax limitation principles in determining the amount of withholding tax due.
However, application of this ruling could also lead to over- withholding in many instances. Over-withholding could result to the extent the foreign partner had sufficient income from other sources to offset potential limitations.
Example. A is a foreign partner in partnership AB which is engaged in a U.S. trade or business. AB is an investment advisor and also trades securities for its own account. A does not materially participate in the business. During 1991, A's allocable share of the income/ loss which is effectively connected is as follows:
Capital losses $ (80)
Passive loss (100)
Net Loss $ (30)
A is also a partner in partnership CD, a real estate partnership, that is engaged in a U.S. trade or business. A does not materially participate in the business. During 1991, A's allocable share of the income/loss which is effectively connected consisted of real estate passive income of $100.
Partnership AB is required to withhold on $150 of effectively connected income, the interest and dividend income, since under regular tax principles capital losses and passive losses cannot be used to offset income in another classification, i.e., interest and dividend income.(1) In addition, partnership CD would be required to withhold on $100 of effectively connected income. However, this result would lead to overwithholding, since parruer A would be able to utilize the passive income generated from the real estate activity to offset the passive loss generated from the advisory business.
What to Do Until the Regulations come Out
Until regulations are promulgated under Sec. 1446 or other authoritative pronouncements are released, it appears that partnerships should take into account general tax limitation principles for purposes of determining the amount of withholding tax due. In light of Sec. 1461, the partnership would be liable for the amount of tax required to be withheld. Therefore, if a partnership is required to pay such tax, but fails to do so, the partnership may be held liable for payment and any applicable penalties and interest. PLR 8952006 is clear indication of the position the IRS will probably take in determining the amount of withholding tax a partnership should remit to the IRS on behalf of a foreign partner. It is recommended to the IRS that an exception be granted to partnerships from applying general tax limitation rules in determining the amount of withholding tax due, if the foreign partner provides the partnership with a certification statement demonstrating that it has sufficient income from outside sources to absorb potential limited items of loss and deduction.
1 It should be noted that to the extent it is not effectively connected with the conduct of a U.S. trade or business, Sec. 1441 may require to withhold from the foreign partner on the gross amount subject to a 30% or lower treaty rate.
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