General Rules

All partnerships with ECTI allocable to a foreign partner under IRC Sec. 704 in any tax year are required to withhold tax, whether or not such income is distributed, in accordance with IRC Sec. 1446. There are generally no exceptions, other than for publicly traded partnerships, even if the foreign partner owes no tax. Naturally, the foreign partner can obtain a refund after filing its annual income tax return. The tax is paid by the partnership by using Form 8813. Forms 8804 and 8805 are used to report the annual amount of withholding tax to the partner. Rev. Procs. 92-66 and 89-31 provide specific rules on how to comply with these requirements.

In addition to the general rules described above, special rules apply for publicly traded partnerships, which generally require them to withhold from distributions to a foreign partner unless the publicly traded partnership makes an election to pay the withholding tax based upon the partnership's ECTI. A publicly traded partnership is a regularly traded partnership within the meaning of IRC Sec. 7704(b).

Amount of Withholding Tax

A partnership with foreign partners must make estimated quarterly installment payments for withholding tax applicable to the foreign partners ECTI. These payments arc due on the 15th day of the fourth, sixth, ninth, and twelfth months of the partnership's tax year. Any additional amounts determined to be due are payable with the filing of the annual return. Estimates generally must be equal to the current year's withholding requirement, although a safe harbor based on the prior year's ECTI may apply. The amount of a partnership's installment payment is equal to the sum of the installment payments for each of the partnership's foreign partners.

The basic requirement is that payments be calculated based on the partnership's ECTI for each quarterly period. Income is annualized by applying the principals used for quarterly corporate estimated tax payment requirements found in IRC Sec. 6655(e)(2) and then multiplied by the applicable tax rate.

Alternatively, under a safe harbor, each installment payment during the partnership's tax year may be made in an amount equal to 25% of the withholding tax that would be payable on the amount of its ECTI allocable to foreign partners for the prior year times the applicable tax rate if the following three conditions are met: 1. The prior tax year consisted of 12 months;

2. The partnership filed Form 1065 for the prior year; and

3. The amount of ECTI for the prior year was not less than 50% of the ECTI reported for the current year. (Note: If there is a large increase in ECTI, this safe harbor may not apply.)

The applicable rate of tax for each partner is the highest rate for U.S. persons or organizations. Accordingly, for 1995 the rates are 35% for foreign partners taxable as corporations and 39.6% for individuals and other foreign partners.

Example

ABC partnership has three partners, a domestic corporation (A), a foreign individual (B), and a foreign corporation (C). There are no special allocations of any partnership items. A's share of partnership income or loss is 50%, while B and C's shares of income and loss are 25% each. Assume the partnership has $100,000 of ECTI for its 1995 tax year. The partnership must withhold $18,650: $9,900 ($25,000 x 39.6%) with respect to B's distributive share of ECTI and $8,750 ($25,000 x 35%) with respect to C's share. No withholding is required on ECTI allocable to A because it is not a foreign partner.

When making a payment of withholding tax to the IRS, a partnership must notify all foreign partners of their allocable share of any IRC Sec. 1446 tax paid by the partnership. This allows the foreign partners to adjust the amount of estimated tax that they must otherwise pay.

In accordance with Rev. Proc. 92-66, a partnership may file for a refund of IRC Sec. 1446 withholding tax for the excess of the estimated payments paid by the partnership over the partnership's IRC Sec. 1446 tax liability as determined by the sum of the total tax creditable to each partner indicated on all Forms 8805 for the taxable year. If a partnership issues Form 8805 to a partner, then the partnership may not claim credit for any amount of tax shown on that form. The partner must then claim credit for such amount on its annual income tax return.

Effectively Connected Taxable Income

The term "effectively connected taxable income" means the excess of the gross income of the partnership that is effectively connected, under the principles of IRC Sec. 864, or treated as effectively connected with the conduct of a U.S. trade or business, over the allowable deductions that arc connected to such income computed in accordance with Subchapter K with the following adjustments:

1. Partnership items that are normally stated separately are included if they generate ECTI;

2. The partnership is allowed a deduction for depletion of oil and gas wells;

3. The partnership may not take into account items of income, gain, loss, or deduction allocable to any partner that is not a foreign partner; and

4. The partnership may not deduct any net operating losses or charitable contributions.

A partnership's ECTI includes partnership income subject to a partner's election under IRC Sec. 871(d) or 882(d) (election to treat real property income as income connected with a U.S. trade or business). It also includes any partnership income treated as effectively connected with the conduct of a U.S. trade or business under IRC Sec. 897 (disposition of investment in U.S. real property), and other items of partnership income treated as effectively connected under other provisions of the IRC, regardless of whether those amounts are taxable to the partner.

The amount of a partnership's ECTI for the partnership's tax year allocable to a foreign partner under IRC Sec. 704 equals a) the foreign partner's distributive share of effectively connected gross income of the partnership that is properly allocable to the partner under IRe Sec. 704, minus b) the foreign partner's distributive share of deductions of the partnership for that year that are connected with that income. This income will be computed to take into account any adjustments to the basis of the partnership's property described in IRC Sec. 743 according to the partnerships election under IRC Sec. 754 and possibly IRe Sec. 108(c), although there is no clear guidance in this matter. Also a partnership's ECTI will not be allocable to a foreign partner to the extent the amounts are exempt from U.S. tax for that partner by treaty or reciprocal agreement, or any other provision of the IRC. Fixed or determinable, annual, or periodical income (i.e., interest and dividends) subject to tax under IRC Sec. 871 (a) or 881 is not included in the partnership's ECTI trader Sec. 1446. These amounts, however, arc independently subject to withholding under the requirements of Secs. 1441 and 1442 and their regulations.

Determination of Foreign Partner

A partnership must determine if any partner is a foreign person subject to IRC Sec. 1446. A foreign person is a nonresident alien individual, foreign corporation, foreign partnership, or foreign trust or estate. A partnership may determine a partner's status by relying on a certification of non-foreign status or by any other means. In TABULAR DATA OMITTED general, a partnership may determine that a partner is not a foreign person by obtaining a certification of nonforeign status from the partner. Rev. Proc. 89-31 states that a partnership that has obtained a certification of nonforeign status may rely upon the certification to determine that the partner is not subject to withholding, but only if the partnership does not have actual knowledge that the certification is false. If a partnership relies in good faith upon a certification, but it is subsequently determined that the certification was false, the partnership shall not be subject to liabilities for failure to withhold and remit such withholding taxes. These liabilities include the withholding tax, penalties, and interest that would accrue upon the failure to make a timely remittance of the withholding tax. A partnership may rely on a partner's certification of nonforeign status until the earliest of -

1. the end of the 3rd year after the tax year of the partnership during which the certification was obtained;

2. the date the partnership receives notice from the partner that it had become a foreign person; or

3. the date the partnership has actual knowledge that the partner is, or has become, a foreign person.

No particular form is required for certification of nonforeign status, nor is any particular language required.

However, the certification must -

1. state that the partner is not a foreign person;

2. state the partner's name, U.S. taxpayer identifying number, and home address (for individuals) or office address;

3. state that the partner will notify the partnership within 60 days of a change of foreign status, and

4. be signed by or for the partner under penalties of perjury.

A partnership must keep a certification of nonforeign status until the end of the 5th tax year after the last tax year in which the partnership relied on the certification. Other means may be utilized to determine a partner's nonforeign status. If a partnership erroneously relies upon such other means, however, it will not be held harmless for the previously described liabilities. To ease the burden for large partnerships, a partnership with more than 200 partners, including a publicly traded partnership that has elected to pay a withholding tax based on ECTI, may rely upon information provided by the partners on Form 1001. Form W-8, or Form W-9. A partnership that relies, in good faith, on these alternative forms, will not be subject to the liabilities described above.

Significant penalties can be imposed on any person required to withhold, account for, and pay the withholding tax under IRe Sec. 1446, but fails to do so. Caution should be taken to ensure that the requirements of IRC Sec. 1446 and the rules provided in Rev. Procs. 89-31 and 92-66 are followed for this sometimes overlooked IRC section.