Category: International; Partnerships & LLCs; Tax Returns, Examinations & IRS Procedure
Subject: Partnership
Title: Withholding Requirements for Partnership with Foreign Partners; Filing Requirements U.S. Partners
IRC Sections: 704, 871, 1445, 1446, 875
Filename: 1293.html
Date Produced: 12/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer (TP) is a limited partnership engaged in real estate development. Some of TP's limited partners are nonresident aliens and citizens of Germany. TP has sold lots in exchange for cash and installment notes. All lots were sold at a loss. TP's income has consisted of ordinary losses from lot sales and administrative expenses, and interest income. Per the K-1 sample provided, such interest income has been treated as portfolio income in the past. Prior to 1995, losses and administrative expenses exceeded the amount of interest income.

The land which was ultimately divided into lots and sold was contributed to the partnership (by the corporate general partner) at a fairly high basis. It is assumed that the requirements of Sections 704(b), 704(c), and the regulations thereunder have been complied with.

In 1994, some of the nonresident alien partners were distributed cash in excess of their partnership interest basis. In 1995, that will happen again. In addition, interest income will exceed administrative expenses. All lots had been sold as of the end of 1994.

Issues
1. What are the partnership's withholding responsibilities with respect its foreign partners based on the facts set forth above?

2. What are the U.S. filing obligations of the nonresident alien partners?

Answers
1A. FIRPTA withholding is not applicable to the sale of lots since all lots were sold at a loss.

1B. FIRPTA withholding is not applicable to any distributions in excess of basis made in 1995 because all real property was disposed of previously. I think it is remotely possible that a FIRPTA withholding obligation existed with respect to distributions in excess of interest basis made prior to 1995. We should pursue this further.

1C. The partnership is required under Section 1446 to withhold tax at the rate of 39.6% on the nonresident alien partners' shares of net income passed through on their K-1's.

2. The nonresident alien partners are subject to taxation in the U.S. on the income or loss passed through from the partnership. This is the case for 1995 as well as prior years. The passive activity rules may prevent the partners from offsetting losses against portfolio income derived from the installment notes. Accordingly, it seems possible that the nonresident alien partners have unsatisfied U.S. tax obligations for prior years. (Query: is the interest from the installment notes really portfolio interest?) In addition, the distributions to the nonresident alien partners in excess of interest basis give rise to gain reportable in the U.S.

Discussion: Overview
Nonresident aliens are taxed in the U.S. at regular graduated income tax rates on any income effectively connected with the conduct of a U.S. trade or business. IRC Section 871(b). Nonresident aliens are also taxed at the rate of 30% on certain types of fixed income such as interest. IRC Section 871(a). Income or loss from disposition of a U.S. Real Property Interest (as defined by Section 897) is deemed (again by Section 897) to be effectively connected income or loss for purposes of Section 871. The 30% tax imposed by Section 871(a) can be mitigated or eliminated by treaty. In addition, the 30% tax is inapplicable if the interest in question is derived from the conduct of an effectively connected trade or business.

Various withholding regimes exist to capture the taxes on U.S. source income earned by foreigners. A partnership has the following obligations.

1. A partnership must withhold 34% of any gain recognized from the disposition of a U.S. Real Property Interest (USRPI) and allocable to a foreign partner. IRC Section 1445.

2. A partnership must withhold tax at the highest rate applicable to a foreign partner with respect to that foreign partner's share of partnership income. IRC Section 1446.

3. A partnership must withhold 30% of various fixed, determinable, annual, or periodic amounts including interest not effectively connected with the conduct of a U.S. trade or business.

Discussion: FIRPTA
There is no question that the partnership in this case has disposed of USRPI's. It has been represented that there were no dispositions at a gain.

Regulation Section 1.1445-5(c)(1)(ii) provides in pertinent part as follows.

A partnership must withhold a tax equal to 34 percent of each foreign partner's distributive share of the gain realized by the partnership upon the disposition of each U.S. real property interest.

Notice that the withholding obligation arises with respect to each disposition but only to the extent of the gain therefrom. Since the partnership has no gain dispositions, there is no FIRPTA withholding obligation.

FIRPTA withholding is also required if a nonresident alien sells a partnership interest and that partnership interest is itself considered a USRPI. If more than 50% of the partnership's assets consist of USRPI's and more than 90% of the partnership's assets consist of USRPI's and cash or cash equivalents, then the partnership interest is considered a USRPI in its entirety. If that is the case in any year in which any nonresident alien partner received a distribution in excess of interest basis, it is arguable that the partnership had a FIRPTA withholding obligation at that time. We should discuss this further at your convenience.

Discussion: Cash in Excess of Basis
Section 875(1) provides that a nonresident alien partner of a partnership engaged in a U.S. trade or business is deemed to be personally engaged in that U.S. trade or business. The result is the same both for limited partners as well as general partners.

Rev. Rul. 91-32, 1991-1 CB 107 provides that a foreigner's disposition of an interest in a partnership engaged in a U.S. trade or business is income effectively connected with a U.S. trade or business and thus subject to U.S. taxation .

Section 731(a)(1) provides that cash distributed in excess of partnership interest basis gives rise to gain. Section 731 (flush language) provides that any gain so realized shall be considered gain from the sale or exchange of the partnership interest of the distributee partner.

It seems to follow from the foregoing that any gain that recognized by the German limited partners resulting from receipt of cash in excess of interest basis is attributable to an effectively connected U.S. trade or business and is thus taxable in the U.S.

Discussion: Withholding on Interest and Partnership Profits
Section 871(a) requires withholding at the rate of 30% on interest paid to nonresident aliens unless the interest is effectively connected with a U.S. trade or business. Section 1446 requires partnership withholding on any profit allocable to nonresident alien partners. For the prior years in question, the nonresident alien partners have a share of interest income which has been entirely offset by administrative expenses and losses from property dispositions. In 1995, the nonresident alien partners have interest income in excess of any other offsetting amounts.

The issue is as follows. Is the partnership required to withhold A) 30% of the gross amount of the interest attributable to nonresident alien partners; or B) 39.6% of the interest net of other expenses and losses? It seems to me that a strong case can be made that the losses and other expenses should be offset against the interest income for withholding purposes.

The crux of the issue is whether the interest income derived from the installment notes is effectively connected with the partnership's U.S. trade or business. Section 864 and the regulations thereunder speak to that issue. Regulation 1.864-4(c) provides as follows.

In determining for purposes of paragraph (a) of this section whether any income for the taxable year from sources within the United States which is described in section 871(a)(1) or 881(a), relating to fixed or determinable annual or periodical gains, profits, and income and certain other gains, or whether gain or loss from sources within the United States for the taxable year from the sale or exchange of capital assets, is effectively connected for the taxable year with the conduct of a trade or business in the United States, the principal tests to be applied are (a) the asset-use test, that is, whether the income, gain, or loss is derived from assets used in, or held for use in, the conduct of the trade or business in the United States, and (b) the business-activities test, that is, whether the activities of the trade or business conducted in the United States were a material factor in the realization of the income, gain, or loss.

It seems clear to me that the interest income was derived from assets used in the U.S. trade or business and the activities of that trade or business were a material factor in the realization of that interest income. Accordingly, it seems to me that the partnership has a good argument that the interest income is effectively connected with the U.S. trade or business and is thus not separately subject to 30% withholding.

Recommendations
1. Dispose of the issue regarding FIRPTA obligations for prior years by discussing the matter with me.

2. Determine whether interest income from the installment notes constitutes portfolio interest. If there is an appropriate position to the contrary, consider amending the partnership return or using Form 8082.

3. Advise the German limited partners that U.S. returns are due for all years in which they invested in the partnership.

4. Advise the German limited partners that the cash distributed in excess of their interest basis produces U.S. taxable income the tax effect of which can be offset in whole or in part by filing U.S. returns for prior years. AMT may limit their ability to enjoy the full tax benefit of net operating losses generated in prior years.

5. Advise the German limited partners that penalties and interest may be due with respect to prior unfiled returns.

6. Determine the amount of profit attributable to nonresident alien partners for 1995. Forms 8804 and 8813 are used to report and transmit withheld amounts to the IRS and Form 8805 is used to report the withheld amounts to foreign partners.