The status of a partnership as either domestic or foreign generally does not have any substantial tax consequences. From a federal income tax perspective, the tax treatment is relatively unaffected with income from both a domestic and foreign partnership being subject to federal income taxes. Meaning, any item of income, gain, loss, and deduction flows through to the partners and is recognized by them on their income tax return.
Now that we’ve laid down the foundation, let’s dive into the details.
A business entity which is organized outside the 50 states (including Washington D.C.) is considered to be a foreign entity. A foreign entity with two or more owners is a partnership if at least one of the owners has ‘unlimited liability with respect to the affairs of the entity.’ Any partnership formally organized under the laws of any state in the United States is a US domestic entity regardless of the citizenship of the partners.
In a similar vein, the partnership remains a fiscally transparent entity under federal law. A US person is considered in control of a foreign partnership if at any time during the year the US person owns more than 50% of the capital or is entitled to more than 50% of the profits, losses or deductions of the partnership. To maintain compliance with IRS regulations, partnerships must adhere to the comprehensive reporting of partner affairs and inclusion of income that is triggered when a U.S. individual holds control of a foreign partnership.
A 30% (thirty-percent) withholding tax rate or lower tax treaty rate is applied to all passive income; requiring a domestic partnership with foreign partners to withhold tax at source for any US passive income allocated to foreign partners (i.e. rents, dividends, and/or royalties). Furthermore, all domestic partnerships are required to additionally deduct taxes on the pro-rata portion of a foreign partner's effectively connected income (ECI) even if there is not a physical distribution of cash.
Consequently, a pro-rata share of the income, gains, losses, and deductions of the foreign partnership is included in the income of the US partner and is taxed accordingly. A 39.6% tax rate on effectively connected income is 39.6% for all foreign individuals and 35% for all foreign corporate partners. The IRS also requires reporting on a ‘transactional basis’ for all foreign partnerships that have more than 10% ownership interest in the United States. This reporting is done on Form 8865, which is similar to the information returns that are required for all U.S. domestic partnerships.
A domestic partnership is a business that is formed within its home state and unless the partnership registers to do business in another state, a Domestic LLC’s activities are confined to its home state.
A domestic partnership that holds more than 10% or more of a foreign partnership’s stock is considered to be a U.S. shareholder. Generally the status of a partnership does not have any notable tax consequences. However, like all things, there are exceptions to this statement. A domestic partnership, in effect, is recognized as a U.S. person whereas a foreign partnership is not. Meaning, that a foreign partnership is treated on an aggregate basis whereas a domestic partnership is treated as an entity. There are a variety of situations, as I’m sure our readers have come across, where a partner’s tax liabilities are affected and impacted by their nationality. These situations likely occur in aggregate basis scenarios, as discussed previously. In these specific scenarios , rather than the treatment of income being dependent on a partner’s location of income activity it is now dependent on the partner’s nationality. There are other situations as well that also qualify as exceptions to the statement made above. Take for example, instances where a domestic partnership’s nationality may not affect the tax liability but may trigger reporting and withholding in specific locations.
The IRS views all partnerships formed within the United States as domestic, regardless of the state of registration or if the partnership generates income in another state. As mentioned previously, the IRS views any partnership registered in another country as foreign. For example, if you register an LLC in the state of Texas, you’re considered to be a domestic partnership, irregardless of whether you generate income by sales in another state. If you were to register an LLC in Australia and do business in the U.S. but not register in a U.S. state, your partnership is considered to be foreign. However, if for example you own a U.K. registered partnership, conduct business in the U.S. and register with a U.S. state, you are considered to be a U.S. domestic partnership and not a foreign partnership.
Please see below for our summary of the draft instructions to Schedules K-2 and K-3 (the “Instructions”) consolidated guidance in previously released post-release changes to the 2021 instructions and Schedule K-2 and K-3 Frequently Asked Questions (Form 1065, 1120S, and 8865). Please note, the Instructions incorporate comments made by the AICPA and tax practitioners. The Instructions also include various clarifications described below and provide illustration examples of the exceptions and reporting. While the IRS allowed an exception in 2021 for certain domestic partnerships and S corporations with domestic partners and no foreign activity, the exception for domestic partnerships is further limited to partnerships held solely by certain domestic individuals, estates, and trusts. Please note, potentially eligible partnerships must also satisfy notification and record keeping requirements.
Schedule K-3 Instruction Updates (2022 Tax year)
Domestic partnership exception for domestic partnerships within the meaning of section 7701(a)(2) and (4) (new)
No limited or foreign activity
i. Foreign activity
Foreign income taxes paid or accrued
Foreign source income or loss
Ownership interest in foreign partnership
Ownership interest in foreign corporation
Ownership of a foreign branch
Ownership interest in a foreign entity disregarded entity
ii. De minimis foreign activity
Foreign activity is limited to passive category (determined without regard to the high-taxed income exception)
Upon which not more than $300 of foreign income taxes allowable as a credit under section 901 are treated as paid or accrued by the partnership
Income and taxes are shown on a payee statement that is furnished or treated as furnished to the partnership.
The $300 threshold of foreign income taxes will likely restrict the number of partnerships eligible for the exception.
Direct domestic partners. All direct partners are:
i. U.S. citizen or resident alien individuals ii. Domestic decedent’s estates, domestic grantor trusts, or domestic non-grantor trusts with solely U.S. citizen and/or resident alien individual beneficiaries. iii. The previous exception included any direct domestic partner, including a domestic corporation or a domestic partnership. By significantly restricting the direct domestic partners, it is less likely that the domestic partnership exception will apply.
Partner notification by partnership
i. If a partnership satisfies the first two criteria, the partnership must send a notification electronically or by mail to its partners dated no later than 2 months before the due date (without extension) for filing the partnership’s tax return. The notification must state that the partners will not receive Schedule K-3 from the partnership unless the partners request the schedule.
No partner request by the 1-month date
i. The partnership does not receive a request from any partner on or before 1 month (the “1-month date”) before the partnership’s tax return due date (without extension). ii. Request on or before the 1-month date
If the partnership receives the request on or before the 1-month date, the partnership is required to file Schedule K-2 and K-3 with the IRS and furnish the Schedule K-3 to the requesting partner. The Schedule K-2 and K-3 are required to be completed only with respect to the parts and sections relevant to the requesting partner(s).