Withholding Tax Responsibilities of U.S. Domestic & Foreign Partnerships with Foreign Partners

By Coleman Jackson, Attorney, CPA
October 05, 2017

Withholding Tax Responsibilities of U.S. Domestic & Foreign Partnerships with Foreign Partners

Internal Revenue Code Section 1446 imposes a duty on any U.S. domiciled partnership & foreign partnership with taxable income and foreign partners to withhold and turn over to the IRS withholding tax in equal proportion to the taxable income allocable to the foreign partners that is effectively connected to the United States.  For purposes of this section, a partnership is domiciled in the United States if it is organized under any state’s partnership laws.  In Texas there does not need to be a partnership agreement to form a partnership under the Texas Business Organizations Code.  In fact, according to BOC Section 152.051 an association of two or more persons to carry on a business for profit as owners creates a partnership regardless of whether (1) the persons intend to create a partnership; or (2) the association is called a “partnership,” “joint venture,” or other name.  It is kind of like the seasons, when summer turns to fall; it is fall regardless of the weather or climate.

Formulation of a partnership can have huge tax consequences even without foreign partners.  Ordinarily partnerships are flow-through entities, which mean that partnerships do not pay federal income taxes at the entity level.  Typically, the taxable income of a partnership flows through to the individual partners and is included on the partners’ individual federal income tax returns.  However, when foreign partners are owners of the partnership, mandatory federal income tax withholding rules apply to the foreign partners’ share of effectively connected income.  Withholding taxes on foreign partners’ share of effectively connected income is mandatory for the partnership entity.  The partnership income that is subject to these rules is all income from any trade or business effectively connected with the conduct of a trade or business within the United States.  United States means any of the fifty states of the U.S. plus U.S. territories.   The mandatory withholding rules apply to partnerships domiciled in the United States as well as partnerships domiciled overseas when there is taxable income effectively connected to the United States.  It is very important for parties to be aware of tax consequences when structuring transactions and business arrangements where foreign citizens are involved. The most important factors that the IRS and courts look to in determining whether a partnership has been created are sharing profits as well as control over the business.  Partnership laws in Texas are set forth in the Business Organizational Code, Chapter 152.  See also the Texas Supreme Court ruling with respect to creation of Texas partnerships in Ingram v. Deere, 288 S.W.3d 866 (Tex. 2009) and Tex. Bus. Orgs Code Ann. Sec. 402.001 (a) (1) (2016).

Withholding Tax Responsibilities of U.S. Domestic & Foreign Partnerships with Foreign Partners

If parties think they never intended to form a partnership; they might be able to prove this no-partnership argument through the parties’ speech, writings and conduct.   It is an uphill battle; but all the facts and circumstances are relevant when determining whether a partnership exists.   If all the facts and circumstances establish a partnership, use more care when structuring future business arrangements.   Each foreign partner is permitted a credit under IRC Section 33 for their proportional share of the withholding tax paid by the partnership entity.

This law blog is written by the Taxation | Litigation | Immigration Law Firm of Coleman Jackson, P.C. for educational purposes; it does not create an attorney-client relationship between this law firm and its reader.  You should consult with legal counsel in your geographical area with respect to any legal issues impacting you, your family or business.

Coleman Jackson, P.C. | Taxation, Litigation, Immigration Law Firm | English (214) 599-0431 | Spanish (214) 599-0432

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