U.S. and foreign taxpayers alike can choose to conduct cross-border business through a variety of business entities. A business entity may be organized either in the United States or in a foreign jurisdiction and, if it has more than one owner, may be classified as either a cor- poration or a partnership. The decision of which jurisdiction to organize in and which type of entity to choose will often depend on several factors, including the business agreement among the owners, the legal characteristics of the entity, and the tax efficiency of the structure. That entity choice will govern the U.S. tax effects and, if a partnership, be ac- companied by U.S. tax-compliance re- quirements that may vary depending on whether the partnership has U.S. part- ners and on the specific type and source of income the partnership generates.
Foreign partnerships
For many reasons, U.S. taxpayers may choose to conduct business through a foreign partnership. In general, a part- nership is a relationship between two or more persons (or entities) to carry on
a trade or business. As defined in Sec. 7701(a)(4), a domestic partnership is a partnership created or organized in the United States or under the law of the United States or any U.S. state. A foreign partnership is one that is not domestic (Sec. 7701(a)(5)).
Under U.S. tax law, foreign partnerships occur in two situations:
- A foreign business entity that is not considered a default corporation under the Regs. Sec. 301.7701-2 rules will be considered a foreign eligible entity and will be considered a partnership if it has two or more members and at least one member has unlimited liability (Regs. Sec. 301.7701-3(b)(2)(i)(A)).
- A multiowner foreign entity in which all members have limited liability will be considered a default corporation, but, if a check-the-box election is made, the entity will be treated as a foreign partnership for U.S. tax purposes (Regs. Sec. 301.7701-3(c)(1)(i)).
US reporting provisions
A U.S. person that owns an inter- est in a foreign partnership may be required to complete and file a Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partner- ships, to report the activities of the foreign partnership (Sec. 6038; Form 8865 instructions). Certain foreign
partnerships may be required to file a Form 1065, U.S. Return of Partnership Income, and provide their partners Form 1065, Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. (Sec. 6031, Form 1065 instructions). A foreign partnership may be required to file either or both forms.
Form 8865 requirement
Form 8865 is used by U.S. persons to report certain information regarding controlled foreign partnerships (Sec. 6038); transfers to foreign partner- ships (Sec. 6038B); and acquisitions, dispositions, and changes in foreign partnership interests (Sec. 6046A). U.S. persons qualifying under one or more of the categories of filers below must complete Form 8865 and file it with their income tax return. U.S. persons required to file Form 8865 that do not have to file an income tax return must file Form 8865 separately with the IRS at the time and place they would be required to file an income tax return (or, if applicable, a partnership or ex- empt organization return) (Form 8865 instructions).
Category 1:
A U.S. person who controlled the foreign partnership at any time during the partnership’s tax year. Control of a partnership is owner- ship of more than a 50% interest in
the partnership. A Category 1 filer also includes a U.S. transferor who must report certain information for a Sec.
721(c) partnership for the tax year of contribution and subsequent years, pur- suant to Regs. Sec. 1.721(c)-6.
Category 2:
A U.S. person who at any time during the tax year of the foreign partnership owned a 10% or greater interest in the partnership while the partnership was controlled by U.S. persons each owning at least a 10% interest. However, if the foreign partnership had a Category 1 filer at any time during that tax year, no person will be considered a Category 2 filer.
Category 3:
A U.S. person who contributed property during that person’s tax year to a foreign partner- ship in exchange for an interest in the partnership, if that person either: (1) owned directly or indirectly at least a 10% interest in the foreign partnership immediately after the contribution,
or (2) contributed property with an aggregate value exceeding $100,000 during the 12-month period ending on the date of transfer.
Category 4:
A U.S. person that had a Sec. 6046A reportable event during that person’s tax year. There are three categories of reportable events under Sec. 6046A: acquisitions, dispositions, and changes in propor- tional interests.
The above categories determine if Form 8865 needs to be completed and filed, as well as dictating which infor- mation, statements, and schedules are required to be included with the filing. If a U.S. person qualifies under more than one category for a particular for- eign partnership, they must submit all the items required for each category they qualify for. Certain exceptions to filing exist, as well as relief for Cat- egory 1 and 2 filers when the foreign partnership files Form 1065.
Form 1065 requirement
A foreign partnership is required to file Form 1065 (and report all its for- eign and U.S. partnership items) if it has either of the following:
- Gross income derived from sources within the United States, or
- Gross income that is effectively connected with the conduct of a trade or business within the United States (Sec. 6031(e)(2)).
Foreign partners are subject to U.S. tax on their share of U.S.-source income and effectively connected in- come (ECI), and the requirement for a foreign partnership to file Form 1065 assists with administering the U.S. non- resident taxing regimes.
US-source income
If a taxpayer is engaged in a trade or business in the United States, gener- ally, all sales, services, or manufacturing income from U.S. sources is ECI (Sec. 864(c)(3)). Income that would normally be U.S.-source investment income (fixed or determinable annual or pe- riodical income) is considered ECI if either: (1) the income is derived from assets used in the conduct of the U.S. trade or business (asset use); or (2) the activities of the trade or business are a material factor in the realization of the income (business activities) (Sec. 864(c)(2)).
Generally, income from foreign sources is not treated as ECI and is therefore not taxable in the United States (Sec. 864(c)(4)). However, there are exceptions for certain income from foreign sources that is attributable to a
U.S. office or fixed place of business (a U.S. branch of a foreign entity) (Sec. 865(e)(2)).
Form 1065 reporting exceptions
Even if a foreign partnership has U.S.-source income, it is not required to file Form 1065 if it qualifies for one of two exceptions. First, foreign partnerships with U.S. partners are not required to file Form 1065 if all the following provisions are met:
- The partnership had no ECI during its tax year;
- The partnership had U.S.-source income of $20,000 or less during its tax year;
- Less than 1% of any partnership item of income, gain, loss, deduc- tion, or credit was allocable in the aggregate to direct U.S. partners at any time during its tax year; and
- The partnership is not a withhold- ing foreign partnership (as defined in Regs. Sec. 1.1441-5(c)(2)(i))
(Regs. Sec. 1.6031(a)-1(b) and Form 1065 instructions).
Second, foreign partnerships with no U.S. partners and no ECI are not required to file Form 1065 if all the following provisions are met:
- The partnership had no ECI during its tax year;
- The partnership had no U.S. partners at any time during its tax year;
- The partnership is not a withhold- ing foreign partnership as defined in Regs. Sec. 1.1441-5(c)(2)(i);
- All required Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-S, Foreign Person’s U.S. Source Income Subject to Withhold- ing, were filed by the partnership or another withholding agent as required by Regs. Secs. 1.1461- 1(b) and (c); and
- The tax liability of each partner for amounts reportable under Regs. Secs. 1.1461-1(b) and (c) has been fully satisfied by the withholding of tax at the source (Regs. Sec. 1.6031(a)-1(b)(3)).
Filing requirement: No partners are considered Form 8865 category filers, and therefore no partners are required to file Form 8865. MNO Part- nership is required to file Form 1065 because its U.S.-source income is con- sidered ECI and therefore does not meet either Form 1065 filing exception.
Awareness and compliance
Taxpayers conducting business through foreign partnerships must comply with the U.S. income tax reporting require- ments for such partnerships. These reporting requirements may include filing either Form 8865 or Form 1065, or both. Taxpayers should be aware of these filing requirements to properly comply and so that foreign partnerships can provide their partners with the in- formation necessary to fulfill their U.S. tax obligations.
