Section 13501 of the Tax Cuts and Jobs Act created a withholding requirement on the transfer of non-publicly traded partnership interests[1] by amending §§864(c) and 1446 of the Internal Revenue Code.[2]
While §1446(f)(1) provides:
that if any portion of the gain on any disposition of an interest in a partnership would be treated under §864(c)(8) as effectively connected with the conduct of a trade or business within the US, then the transferee must deduct and withhold a tax equal to 10 percent of the amount realized on the disposition.
Similar to the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), transferees are required to withhold 10% of the amount realized on the exchange if (1) the transferors are non-US taxpayers and (2) the partnership interest is effectively connected with a US trade or business. The new law treats a foreign taxpayer’s gain or loss on the sale or exchange of a partnership interest as effectively connected with the conduct of a trade or business in the United States to the extent that gain or loss would be treated as effectively connected with the conduct of a trade or business in the United States if the partnership sold all of its assets in a hypothetical disposition. In other words, an asset liquidation test determines whether the ownership interest is effectively connected.
Should the transferee fail to withhold any amount required to be withheld under §1446(f)(1), the partnership is required to deduct and withhold from the distribution to the transferee a tax in the amount equal to the failed withholding plus interest.
Before a transferee panics over the withholding requirement, not every partnership sale will require withholding. Withholding is NOT required where the transferor is a US taxpayer, where the sale does not create a gain, or where the effectively connected gain is less than 25% of the total gain. The transferee should maintain records supporting the absence of a withholding obligation. IR Notice 2018-29 lists various certifications the transferee should obtain to prove that withholding was unnecessary. A transferee only needs to obtain one of these:
- A Certification of Non-foreign Status
Section 1446(f)(2) provides that no person shall be required to deduct and withhold any amount under section 1446(f)(1) with respect to any disposition of an interest in a partnership if the transferor furnishes to the transferee an affidavit by the transferor stating, under penalty of perjury, the transferor’s U.S. TIN and that the transferor is not a foreign person. Thus, unless the transferee receives the required affidavit, it must presume that the transferor is foreign for purposes of withholding under section 1446(f)(1).
Typically, incoming partners would provide the partnership with their citizenship status. Without proof that the partner is a US Taxpayer, the partnership is required to withhold tax on income allocated to the foreign partner through forms 8804 and 1042.
- A Certification of No Realized Gain
One way of verifying if the transaction will result in a realized gain is through the partnership. Unlike corporations where only shareholders are aware of their stock basis, a partner’s inside basis is maintained by the partnership and can sometime be verified directly on the partner’s K-1.
- A Certification that Transferor Had Less than 25 Percent Effectively Connected Taxable Income in Three Prior Taxable Years
[Upon] the transfer of a partnership interest if no earlier than 30 days before the transfer the transferee receives from the transferora certification (signed under penalties of perjury and including a U.S. TIN, to the extent required under section 4.01 of this notice) that for the transferor’s immediately prior taxable year and the two taxable years that precede it the transferor was a partner in the partnership for the entirety of each of those years, and that the transferor’s allocable share of effectively connected taxable income (ECTI) (as determined under §1.1446-2) for each of those taxable years was less than 25 percent of the transferor’s total distributive share of income for that year. For this purpose, the transferor’s immediately prior taxable year is the most recent taxable year of the transferor that includes the partnership taxable year that ends with or within the transferor’s taxable year and for which both a Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax, and a Schedule K-1 (Form 1065) were due (including extensions) or filed (if earlier) by the time of the transfer. In no event may a transferee rely on a certification provided prior to the transferor’s receipt of the relevant Forms 8805 and Schedules K-1 (Form 1065).For purposes of this rule, a transferor that had a distributive share of deductions and expenses attributable to the partnership’s U.S. trade or business but no ECTI allocated to it in a year must treat its allocable share of ECTI for that year as zero. A transferor that did not have a distributive share of income in any of its three immediately prior taxable years during which the partnership had effectively connected income cannot provide this certification. A transferee may not rely on the certification and is not relieved from withholding if it has actual knowledge that the certification is false. When a partnership is a transferee by reason of making a distribution, this section does not apply.
The line between ECTI and FDAP can sometime be a blurred one. For example, assume the partners received management fees for managing US passive assets in a tiered partnership structure. Management fees are tied to the asset book value and not the income generated. Thus, in a year where the assets might not generate enough income, the partners could receive management fees (ECTI) above 25% despite being in a typical FDAP structure.
- A Certification from Partnership of Less than 25 Percent Effectively Connected Gain Under Section 864(c)(8)
[Upon] the transfer of a partnership interest if the transferee is provided a certification, issued by the partnershipand signed under penalties of perjury no earlier than 30 days before the transfer, certifying that if the partnership had sold all of its assets at their fair market value, the amount of gain that would have been effectively connected with the conduct of a trade or business within the United States would be less than 25 percent of the total gain. For purposes of this section … effectively connected gain includes gain treated as effectively connected with a trade or business in the United States under section 897. Principles similar to the rules of §1.1445-11T(d)(2)(ii) and (iii) apply to certifications furnished pursuant to this section … When a partnership is a transferee by reason of making a distribution, the transferee partnership must retain a record of the documentation relied upon to determine the amount of gain (if any), and the portion of the gain that would have been effectively connected with the conduct of a trade or business in the United States (if any). This documentation must be retained for the period described in … this notice.
Similar to §1445 FIRPTA withholding, this might be the hardest certification to obtain. It relies heavily on the partnership’s ability to gather fair market value of assets at the time of sale.
- The Transaction Qualifies for Non-recognition
[Upon] the transfer of a partnership interest if the transferee receives from the transferor a notice that satisfies the requirements of §1.1445-2(d)(2), treating references to section 1445(a) as references to section 1446(f), and references to “U.S. real property interest” as “partnership interest”, except as provided in this section… Until guidance providing for the treatment of nonrecognition transactions under section 864(c)(8) is issued, a transfer in which the transferor is not required to recognize any gain or loss by reason of a nonrecognition provision of the Code (without regard to section 864(c)(8)) will be eligible for the exception from withholding provided in this section… When a partnership is a transferee by reason of making a distribution in which no gain is recognized, the transferee partnership is not required to withhold and the transferor is not required to provide a notice to the transferee partnership.
If the transferee can obtain any one of the certification, the withholding requirement does not apply.
Record Keeping:
As noted in IR Notice 2018-29, the certifications do not need to be filed with the IRS. However, as with any documents used for tax purposes, records should be maintained in case the IRS questions the transaction.
A transferee that obtains and relies upon an affidavit or certification provided for in this notice must retain that document with its books and records for a period of five calendar years following the close of the last calendar year in which the entity relied upon the certification or as long as it may be relevant to the determination of the transferee’s withholding obligation under section 1446(f), whichever period is longer.
Amount Realized:
If the transferee fails to obtain any of the previously mentioned certifications, the transferee should withhold on the amount realized.[4] IR Notice 2018-29 provides guidance on how to calculate partnership’s liabilities included in the amount realized.
In cases where the transferor is not a controlling partner, the transferor
may provide to the transferee a certification (signed under penalties of perjury and including a U.S. TIN, to the extent required [in Noticed 2018-29]) that provides (i) the amount of the transferor’s share of partnership liabilities reported on the most recently received Schedule K-1 (Form 1065) from the partnership, for a partnership taxable year that closed no more than 10 months before the date of transfer, and (ii) that the transferor does not have actual knowledge of events occurring after the Schedule K-1 (Form 1065) was issued that would cause the amount of the transferor’s share of partnership liabilities at the time of the transfer to be significantly different than the amount shown on the Schedule K-1 (Form 1065). A difference in the amount of the transferor’s share of partnership liabilities of 25 percent or less is not a significant difference. A transferor is a controlling partner … if the transferor (and related persons) owned a 50 percent or greater interest in capital, profits, deductions or losses in the 12 months before the transfer.
Additionally, the partnership may certify
(i) the amount of the transferor’s share of partnership liabilities, which may be the amount reported on the most recently prepared Schedule K-1 (Form 1065), and (ii) that the partnership does not have actual knowledge of events occurring after its determination of the amount of the transferor’s share of partnership liabilities that would cause the amount of the transferor’s share of partnership liabilities at the time of the transfer to be significantly different than the amount shown on the certification provided to the transferee. A difference in the amount of the transferor’s share of partnership liabilities of 25 percent or less is not a significant difference.
Limitations on Certain Transferor’s Share of Partnership Liabilities
[If] the amount otherwise required to be withheld under section 1446(f) exceeds the amount realized less the decrease in the transferor partner’s share of partnership liabilities, then the amount of withholding required by section 1446(f)(1) is the amount realized less the decrease in the transferor partner’s share of partnership liabilities. In addition, if a transferee is unable to determine the amount realized because it does not have knowledge of the transferor partner’s share of partnership liabilities … then the amount of withholding required is the entire amount realized, determined without regard to the decrease in the transferor partner’s share of partnership liabilities. In both cases, the amount of withholding under section 1446(f) is generally the amount that the transferor would, but for the transferee remitting it as withholding under section 1446(f), receive from the transferee. A transferee may rely on this rule only if the transferee (1) is not the partnership in which the transferor is a partner, and (2) is not a related person to the transferor. A transferee applying this section 8 must check the box on line 5c of Part I of Form 8288 and include the amount withheld in the total reported on line 6, Part I of Form 8288 and line 2 of Form 8288-A.
Further Guidance
As of the date of this notice, no form has been issued in regard to §1446 withholding. Treasury recommends following guidance under §1445 withholding until further §1446 guidance is provided.
The Treasury Department and the IRS have determined that, until regulations, other guidance, or forms and instructions have been issued under section 1446(f), transferees required to withhold under section 1446(f)(1) must use the rules in section 1445 and the regulations thereunder for purposes of reporting and paying over the tax, except as otherwise provided in this notice. See, e.g., §1.1445-1(c). The forms specified in those rules include Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests, and Form 8288-A, Statement of Withholding on Dispositions by Foreign Persons of U.S. Real Property Interests. The transferee must include the statement “Section 1446(f)(1) withholding” at the top of both the relevant Form 8288 and the relevant Form 8288-A. Except as provided in section 8 of this notice, the transferee must also enter the amount subject to withholding under section 1446(f)(1) on line 5b of Part I of the Form 8288 and on line 3 of Form 8288-A and enter the amount withheld on line 6 of Part I of Form 8288 and on line 2 of Form 8288-A. At this time, the IRS will not issue withholding certificates under section 1446(f)(3), such as those provided on Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests.
Coordination with §1445 Withholding:
In cases where withholding under both §1445 and §1446 applies, §1445 withholding prevails.
The Treasury Department and the IRS intend to issue regulations providing that a transferee that is otherwise required to withhold under section 1445(e)(5) or §1.1445-11T(d)(1) with respect to the amount realized, as well as under section 1446(f)(1), will be subject to the payment and reporting requirements of section 1445 only, and not section 1446(f)(1), with respect to such amount. However, this rule applies only if the transferor has not obtained a withholding certificate that is provided for in the last sentence of §1.1445-11T(d)(1). If the transferor has obtained such a withholding certificate, the transferee must withhold the greater of the amounts required under section 1445(e)(5) or section 1446(f)(1). Under these circumstances, a transferee that has complied with the withholding requirements under either section 1445(e)(5) or section 1446(f)(1), as applicable, will be deemed to satisfy the other withholding requirement.
Conclusion
Now is the best time to revisit your Partnership Agreement if you have not already done so. This new partnership withholding procedure and the new partnership audit rules place tremendous responsibilities on the partnerships are managed. Accurate and efficient record keeping is essential if a partnership is to be tax compliant.
[1]IR Notice 2018-08 (suspends the application of new section 1446(f) of the Internal Revenue Code (“Code”) in the case of a disposition of certain publicly traded partnership interests).
[2]§ 13501 of “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” P.L. 115-97 (the “Act”).
[3]IR Notice 2018-08.
[4]I.R.C. 1446(f)(1).
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