IRC 1446(f) Compliance: What Buyers and Sellers of Partnership Interests Need To Know

Internal Revenue Code (IRC) Section 1446(f) was enacted as a part of the Tax Cuts and Jobs Act (TCJA) of 2017. Section 1446(f) addresses the disposition of partnership interests by foreign persons when the partnership is engaged in a U.S. trade or business.

The purpose of this provision is to ensure that foreign partners pay U.S. tax on the gain from the sale or transfer of their partnership interest.

Why Section 1446(f) Exists: A Legal Tug-of-War

The general sourcing rule related to gains from the sale of tangible personal property (exceptions to the general rule such as sale of inventory and real property are outside of the scope of this article) is that gains are sourced by the tax residence of the seller. Under that rule, prior to TCJA, foreign persons could potentially avoid U.S. taxation on gains from the sale of a partnership interest as the gain was treated as foreign source income.

There was significant confusion and litigation related to this rule, including a court case (United States v. Grecian Magnesite Mining, Industrial, & Shipping Co., SA (2017)) which indicated that the foreign partner was not subject to U.S. tax on the sale of its partnership interest. The IRS tried to counter this with Revenue Ruling 91-32, which determined that foreign persons were subject to tax on the gain from the sale of a partnership interest to the extent the gain was connected to a U.S. trade or business.

However, the courts didn’t agree, setting off competing positions between the courts and IRS. So, as part of TCJA, both IRC Section 864(c)(8) and Section 1446(f) were added to codify the IRS’s position.

• IRC Section 864(c)(8) – A foreign partner is subject to U.S. tax on gain from the sale of partnership interest if the partnership is engaged in a U.S. trade or business. This is determined by looking to the underlying assets of the partnership and determining if the transferor would have had U.S. effectively connected gain or loss if the partnership had completed a deemed sale or exchange at fair market value of all the underlying assets of the partnership.
• IRS Section 1446(f) – Withholding is required on the disposition of a partnership interest by a foreign person. This is the enforcement mechanism for Section 864(c)(8). The obligation for withholding falls on the transferee/buyer with secondary withholding on the partnership if the transferee/buyer fails to complete their obligations.

Putting 1446(f) Into Practice: Key Rules for Foreign Sellers and U.S. Partnerships

Section 1446(f) applies when a foreign person disposes of an interest in a partnership that is engaged in a U.S. trade or business. Therefore, the gain (or at least a portion of the gain) is considered to be effectively connected income (ECI). The transferee/buyer is responsible for withholding 10% of the amount realized on the transaction. This rule is effective for sales, exchanges, and dispositions after Dec. 31, 2017.

Please note, there are some varying dates of enforcement and compliance applicability based on various notices and when proposed and final Treasury Regulations were published.

Section 1446(f) only applies to foreign persons, which includes nonresident aliens, foreign corporations, foreign partnerships, foreign trusts, and foreign estates. It does not apply to U.S. persons, which include U.S. citizens, U.S. resident aliens, U.S. domestic entities, U.S. trusts, or U.S. estates.

It includes the sale, exchange, or disposition of a partnership interest. This term is broad and includes the direct sale of a partnership interest, transfers due to a redemption or as a part of a merger/acquisition or a partnership interest, or even indirect dispositions if an upper tier partnership disposes of a lower tier. There is also applicability of these rules to publicly traded partnerships (PTPs). That discussion is outside the scope of this post. The rules are still developing.

How Much To Withhold? A Step-by-Step Look at 1446(f) Calculations

The withholding amount is 10% of the amount realized by the foreign seller. The amount realized is determined under Section 1001 and includes:

1. The amount of cash paid;
2. The FMV of property transferred;
3. The amount of liabilities assumed by the transferee; and
4. Any reduction in the transferor’s share of partnership liabilities that occurs as a result of the transfer.

This calculation requires that the partner has actual knowledge of their share of the underlying partnership liabilities. If that amount is not able to be determined, then the transferee is required to withhold 100% of the amount realized without reduction for any partnership liabilities per Treasury Reg. 1.1446(f)-2(c)(3). A transferee must certify to the partnership within 10 days of the transfer the extent to which Section 1446(f) applies and has been satisfied.

Form 8288 will need to be filed to report and submit the amount withheld by the 20^th day after the date of the transfer. Form 8288-A needs to be attached to Form 8288 for each person subject to withholding.

The IRS will stamp Copy B of each Form 8288-A and will forward the stamped copy to the foreign person subject to the withholding. The foreign person must have a U.S. TIN to get this copy.

Avoiding the Withholding: Key Exceptions to Section 1446(f)

There are several exceptions to avoid or minimize withholding under Section 1446(f). It’s important to apply these exceptions where possible as it can be administratively difficult to get a refund of over withheld tax. A transferee is not required to withhold under IRC Section 1446(f) if one of the exceptions in Treasury Regulation 1.1446(f)-2(b)(2)-(7) are met.

1. Nonforeign status by transferor – Certification of non-foreign status from a transferor that states the transferor is not a foreign person and includes the transferor’s name, TIN, and address. This can be provided on a valid Form W-9.
2. No realized gain by transferor – Certification from the transferor that states that the transfer of the partnership interest would not result in any realized gain to the transferor as of the determination date.
3. Less than 10% effectively connected gain – Certification from the partnership that states that if the partnership sold all of its assets at fair market value as of the determination date, one of the following would occur:
4. The partnership would have no gain that would have been U.S. ECI, or
5. The net gain attributable to U.S. ECI would be less than 10% of the total gain, or
6. The transferor would not have a distributable share of net gain from the partnership that would have been U.S. ECI, or
7. If the transferor would have a distributable share of net gain from the partnership that the portion that would be U.S. ECI would be less than 10% of the total gain.
8. Less than 10% ECI – Certification from the transferor that states that the transferor was a partner in the partnership during the lookback period (typically three years as defined in Treasury Reg. 1.1446(f)-2(b)(5)(ii)) and their distributive share of gross ECI from the partnership was less than $1M and less than 10% of the total distributive share of gross income for the partnership during each year in the lookback period.
9. Nonrecognition transfer – Certification from the transferor that provides that by operation of a nonrecognition of a provision of the IRC, the transferor does not need to recognize gain or loss from the transfer.
10. Income Tax Treaties – Certification from the transferor that provides that the transferor is not subject to tax on gain from the transfer due to an income tax treaty between the U.S. and a foreign country. This is subject to the requirements of Treasury Reg. 1.1446(f)-2(b)(7).

Additionally, the withholding may be reduced if the foreign transferor’s maximum liability on the disposition is less than the amount required to be withheld. In that scenario, a transferee may rely on a certification from a transferor that indicates that fact, although the statement is very specific, as found in Treasury Reg. 1.1446(f)-2(c)(4).

When Buyers Don’t Withhold, Partnerships Must Act

If the transferee fails to withhold the required amount under Section 1446(f), the obligation falls to the partnership whose interest was transferred. In that scenario, the partnership must withhold 100% of all distributions to the transferee partner until the transferee’s withholding obligation (and interest on the under withheld amount) is satisfied. This can lead to an administrative burden on the partnership but also a risk that the partnership has liability related to a transfer that it did not know about until well after the time of transfer. The taxes paid by the transferee are not eligible to claim as a credit against their personal tax liability. The withholding is reported on Form 8288-C by the partnership.

Recommendations To Ease the Compliance Burden

In order to help ease the compliance burden, there are several things that can be done in advance of a transaction:

1. Ensure that all foreign partners have U.S. identifying numbers (either U.S. Social Security numbers if they are eligible or a U.S. ITIN).
2. The partnership should have a valid Form W-9 or Form W-8 series form from each partner in the partnership.
3. Each partner should be aware of their responsibility to notify the partnership in advance of any transfers of a partnership interest and understand that they must notify the partnership within 10 days that they have met their Section 1446(f) responsibilities.
4. Determine if there are tax planning strategies that can be implemented that would allow for one of the exceptions from withholding to apply.

These rules are complex. Please reach out to your KSM advisor with any questions or concerns or complete the form below.