What is a Foreign Partnership and How is it Taxed and Reported in the US?
Venturing into the world of international business is very exciting; however, it can be very demanding and require many resources, not to mention a huge time commitment. Therefore, many people decide to find a business partner (or even a few business partners) before starting a business. In this scenario, the business is treated as a partnership for tax purposes, and if a U.S. taxpayer is overseas, this has certain implications from a U.S. tax perspective.
But before we discuss foreign partnerships and the taxation around these entities, we should first define what a partnership is. A partnership is formed when two or more people engage in a business and each person contributes time, money and/or resources to the partnership and in turn shares a portion of the income and expenses of the partnership. A foreign partnership, then, is a partnership that is formed outside of the United States.
Typically, the income and expenses of a partnership flow through to each partner. That is, if the partnership has a profit at the end of the year, the share of the profits is reported on a Schedule K-1, which is distributed to each partner, who in turn must report the profit on their personal income tax return. If the partnership has a loss, then the loss is reported on a Schedule K-1 and each partner must report the loss on their personal tax return.
In terms of reporting requirements of a foreign partnership in the U.S., there are typically two forms that need to be prepared: Form 1065 and Form 8865. Form 1065 is the federal tax form for a partnership that has income that relates to a U.S. trade or business. Simply put, if you are a partner in a business and that business has U.S.-sourced income, this is the form the partnership would need. In addition, as mentioned previously, a Schedule K-1 will need to be generated for and distributed to each partner, who then has to report their share of the partnership’s income on their personal tax return.
In addition, for a foreign partnership that is controlled by U.S. partners, a Form 8865 needs to be filed with each partner’s personal tax return. A controlled foreign partnership is similar to a controlled foreign corporation (CFC), which we have discussed in previous articles. Simply put, when greater than 50 percent of a foreign partnership is owned by U.S. partners, the partnership is considered to be a controlled foreign partnership.
Similar to a CFC, there are numerous categories of filers for a controlled foreign partnership, as follows:
- Category 1 – A U.S. person who has control (greater than 50 percent ownership) of a foreign partnership
- Category 2 – A U.S. person who has at least 10 percent ownership in a foreign partnership that is controlled by U.S. persons each having at least 10 percent ownership
- Category 3 – A U.S. person who contributed property to the foreign partnership in exchange for an interest in the partnership if the person ends up having at least a 10 percent ownership after the transfer
- Category 4 – A general category containing many scenarios, the most common of which is a scenario in which a U.S. person acquires a 10 percent or greater ownership in the foreign partnership
Please note that there are exceptions to the above categories and that every possible scenario cannot be discussed within a short blog article. However, it is safe to say that if you have ownership in a foreign partnership and you are a U.S. person, you should seek professional assistance, as you may likely have a filing requirement related to the foreign partnership.
And what are the penalties for not reporting the interest in a foreign partnership correctly or on a timely basis?
A $10,000 penalty is imposed for each tax year of each foreign partnership for failure to furnish the required information within the time prescribed. If the information isn’t filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign partnership) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure. Other penalties may apply, depending upon the category of filer and their unique situation.
Please also note the due dates for each form. Form 1065 is typically due on March 15 for calendar-year partnerships, while the due date for Form 8865 is the same as the U.S. person’s tax return, April 15.
If you have ownership in a foreign partnership and you are a U.S. person, please reach out today to assess whether you have been filing the required forms correctly. When the stakes are so high with reporting requirements, we can offer huge peace of mind and help you file the required forms accurately and on a timely basis.