How the Tax Reform Created a 10% Tax For Foreign Partners Who Sell Their U.S. Partnership Holdings

How the Tax Reform Created a 10% Tax For Foreign Partners Who Sell Their U.S. Partnership Holdings

As far as the IRS is concerned, single member LLC’s with a foreign owner are a disregarded entity and still need to report to the IRS just like corporations do. They will also be penalized and will be required to keep records like corporations- so that they can be held to the same standards as corporations and punished for non-compliance just like corporations.

These are new regulations that are coming in response to foreign investors using LLC’s to purchase real estate and then parking cash in these LLC’s and using them as a front to escape paying taxes on assets owned to foreign governments. They then create a Grantor Trust and use foreign accounts or trust companies to avoid probate and own the assets through fully owned LLC’s.

Some of the new reporting requirements:

  • Filing is an obligation even if foreign owned
  • File form 5472
  • Keep detailed records of all transactions between parties
  • Obtain and EIN or Tax ID
  • Inform and report all reportable transactions like loans, licenses, property sales, leases, assignments, any amounts paid or received from the formation, dissolution, disposition, or acquisition of the entity
  • Any funding for the LLC whether through contribution or loan

Because of the unscrupulous nature of some foreign owned single member LLC’s, the IRS is cracking down and requiring that all single member LLC’s with foreign owners need to report to the IRS. It’s better for all in the long run, but doesn’t feel easy at the moment when so many people have been able to shield assets for so long and not been held accountable for them.

These are not the only changes that have happened however. Anthony S. Bakale, CPA over at did a fascinating write up back on Aug. 7th, 2018 that further lays out all of the withholding requirements and changes that come when the sale of a property, disposition of a partnership or other exchange happens and the seller happens to be foreign. It was signed into law in December of 2017 that 10% of the sale must be withheld as a tax and reported to the IRS. It’s interesting to note though that the foreign seller doesn’t do the withholding. Instead that burden falls directly on the U.S. buyer.

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These changes have created quite a bit of uncertainty in regards to calculating the withholding for both publically traded dispositions and non-publically traded dispositions. Prior to the changes, a partnership was basically valued by an aggregation of assets for the purposes of trying to calculate ECI when partnership interests are exchanged or sold. Basically a foreign partner was subject to tax on his or her share of the gains when the partnership interest is exchanged or sold. A foreign persons gain on the sale as long as the partnership is conducting business in the United States is treated as ECI assuming their share of gain is made of up ECI property.

In 2017, the Tax court ruled that the capital gain from the sale of an interest in a partnership that was engaged in a U.S. business or trade was not ECI to the foreign partner (subject to exceptions of course). The tax court totally went against the IRS’s long-standing ruling about ECI and selling a partnership interest. The court decided that the sale of a partnership interest is an indivisible capital asset and not ECI. The IRS appealed this decision but as it remains, it’s been a very favorable ruling for foreign investors. The TCJA changes however, have basically reversed the application of the 2017 ruling in respects to future transfers of U.S. partnerships. The New Sec. 864(c)(8) says that a gain or loss to a non resident alien individual or a foreign corporation in the disposition of a partnership interest or sale or exchange will be considered ECI assuming that the gain would have been ECI if the partnership sold all of it’s assets at fair market value.

We mentioned that the withholding of the 10% tax at the time of sale is the responsibility of the buyer if the seller is a foreign person. If the withholding is not withheld, then the partnership is supposed to deduct the amount plus interest from any distributions until the requirement is satisfied. The IRS expects the tax due from the sale or disposition of a U.S. partnership by the foreign person. Questions have arisen though on how to determine the tax status of the seller of a PTP when those sales or exchanges happen on an exchange. Others wonder how to comply with the obligation to withhold tax when the buyer of a PTP doesn’t withhold the necessary amount like they were supposed to.

Because of these questions, on December 29, 2017 the Treasury and IRS released a notice that would grant a temporary suspension on the 10% withholding requirement until further regulations and guidance are given. Even the IRS realizes that it’s nearly impossible to know if a seller is a foreign person when these transactions are done through clearing agents and held by brokers.

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On April 2, 2018, the IRS and Treasury again issued notices to provide some interim guidance on the withholding requirements on transfers of non-publically traded partnerships. The notice again states that a transferee must report and remit the withholding within 20 days of the disposition of U.S. real property by a foreign seller. There are certain exceptions that would exempt a transferee from the with holding requirements and they are:

  • Certification of non-foreign status: The withholding exception related to certifying non-foreign status can be satisfied by obtaining certifications and submitting a Form W-9, Request for Taxpayer Identification Number and Certification, to a transferee that includes certain information to satisfy this requirement, and a transferee may generally rely upon a Form W-9 previously received that includes the required information.
  • Certification of no realized gain: A transferee can be exempt from the withholding requirement if the transferee received a certification from the transferor stating that the transfer of its partnership interest will not result in realized gain.
  • Certification of less than 25% ECI in three prior tax years or less than 25% effectively connected gain: A transferee can be exempt from withholding if the transferee receives a certification that (1) the transferor was a partner in the partnership for the entirety of the partner’s prior tax year and the two tax years that precede it, and the transferor’s ECI is less than 25% of the transferor’s total distributive share of income from the partnership in each of those years, or (2) if the partnership was deemed to sell its assets at fair market value, the amount of gain that would be ECI would be less than 25% of the total gain on the deemed sale.
  • Non-recognition transaction: No withholding is required if the transferee receives a notice from the transferor that the transfer is a non-recognition transaction.

The fact remains though, we still need permanent rules and regulations on what needs to be done in regards to this 10% withholding rule and we need a lot of clarification on non-PTP withholdings. It seems that the partners buying and selling PTP’s are exempt from this withholding tax, the same cannot be said for non-PTP sales. There are still questions and uncertainty as to how these rules should be applied to different scenarios but until we have more concrete guidance, some of the above will have to suffice.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.

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Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA I am Certified Public Accountant, specialized in Tax Planning & Offshore Strategies for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution. You can email me and follow us on Facebook : FAS CPA & Consultants.

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