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 corporation 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 accompanied by U.S. tax-compliance requirements that may vary depending on whether the partnership has U.S. partners 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 partnership 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:

1. 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)).

2. 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 interest in a foreign partnership may be required to complete and file a Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, 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 partnerships (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 exempt 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 ownership 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, pursuant 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 partnership 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 proportional interests.

The above categories determine if Form 8865 needs to be completed and filed, as well as dictating which information, 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 foreign partnership, they must submit all the items required for each category they qualify for. Certain exceptions to filing exist, as well as relief for Category 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 foreign 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 income (ECI), and the requirement for a foreign partnership to file Form 1065 assists with administering the U.S. nonresident taxing regimes.

US-source income

If a taxpayer is engaged in a trade or business in the United States, generally, 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 periodical 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, deduction, 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 withholding 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 withholding 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 Withholding, 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)).

Examples

The following examples illustrate the Form 8865 and Form 1065 filing requirements:

Example 1: ABC Partnership is a foreign partnership owned 80% by a U.S. person and 20% by a foreign person. ABC Partnership has foreign trade or business income but has neither ECI nor any other U.S.-source income.

Filing requirement: The U.S. partner is required to file Form 8865 because it controls the foreign partnership and is considered a Category 1 filer. ABC Partnership is not required to file Form 1065 because it did not have any U.S.-source income.

Example 2: DEF Partnership is a foreign partnership owned 75% by a foreign person and 25% by a U.S. person. DEF Partnership has both foreign trade or business income and ECI. The U.S. partner did not make any current-year contributions to the partnership and did not have a Sec. 6046A reportable event during the year.

Filing requirement: The U.S. partner is not required to file Form 8865 with its tax return because it is not considered a Form 8865 category filer. DEF Partnership is required to file Form 1065 because it has U.S.- source income and does not meet either Form 1065 filing exception.

Example 3: GHI Partnership is a foreign partnership owned 60% by foreign persons and 40% by two U.S. persons (20% each). Neither U.S. partner made any current-year contributions to GHI Partnership, and neither had a Sec. 6046A reportable event during the year. GHI Partnership has foreign trade or business income but has neither ECI nor any other U.S.- source income.

Filing requirement: Neither U.S. partner is required to file Form 8865 because they do not meet the requirements of any of the four categories of filers. GHI Partnership is not required to file Form 1065 because it did not have any U.S.-source income.

Example 4: JKL Partnership is a foreign partnership owned 75% by a U.S. person and 25% by a foreign person. During the year, a different U.S. person contributed $115,000 to the partnership in exchange for an interest in the partnership. JKL Partnership has both foreign trade or business income and effectively connected U.S.-source income.

Filing requirement: The legacy U.S. partner is required to file Form 8865 because it qualifies as a Category 1 filer due to it controlling the entity. The new U.S. partner qualifies as a Category 3 filer due to its contribution of over $100,000 to the partnership. JKL Partnership is required to file Form 1065 because it has ECI and thus does not meet either of the Form 1065 filing exceptions. If JKL Partnership files Form 1065, the legacy U.S. partner may use a copy of the completed Form 1065 schedules in place of the equivalent Form 8865 schedules (Form 8865 instructions).

Example 5: MNO Partnership is a foreign partnership owned 100% by foreign partners. MNO Partnership has foreign investment income and U.S.-source income of $35,000. The U.S. income is attributable to its U.S. office. MNO Partnership filed Form 1042 and properly withheld U.S. tax on the foreign partners’ share of U.S. income. MNO Partnership is not considered a foreign withholding partnership.

Filing requirement: No partners are considered Form 8865 category filers, and therefore no partners are required to file Form 8865. MNO Partnership is required to file Form 1065 because its U.S.-source income is considered 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 requirements 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 information necessary to fulfill their U.S. tax obligations.