US Partnership Interest Disposition by Foreign Partners

The IRS issued final regulations under Sections 864(c)(8) and 1446(f), which retain the basis structure and approach of the respective proposed regulations issued in May 2019.  Here are the key provisions contained in the final regulations that U.S. partnerships with foreign partners, directly and indirectly, should be aware of.

Final regulations under Section 864(c)(8) provide that all or portion of the gain or loss derived by a foreign person from the sale or exchange of a partnership interest is treated as gain or loss effectively connected with the conduct of a US trade or business (ECI). The amount of effectively connected gain or loss is the amount of effectively connected gain or loss that the foreign person would have been allocated had the partnership sold all its assets at fair market value as of the date of the sale or exchange of the partnership interest.  The provision is relevant to foreign person with a direct interest in a US partnership as well as tiered partnerships.

The IRS also finalized regulations under Section 1446(f), which requires withholding on the transfer of a partnership interest subject to the Section 864(c)(8).  The final regulations require the transferee to deduct and withhold a tax equal to 10% of the amount realized on the disposition if a portion of the gain would be treated as effectively connected with the conduct of a US trade of business under Section 864(c)(8).

Generally, the provisions contained in the two final regulations are applicable for partnership taxable years beginning after December 31, 2017.

A partnership that is required to pay Section 1446 tax but fails to do so, or pays less than the amount required, is liable under Section 1461 for the payment of the tax required to be withhold and may be subject to severe penalties.

The IRS released a draft of the instructions for Form 1065 (“Proposal”) for 2020 tax year which contains the IRS’s proposed requirement for reporting partners’ capital on the schedule K-1 on a transactional tax basis.  This requirement is expected to add significant compliance hours unless the partnership has been tracking partners’ capital using tax basis.  The IRS is accepting comments on the draft instructions for 30 days and plans to issue final instructions in December.

According the Proposal, partnerships filing Form 1065 for tax year 2020 must calculate partner capital accounts using the transactional approach for the Tax-Basis Method.  Under the tax-basis method, partnerships report partner contributions, the partner’s share of income or loss, withdrawals and distributions, and other increases or decreases using the tax principles as opposed to GAAP or other hybrid methods previously allowed.  Partnerships that did not prepare schedule K-1 under the tax-basis method for 2019 or otherwise maintained tax-basis capital accounts in their books and records may determine each partner’s beginning tax-basis capital account balance for 2020 using one the following methods:  the modified outside basis method, the modified previously taxed capital method, or the Section 704(b) method.

Modified Outside Basis Method

The amount to report as a partner's beginning capital account under the modified outside basis method is equal to the partner's adjusted tax basis in its partnership interest as determined under the principles and provisions of subchapter K including, for example, sections 705, 722, 733, and 742; and subtracting from that basis (1) the partner's share of partnership liabilities under section 752 and (2) the sum of partner's section 743(b) adjustments (that is, net section 743(b) adjustments). For purposes of establishing a partner's beginning capital account, you may rely on the adjusted tax basis information provided by your partners

Modified Previously Taxed Capital Method

The amount to report as a partner's beginning capital account under the modified previously taxed capital method is equal to the following:

• The amount of cash the partner would receive if you liquidated after selling all of your assets in a fully taxable transaction for cash equal to the fair market value of the assets; increased by
• The amount of tax loss determined without taking into account any section 743(b) basis adjustments (including any remedial allocations under Regulations section 1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse); and decreased by
• The amount of tax gain determined without taking into account any section 743(b) basis adjustments (including any remedial allocations under Regulations section 1.704-3(d)) that would be allocated to the partner following such a liquidation (treating all liabilities as nonrecourse). Instead of using the assets' fair market value, you may determine the partnership's net liquidity value, and gain or loss, by using such assets' bases as determined under section 704(b), as determined for financial accounting purposes, or on the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management.

704(b) Method

The amount to report as a partner's beginning capital account under the section 704(b) method is equal to the partner's section 704(b) capital account, minus the partner's share of section 704(c) built-in gain in the partnership's assets, plus the partner's share of section 704(c) built-in loss in the partnership's assets. Property contributed to a partnership is section 704(c) property if, at the time of the contribution, its fair market value differs from its adjusted tax basis. Section 704(c) property also includes property with differences resulting from revaluations (reverse section 704(c) allocations). For more information see sections 704(b) and 704(c) and Regulations sections 1.704-1 through 1.704-3.