Business is strong, and your partnership’s cash flow is healthy. You make a significant distribution to your partners, including a $500,000 wire to a foreign investor. Standard procedure. Books are all in order. Everyone is happy.
It’s only months later, when you meet with your accountant, that you learn you owe a considerable sum for taxes you didn’t know existed, on income you never received. Your “routine” distributions carry hundreds of thousands of dollars in tax liability that you never anticipated. Your formerly thrilled investors are now disgruntled. How does a simple transaction turn into a full-blown tax nightmare?
The rules related to withholding on payments to foreign persons apply to dozens of payment types: U.S. partnerships distributing income to foreign investors, a domestic company paying interest to its overseas lender, dividends to foreign shareholders, and even some payments to foreign vendors; any cross-border payment can trigger the same trap.
The U.S. payer will always be held fully liable for the taxes if it fails to withhold where required. The IRS will take action to collect taxes from the U.S. payer that neglected to withhold, regardless of whether the failure was due to a taxpayer’s ignorance or to sloppy or incomplete documentation. Compliance with withholding rules is mandatory; noncompliance can result in the IRS asserting penalties, and, in some cases, penalties can be imposed even when no tax is due.
The Withholding Agent: Why U.S. Entities Bear the Burden
Here’s the tricky part about withholding taxes. Technically, the tax is meant to be paid by the foreign recipient of the income. But the IRS has no mechanism to compel foreigners to pay taxes on U.S.-source income, especially if they have no assets or presence in the U.S. To solve this enforcement gap, the statute places the responsibility squarely on the “U.S. withholding agent”, who is the last U.S. person or entity with custody of the funds or income that are being paid to a non-U.S. person or entity.
When a U.S. company pays interest, dividends, or partnership income to a foreign person, that company becomes the IRS’s collection point. If a withholding agent fails to withhold or obtain the requisite withholding tax documentation, both the U.S. withholding agent and the foreign party are held jointly liable for the tax and may end up paying tax on income that isn’t theirs, plus interest and potential penalties.
What Payments Trigger Withholding?
U.S. withholding tax applies broadly for a variety of payments made to foreign individuals and entities that constitute U.S.-source income. These types of payments include:
- Interest on loans
- Dividends from U.S. corporations
- Rent from U.S. real estate
- Royalties from intellectual property
- Compensation for services performed in the United States.
Whenever a U.S. person or entity pays a nonresident, they must withhold the appropriate tax. With respect to domestic partnerships, the entity itself is responsible for withholding any U.S.-source income attributable to foreign partners.
Partnership Liability: No Escape Clause
Even if the partnership does not actually distribute income, it is still required to calculate and withhold taxes based on the income allocated to partners on their K-1s. Failure to comply exposes the partnership to direct liability, and the foreign partners can also face future consequences if withholding is mishandled.
Four Key Withholding Regimes
There are several distinct U.S. withholding regimes, each designed to ensure taxes are collected on specific types of payments to foreign persons.
- FDAP withholding: This is the most common withholding regime and applies to “fixed, determinable, annual, or periodic” (FDAP) income paid to foreign persons. Some examples include interest, dividends, rents, royalties, and certain compensation for services.
Under the FDAP withholding rules, the U.S. withholding agent must deduct tax at a flat rate, typically 30%, before making the payment to the foreign recipient. This rate may be reduced to as low as 0% if a treaty is in place between the U.S. and the country of the foreign recipient.
- FATCA withholding: The Foreign Account Tax Compliance Act (FATCA) imposes withholding on certain payments to foreign financial institutions and non-financial foreign entities that fail to provide the IRS with information about U.S. account holders.
Essentially, FATCA is designed to prevent U.S. tax evasion through offshore accounts, and the withholding applies to payments such as interest, dividends, and certain gross proceeds of U.S. assets. Non-compliant foreign entities are subject to a 30% withholding on these U.S.-source payments.
- Effectively Connected Income (ECI) withholding: ECI withholding applies to U.S. partnerships with foreign partners whose income is effectively connected with the conduct of a U.S. trade or business. The ECI withholding tax rate is based on the highest tax rate applicable to the foreign partner’s taxpayer classification (e.g., individual or corporation). It would be 21% for foreign corporations and up to 37% for foreign individual partners.
- Foreign Investment in Real Property Tax Act (FIRPTA) withholding: FIRPTA focuses on gains realized by foreign persons on the sale of U.S. real property. As per the FIRPTA rules, when a foreign person is selling a U.S. real property interest, the buyer must withhold 15% of the gross sales price and remit it to the IRS. This ensures that the U.S. can collect tax on gains from the disposition of real property by foreign investors.
In some cases, tax treaties between the U.S. and other countries can reduce or even eliminate withholding on certain types of income paid to foreign persons. But to claim these treaty benefits, the foreign person must provide the U.S. withholding agent with the proper documentation, generally a completed Form W-8, before making any payments. Without the correct documentation, the standard withholding rules apply.
Action Steps for Compliance
If your company makes payments to foreign persons or entities — whether for distributions, interest, rent, royalties, or services — it’s time to take a closer look. Start by reviewing your current and potential foreign payees to identify any withholding obligations you may have overlooked. Then, meet with your accountant or tax advisor to discuss your specific withholding responsibilities to ensure you’re meeting all compliance requirements.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
