Last week I blogged about the US income tax issues that plague a US partnership when it has a foreign partner. That post showed things can get ugly when a US partnership has a foreign partner.
The post got a lot of views and feedback so it is evidently a topic of interest. I thought it would be instructive for readers to put the shoe on the other foot. Today’s post will explain how easy it is for the foreign person to fall into a quagmire of US tax traps when he or she goes into foreign partnership with a US person, even if that foreigner never sets foot in America and works solely from the foreign location. Foreign partnership, beware of your US partner!
So, what happens when an individual who is not a US citizen or “resident” (i.e., a “nonresident alien”, or NRA), goes into a non-US partnership with a US individual?
Quick Answer: He sets himself up for some big and nasty US tax issues. Forewarned is forearmed. Thus, today’s post!
A Typical Case
Let’s take the case of Gerhard, a German national living in Germany. He became partners with Sam, a US citizen living in the US. Gerhard and Sam created “Partnership”, a service partnership that was organized under the laws of Germany. Partnership had offices in Germany and in the United States. Gerhard, the NRA individual was a resident of Germany under Article 4 of the US –German Income Tax Treaty (Treaty), and Sam was a United States resident. Gerhard performed services solely at Partnership’s office in Germany; Sam performed services solely at Partnership’s office in the United States. They agreed to divide the profits of the Partnership equally.
Gerhard thought all of the partnership profits he earned were not taxable by the United States since he was a NRA and he was not physically present in the US at any time.
The Internal Revenue Service (IRS) told him differently! Here’s what happened to Gerhard:
Even though Partnership was created under German laws, and Gerhard performed services solely in Germany through the German office (with Sam performing services in America through the US office), the activities of Sam in America caused Gerhard to be ‘deemed’ engaged in a US trade or business (USTB). The USTB concept is briefly described here. The relevant US tax law involves section 875(1) of the Internal Revenue Code (Code), pursuant to which a NRA individual who is a partner in a partnership that is engaged in a USTB is himself considered to be so engaged. Section 871(b)(1) of the Code provides that the NRA is taxable on his income that is effectively connected with the conduct of that USTB.
Gerhard himself was thus treated under the US tax rules as performing services in the USA, based on what his partner, Sam, did there. As a result, Gerhard was required to annually file a US income tax return and pay US income tax on his share of the US profits earned by Partnership.
Other US tax Implications
Other US tax consequences will fall directly on to the entity, the German Partnership.
The German Partnership itself, must annually file with the IRS a Form 1065 (US return of Partnership Income).
In addition, Partnership will have withholding duties pursuant to Code Section 1446. The withholding duties are imposed in order to ensure the US Treasury will be paid the taxes due even if Gerhard does not file his US tax returns. The German Partnership must quarterly withhold at the highest individual tax rate (currently 37%) on all US profits allocable to Gerhard, the German NRA partner.
The following US tax forms will be relevant to the Partnership with regard to its withholding obligations:
Form 8804 Annual Return for Partnership Withholding Tax (Code Section 1446)
Form 8805 Foreign Partner’s Information Statement of Section 1446 Withholding Tax
Form 8813 Partnership Withholding Tax Payment Voucher (Code Section 1446)
Treaty No Help
Many foreign investors will automatically think that because an income tax treaty is in place between the United States and their country, that they will not owe any US tax. This is often a big mistake. The treaty must be examined very carefully to determine the tax results.
In the case of Gerhard and Sam, the US-German Income Tax Treaty also would not change the tax result. In part, Article 14 of the Treaty provides –
“Income derived by an individual [here, Gerhard] who is a resident of a Contracting State [here, Germany] from the performance of personal services in an independent capacity shall be taxable only in that State, unless such services are performed in the other Contracting State [here, the US] and the income is attributable to a fixed base regularly available to the individual in that other State [i.e., the US] for the purpose of performing his activities….”
Why Didn’t the Treaty Help Gerhard?
Under the US tax rules, the services carried out by Sam in the US were treated as if they were carried out by Gerhard. This is a function of “agency” law (that is carried over to the tax law under Section 875, mentioned above); each partner is the agent of the other through the partnership. Put another way, every partner is an agent of the firm and his other partners. In addition, the office or permanent establishment of a partnership is, as a matter of law, treated as the office of each of the partners.
In our case, what this means is that the US office of the Partnership was attributed not only to Sam, but to Gerhard as well. Gerhard was thus treated as having a “fixed base” regularly available to him in the United States from which he was deemed to perform services. As a result, he was subject to US income tax on his share of income from Partnership to the extent that the income was attributable to the “fixed base” in the United States. It did not matter that Gerhard himself did not actually perform any services in the United States.
US Taxman Has A Long Arm
If you are planning on doing any business activity in the US or you are involved with US partners or business associates, you should obtain proper tax advice well beforehand. You’d be surprised at how long the arm of the IRS can be!
Posted October 5, 2023
All the US tax information you need, every week –
Named by Forbes, Top 100 Must-Follow Tax Twitter Accounts @VLJeker
Named by Bloomberg, Tax Professionals to Follow on LinkedIn
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox. My blog specializes in foreign and US international tax issues.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920
Virginia - US TAX TALK 
Hello Virginia, I’d be curious about the case where an NRA and a US citizen form a partnership in Europe, both work and provide services in Europe, all income is European. Is the IRS still due taxes and/or filings?
Thank you for the blog post
LikeLike
Hi! We don’t address questions on the blog. If you’d like to engage me, please email.
LikeLike
Thanks for this information. It does not apply to me, nor is it ever likely to apply to me (I’ve been retired for 12 years!), not does it apply to any of my friends or family.
However, I find your emails very interesting and easy to follow, especially considering that the subject is anything but easy.
Keep up the good work.
LikeLike
Always so nice to get a compliment. Thank you Mary
LikeLike
Virginia: Great analysis and entirely correct. It does lead to some interesting follow on issues.
1. The real problem here is that they agree to spilt worldwide profits 50-50. In that case, each partner is deemed to get 50% of the income from their “home” country and 50% of the income generated by their partner in the other country. Likely they are taxed in the home country on 100% of the income (with a credit for some – but not always all – of the tax paid to the other country) and in the other country on the 50% of the income generated in that country. This can cause a real problem if the tax rates in the 2 countries are significantly different.
2. They cannot easily use “special allocations” to solve the problem if they split everything 50-50. That is, they cannot say “Sam gets all the US income and Gerhard gets all the German income” if they split worldwide profits 50-50. On the other hand, they likely could specially allocate German income to Gerhard and US profit to Sam if they agreed to split the profits accordingly. That is, if more of the profits end up arising from Gerhard’s efforts in Germany, and if Gerhard gets more money than Sam, then the special allocation of German profits to Gerhard and US profits to Sam likely would be respected.
3. One way to “have your cake and eat it too” would be to use guaranteed payments for a portion of the expected profits. Using guaranteed payments means that only the net profit above the guarantee are split 50-50. The guaranteed amount would be sourced based on where each partner performs services. While there is a risk that might not work for a 2 person partnership with guarantees close 100% of the anticipated profit, it likely would work for a partnership with a larger number of partners and a guarantee significantly below the anticipated profits.
As you say, taxation of cross-border partnerships is VERY complex and participants need advice from a sophisticated practitioner such as yourself if they are to stay compliant.
LikeLike
Thank you Richard for the follow on comments. You’re always educating us and at the same time, getting readers of my blog posts to think about the true breadth of complexity in US tax matters. I will email you – I would like to make this a separate post so it can reach as many readers as possible.
LikeLike