Foreign Partnerships with a US Partner? Some Planning Ideas

An earlier blog post explained how easy it is for the foreign person to fall into some nasty US tax traps when entering a foreign partnership with a US person.  Even if that foreigner never sets foot in America and works solely from the foreign location, he can end up paying US taxes. In addition, the foreign partnership itself will have US tax duties – annual filing of a partnership US tax return (Form 1065) as well as withholding tax obligations.

Renowned international tax attorney, Richard LeVine sent comments on the post detailing some very interesting follow-on issues.  I have made these comments the subject of today’s blog post which explores what could have been done differently to possibly mitigate the US tax bite for the foreign partner.  Richard has given me permission to use these comments so readers can learn more about how the US partnership tax rules work.

Partnership taxation is not a simple area of tax law, but Richard’s comments help us understand more about them.  Furthermore, they show how very complicated the taxation of cross-border partnerships really is and why participants need a sophisticated tax practitioner to help them.

Gerhard and Sam – Partners in a German Partnership

Summarizing the fact pattern that was set out in the earlier post:  Gerhard, a German national resident in Germany became partners with Sam, a US citizen resident in the US.  Together they created “Partnership”,  a service partnership organized under German law which had offices in both Germany and the US. 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 nonresident alien individual and was not physically present in the US at any time.  The Internal Revenue Service (IRS) burst Gerhard’s bubble. The activities of Sam in America caused Gerhard himself to be treated as engaged in a US trade or business. This meant that Gerhard was taxable on his share of the US profits earned by Partnership.

US Partnership Taxation: What Could Gerhard and Sam have Done Differently?

Richard’s comments follow below:

1. The real problem here is that Gerhard and Sam agreed 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. Gerhard and Sam cannot easily use “special allocations” to solve the problem if they split everything 50-50.

Partnership “Special Allocations”

Before continuing Richard’s comment, let me explain the tax concept of partnership “special allocations”.  Simply put, a special tax allocation is an allocation of an item of partnership loss, deduction, income, or gain among the partners that is not in proportion to the partners’ overall ownership interest in the partnership.  Generally, to determine the ownership interest of a partner, one looks to the partnership agreement to see the partner’s stated interest in the partnership distributions and capital. By way of example, an allocation of 60 percent of a partnership’s tax loss to a partner whose stated ownership is only 25 percent, is a “special allocation” of the tax loss.  Of course, this mechanism is ripe for tax abuse and of course, over the years, the IRS has issued numerous complicated regulations designed to prevent “abusive” partnership tax allocations.

Returning now to Richard’s comment on “special allocations”  and why Gerhard and Sam cannot easily use special allocations:

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.  (VLJ Comment: If this kind of special allocation could be implemented, then German profits to Gerhard would not be taxed in the US since they do not have a US source).

Partnership “Guaranteed Payments”

3. One way to “have your cake and eat it too” might be to use “guaranteed payments” for a portion of the expected profits.

Before continuing Richard’s comment, let me explain the tax concept of partnership “guaranteed payments”. Neither the IRS nor the courts have agreed on a definition, so it is a slippery concept.  Essentially, a guaranteed payment to a partner is applied to make sure that the partner gets a specific amount for services or capital that the partner provided. The payments are considered “guaranteed” because they are given first-priority and are distributed to that partner even if a net loss results for the partnership. Even though this concept sounds simple, if not planned properly, the tax ramifications of these payments can result in unexpected difficulties for all the partners.

Returning now to Richard’s comment on “guaranteed payments” in the case of Gerhard and Sam:

Using guaranteed payments means that only the net profit above the guarantee is split 50-50. The guaranteed amount could be sourced based on where each partner performs services (VLJ Comment: If this was successfully done, then Gerhard would not be taxed by the US on the guaranteed payment amounts since their source would be in Germany where Gerhard performs all of his services). While there is a risk that might not work for a 2-person partnership with guarantees close to 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.

Posted November 9, 2023

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