LawFlash

IRS Proposes Regulations for Withholding on Transfers of Partnership Interests

June 04, 2019

The US Internal Revenue Service (IRS) issued proposed regulations on May 7 that would expand tax withholding and reporting requirements in certain sales or exchanges of interests in partnerships engaged in one or more US trades or businesses (the Proposed Regulations). The Proposed Regulations generally follow prior guidance from the IRS, but they add significant requirements increasing the circumstances in which withholding may be required, particularly where a partnership may be unfamiliar with these requirements or unwilling to provide highly complex certifications (which may include computations related to both inside and outside partnership interest basis) – even if the partnership at issue generates little or no income effectively connected with a United States trade or business (such as with respect to a foreign partnership whose activities are solely outside the United States).

By way of background, Section 864(c)(8) of the Internal Revenue Code (the Code) was enacted in the 2017 tax reform act to provide that with respect to sales or exchanges of partnership interests on or after November 27, 2017, gain or loss from the sale of a partnership interest is treated as effectively connected with a US trade or business to the extent that the seller of such interest would have had effectively connected gain or loss had the partnership sold all of its assets for their fair market value as of the date of sale. To help facilitate collection of tax on this “effectively connected income” (ECI), the 2017 tax reform act also introduced new Code Section 1446(f). This section requires the buyer of a partnership interest to withhold a 10% tax on the “amount realized” by the seller on the sale or exchange of a partnership interest occurring after December 31, 2017, if any portion of the seller’s gain on the sale of the interest would be ECI under Code Section 864(c)(8) and the seller does not provide a certification of non-foreign status.[1]

The Proposed Regulations, if finalized, will supersede existing interim guidance provided by Notice 2018-08 released on December 29, 2017, and Notice 2018-29 released on April 2, 2018, (the Notices) and expand upon proposed regulations under Code Section 864(c)(8) published by the IRS on December 27, 2018. Notable portions of the Proposed Regulations are described below. As noted above, although the Proposed Regulations broadly follow the approach of the Notices, they add significant requirements increasing the circumstances in which withholding may be required.

Withholding on PTP Interest Transfers.Shortly after tax reform was enacted, the IRS suspended the requirement to withhold on amounts realized in the sale, exchange, or disposition of publicly-traded interests in a publicly traded partnership not treated as a corporation under Code Section 7704 and the regulations thereunder (a PTP). The Proposed Regulations activate this withholding requirement and provide special rules for transfers of publicly traded PTP interests effected through one or more “brokers” not otherwise discussed herein. Assuming the Proposed Regulations are enacted in final form, “brokers,” defined for this purpose to include certain clearing organizations and any person that in the ordinary course of a trade or business stands ready to effect sales made by others, and that, in connection with a transfer of a publicly traded PTP interest, receives all or a portion of the amount realized on behalf of the transferor, will become withholding agents for these purposes. However, if the transferred PTP interest is not publicly traded or the transfer of a publicly traded PTP interest is not effected through a “broker,” then the general rules discussed herein applicable to transfers of non-PTP interests will apply.

Partnership Withholding Under Code Section 1446(f)(4). The Proposed Regulations activate provisions that had previously been suspended requiring a partnership to withhold on distributions to a transferee under Code Section 1446(f)(4) to the extent the transferee fails to properly withhold. A transferee must furnish, no later than 10 days after a partnership interest transfer, a certification to the partnership that either includes a copy of a Form 8288-A that it files with the IRS, or states the amount realized on the transfer and any amount withheld by the transferee. The partnership must then conduct its own review of the certification provided by the transferee (and, as noted in the Preamble to the Proposed Regulations, may determine based upon information in its books and records not available to the transferor that the certificate cannot be relied upon). Therefore, a transferee that has relied on a certification claiming an exception or adjustment to withholding may want to ensure that the partnership has determined the certification to be correct and reliable before the due date for payment of any withheld amounts to the IRS. Moreover, partnerships may wish to consider restricting transfers pending approval of such certifications.

Reporting Requirements for Foreign Transferors and Partnerships with Foreign Transferors. The Proposed Regulations provide that a foreign partner must generally notify a partnership within 30 days of a relevant partnership interest transfer. This 30-day notice requirement is a new one not addressed by the Notices. The Proposed Regulations further require that the partnership furnish to the notifying transferor the information necessary for the transferor to comply with Code Section 864(c)(8) by the due date of the Schedule K-1 (Form 1065) for the tax year of the partnership in which the transfer occurred. Transferors and funds that engage in or allow for secondary sales of their interests should be mindful of these requirements. Moreover, because distributions made by non-PTPs may be treated as transfers for purposes of Code Section 1446(f), it appears that a privately-held partnership routinely needs to provide the information required under the aforementioned rules whenever it makes a distribution (unless the partnership can determine, based upon its books and records or a transferor certification, that the distribution will not trigger gain for the transferor).

Coordination with FIRPTA Withholding. The Proposed Regulations provide a rule coordinating Code Section 1446(f)(1) with Code Section 1445, which such section speaks to withholding for Foreign Investment in Real Property Tax Act purposes (so-called FIRPTA withholding). Generally, if a transferee is required to withhold under FIRPTA and Code Section 1446(f)(1), then the transferee will be subject to the payment and reporting requirements of FIRPTA only (which means under current law withholding will apply at a 15% rate under the FIRPTA withholding rules rather than the 10% rate under Code Section 1446(f)).

Coordinating 1446 Withholding Among Tiered Partnerships. Because gain that an upper-tier partnership recognizes on the transfer of an interest in a lower-tier partnership engaged in the conduct of a trade or business within the United States is included when calculating the upper-tier partnership’s ECI, the Proposed Regulations provide a coordination rule that allows a partnership that is withheld upon under Code Section 1446(f)(1) (in its capacity as a transferor) to claim a credit for the amount withheld against its withholding tax liability under Code Section 1446(a) (if any). This taxpayer-friendly clarification should help lessen overwithholding upon funds-of-funds and other partnerships invested in lower-tier partnerships.

Exceptions to Withholding on the Transfer of a Non-PTP Interest by a Foreign Person. The Proposed Regulations provide six exceptions to withholding by a transferee of a non-PTP partnership interest. The exceptions, described below, generally follow the exceptions provided in the Notices but with lower thresholds in some cases.

  1. Certification of Non-Foreign Status by Transferor: The transferor certifies to its non-foreign status (as shown on a valid IRS Form W-9). Withholding determinations with respect to a foreign partnership may be made on a look-through basis via a Form W-8IMY. Foreign transferors may wish to take advantage of this exception by investing in ECI-generating partnerships through a domestic partnership that can provide a Form W-9 in order to internalize any applicable withholding determinations.
  2. No Realized Gain by Transferor: The transferor certifies that it would not realize any gain on the transfer of the partnership interest, taking into account any ordinary income arising from application of Code Section 751(a) (so-called “hot assets”). As a new requirement not in the Notices, a transferor may not provide the certification if the existence of hot assets require the transferor to realize ordinary income, even if the transferor would realize an overall loss on the transfer.
  3. Effectively Connected Gain upon a Partnership’s Deemed Sale. The transferee receives a certification from the partnership stating that if the partnership sold all of its assets at fair market value, the amount of net effectively connected gain resulting from the deemed sale would be less than 10% of the total net gain. The Notices provided a similar rule, but at a threshold of less than 25%.
  4. Allocable Share of ECI. A de minimis ECI exception applies but the Proposed Regulations change the ECI threshold from the Notices from less than 25% to less than 10%. As new requirements added by the Proposed Regulations, the transferor must also certify, based on a Schedule K-1 and an IRS Form 8805 delivered to it by the partnership, that (i) in the immediately prior taxable year and the two that preceded it, the transferor’s allocable share of ECI was less than $1 million, and (ii) its distributive share of ECI has been reported on a federal income tax return and all amounts due with respect to the return are timely paid for each of the three preceding taxable years, if required to be filed. Given the requirement under clause (ii), a transferor does not qualify for this exception if the transferor did not have a net distributive share of income allocated to it, or any ECI allocated to it (as reflected by an IRS Form 8805) unless effectively connected losses were allocated to it (as reflected by a Schedule K-1) in any of its previous three taxable years.
  5. Nonrecognition by Transferor. A nonrecognition provision of the Code applies to all of the gain realized on a transfer. If only a portion of the gain realized on the transfer is subject to a nonrecognition provision, an adjustment to the amount that must be withheld may be permitted.
  6. Claim of Treaty Benefits. The transferor is not subject to tax on any gain from the transfer pursuant to an income tax treaty in effect between the United States and a foreign country. Note in this regard that a US permanent establishment of a partnership may be treated as the permanent establishment of the transferor and prevent eligibility for tax treaty benefits.

In cases where a partnership is treated as a transferee by virtue of making a distribution, generally, the partnership may apply these exceptions based on its books and records in lieu of obtaining a certification.

Determining the Amount to Withhold.The amount that must be withheld is determined by reference to the transferor’s “amount realized” on the transfer, including any cash paid or distributed, the fair market value of property paid or distributed, any liabilities assumed by the transferee, and the reduction in the transferor’s share of partnership liabilities. Allocation of liabilities to a partner is not information that normally would be available to a transferee. The Proposed Regulations provide procedures similar to those outlined in the Notices that generally allow a transferee to rely on a certification from the transferor or the partnership to determine its share of these liabilities. In a helpful change, transferees can rely on the share of liabilities reflected on a Schedule K-1 provided by the partnership, in general terms, for a tax year ending within 22 months of the transfer date, rather than the requirements of the Notice, for which the Schedule K-1 needed to have been provided with respect to a tax year ending within the preceding 10 months. When a foreign partnership transfers its interest in a partnership, the Proposed Regulations provide a procedure to limit the amount realized for withholding purposes to the portion of the amount realized that is attributable to foreign persons, which is welcome relief to help avoid overwithholding. The Proposed Regulations make further clarifications not discussed herein regarding “amount realized,” including with respect to certifications of maximum tax liability to avoid overwithholding.

Reporting and Paying Withheld Amounts.A transferee required to withhold must report and pay any tax withheld by the 20th day after the date of the transfer. If the amount of tax withheld by a partnership from a transferee post-transfer exceeds its liability (because, for example, the transferor paid all amounts due by it), only the partnership may claim a refund on behalf of the transferee for the excess amount. Thus, partnerships and transferees will need to make contractual arrangements to allow the transferee to be reimbursed for amounts refunded to the partnership.

Reliance.The Proposed Regulations generally do not apply to transfers until 60 days after the regulations are finalized, although taxpayers are generally permitted to rely on them before finalization. Some taxpayers may prefer to rely on the guidance under the Notices, which are in some cases more taxpayer-favorable and remain in effect until such time, if any, as the Proposed Regulations go into effect. As a precaution in planning, it should be assumed that the IRS will finalize the Proposed Regulations as drafted, which taxpayers should take into account in considering their applicable withholding and reporting obligations.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Daniel A. Nelson
Gabriel A. Quihuis
Meghan E. McCarthy

New York
Charles R. Bogle
Richard S. Zarin

Philadelphia
William P. Zimmerman
Nawal K. Maalouf

San Francisco
Sarah-Jane Morin

Washington, DC
Kathryn W. Hambrick
Richard C. LaFalce


[1] For more information on this new withholding rule and the treatment of gain on the sale of partnership interests as income that is effectively connected with a US trade or business, see our December 28, 2017, LawFlash: Tax Reform Legislation Reverses Grecian Magnesite Mining, Adds New Withholding Tax and our April 19, 2018, LawFlash: IRS Issues Withholding Guidance on Transfers of Non-Publicly Traded Partnership Interests by Non-US Persons.