Isolating Pass-Through Profits
You own thirty percent of a Delaware LLC that elected partnership treatment and runs a real operating business in Texas. You live in Lisbon, you have never set foot in the United States, and you assumed the partnership's U.S. tax problems belonged to the partnership. They do not. Federal law treats the partnership's trade or business as yours, and the cash consequences start before you receive a single distribution.
The attribution rule that starts everything
IRC §875(1) is one sentence long and it governs the whole subject. A nonresident alien individual or a foreign corporation "shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged."
There is no materiality threshold in that sentence. No minimum ownership percentage. No carve-out for a passive investor who took a small slice of a friend's company and never attended a meeting. If the partnership is engaged in a U.S. trade or business, every partner is, for federal income tax purposes.
That attribution has a direct consequence. Under IRC §871(b) for individuals and IRC §882(a) for foreign corporations, income effectively connected with a U.S. trade or business is taxed on a net basis at graduated rates, on a filed return. It is not taxed at a flat rate at source and forgotten. A person who was invisible to the U.S. system yesterday becomes a filer today because of what a partnership did.
Two income streams, two withholding regimes
A partnership with a foreign partner can generate two very different kinds of income, and each carries its own withholding machinery. Conflating them is the most common error in this area.
| Effectively connected taxable income | FDAP income | |
|---|---|---|
| Governing withholding provision | IRC §1446(a) | IRC §1441, §1442 |
| Rate applied | Highest rate under IRC §1 for non-corporate partners, highest rate under IRC §11(b) for corporate partners | 30 percent, subject to treaty reduction |
| Trigger | Allocation under IRC §704, whether or not cash moves | Payment |
| Annual return | Form 8804, with Form 8805 per partner | Form 1042, with Form 1042-S per recipient |
| Partner-level return | Required to claim deductions | Often not required if withholding is correct |
The highest rate under IRC §1 is currently 37 percent and the IRC §11(b) corporate rate is 21 percent. Treas. Reg. §1.1446-3(a)(2) lets a partnership apply the rate attaching to a particular category of income, such as long-term capital gain allocable to a non-corporate partner, but only where it holds documentation establishing the partner's status and is not otherwise required to use the highest applicable percentage.
What §1446 costs you in cash before anyone is paid
IRC §1446(a) applies when a partnership has effectively connected taxable income and any portion of it is allocable under IRC §704 to a foreign partner. Allocation is the trigger. Distribution is not mentioned.
An illustrative case. The LLC earns $1,000,000 of effectively connected taxable income and allocates $300,000 to you. It reinvests everything and distributes nothing. Under IRC §1446(b) the partnership still owes withholding tax measured by the top individual rate on your $300,000 allocation, and Treas. Reg. §1.1446-3(d)(1)(ii) requires it to pay in installments on the fifteenth day of the fourth, sixth, ninth and twelfth months of its tax year, using Form 8813. It reconciles on Form 8804 and issues you a Form 8805. Cash left the business for a partner who received nothing.
This is the number that surprises operating partners. It is also the number that belongs in the operating agreement, as a mandatory tax distribution provision, before the first foreign partner is admitted. A foreign partner may certify partner-level deductions and losses on Form 8804-C, which the partnership may take into account in computing the §1446 tax, subject to the conditions in the regulations.
The partner still has to file
Withholding under IRC §1446 is a prepayment, not a settlement. IRC §1446(d) gives the foreign partner a credit under IRC §33 for the partner's share of the tax paid, and Form 8805 is the document that substantiates it. The credit is claimed on the partner's own return: Form 1040-NR for an individual, Form 1120-F for a foreign corporation.
Filing is also how deductions survive. IRC §874(a) allows deductions to a nonresident alien only if a true and accurate return is filed, and Treas. Reg. §1.874-1(b)(1) sets that boundary at sixteen months after the due date under IRC §6072. The parallel rule for foreign corporations sits in IRC §882(c)(2) and Treas. Reg. §1.882-4(a)(3)(i), with an eighteen-month outer limit. Miss it and the statutory consequence is tax measured on gross effectively connected income, with the Commissioner's waiver authority as the only route back.
Form 1040-NR is due June 15 for a calendar-year nonresident with no wages subject to withholding and no U.S. office, under IRC §6072(c). Form 1120-F is due the fifteenth day of the sixth month for a foreign corporation with no U.S. office, and the fifteenth day of the fourth month if it maintains one.
Selling the interest is its own event
In Grecian Magnesite Mining, Industrial & Shipping Co. v. Commissioner, 149 T.C. 63 (2017), aff'd 926 F.3d 819 (D.C. Cir. 2019), a foreign partner's gain on redemption of a partnership interest was held not to be effectively connected income. Congress had already changed the rule prospectively. IRC §864(c)(8), enacted in 2017, treats gain or loss on the sale or exchange of a partnership interest as effectively connected to the extent of the gain the partner would have been allocated on a hypothetical sale of all partnership assets at fair market value.
IRC §1446(f)(1) is the collection mechanism. The transferee must deduct and withhold 10 percent of the amount realized, not 10 percent of the gain. On a $2,000,000 purchase of a partnership interest with a $1,900,000 basis, the buyer's withholding obligation is $200,000 against a $100,000 gain, absent an exception. Payment and reporting run on Forms 8288 and 8288-A, due by the twentieth day after the transfer.
If the transferee fails to withhold, IRC §1446(f)(4) shifts the obligation. Treas. Reg. §1.1446(f)-3 requires the partnership to withhold that amount from distributions on the transferred interest, and a partnership that receives IRS notification of an incorrect or unpaid transferee certification must withhold on distributions made on or after the fifteenth day following notification. Partnerships that treat buyer-side compliance as someone else's problem inherit it.
The certifications that turn the withholding off
Treas. Reg. §1.1446(f)-2(b) sets out the exceptions a transferee may rely on. Each is a document obtained before or at closing, signed under penalties of perjury.
- Certification of non-foreign status from the transferor.
- Certification that the transfer produces no realized gain, taking IRC §751 ordinary income into account.
- Partnership certification that a deemed sale of all its assets would produce no effectively connected gain, or effectively connected gain of less than 10 percent of total net gain.
- Transferor certification that, for each year in the lookback period, its distributive share of gross effectively connected income was less than $1,000,000 and less than 10 percent of its total distributive share of gross income from the partnership.
- Certification that a nonrecognition provision applies.
- Certification that an income tax treaty relieves the transferor of tax on the gain.
None of these are self-executing. They depend on the partnership producing information the buyer cannot generate alone, on a closing timetable. That is a diligence workstream, and it belongs in the purchase agreement.
Where a separate vehicle earns its keep
The reason practitioners separate active and passive holdings is that IRC §875 attribution is contagious in one direction only. A partnership interest that produces effectively connected income pulls the partner into the U.S. filing system. Once there, IRC §864(c)(3) treats most other U.S.-source income of that person as effectively connected as well.
Income that would otherwise sit outside that system includes qualifying portfolio interest under IRC §871(h) and IRC §881(c), which is excluded from the 30 percent tax on FDAP income if the statutory conditions are satisfied. Those conditions include the 10-percent ownership limitation in IRC §871(h)(3), which for an obligation issued by a partnership tests a 10 percent or greater interest in capital or profits. Holding a lending position and an operating partnership interest inside the same person is the fact pattern that puts that exclusion at risk. Whether separation helps in a given case depends on the identity of the obligor, the ownership percentages, and the treaty position of the holder.
What to do before the next allocation
Pull three documents: the partnership agreement's tax distribution clause, the most recent Form 8805 issued to each foreign partner, and the Schedule K-3 supporting it. Confirm that the §1446 installments were actually paid on the four statutory dates rather than accrued. Confirm each foreign partner has filed the return that carries the IRC §33 credit and preserves deductions inside the sixteen or eighteen month window. If an interest transfer is contemplated, start the Treas. Reg. §1.1446(f)-2(b) certification package early, because the partnership-level information takes longer to assemble than the closing calendar usually allows.
Structural questions of this kind are what the firm's international diagnostic is built to map. Further background sits on the international tax matters pillar. This article is general information about published law and not advice on any particular set of facts.