Section 1446(f) Creates Trap When Selling Partnership Interests

On May 7, the U.S. Department of the Treasury and the IRS issued proposed regulations under IRC Section 1446(f), which was enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). IRC Section 1446(f) imposes new withholding requirements for gain realized on disposition of a partnership interest by a foreign partner. The proposed regulations incorporate many of the provisions of Notice 2018-29, which established interim procedures for implementing IRC Section 1446(f) and are applicable to transactions occurring between Dec. 31, 2017, and the effective date of final regulations. Like the notice, the proposed regulations apply only to interests in partnerships that are not publicly traded and are effective for dispositions of partnership interests occurring on or after the date that is 60 days after the date they are published as final regulations in the Federal Register.  

Background

For more than 25 years, the IRS maintained that the sale of a partnership interest is income effectively connected with a U.S. trade or business (ECI) if the seller was a foreign person and the partnership was engaged in a trade or business in the U.S.¹ As ECI, gain on the sale of a partnership interest was subject to U.S. income tax contrary to other gains realized by foreign persons from the sale of property. In a 2017 decision, a U.S. Tax Court rejected the IRS position that gain from the sale of a U.S. partnership interest qualified as ECI.² Consequently, Congress enacted IRC Section 864(c)(8) as part of the TCJA to legislate the IRS position that gain or loss realized by a foreign partner from the disposition of an interest in a U.S. partnership can generate ECI. 

IRC Section 1446(f)(1) provides that if any portion of the gain on any disposition of an interest in a partnership would be treated as ECI under Section 864(c)(8), the transferee must deduct and withhold a tax equal to 10% of the amount realized on the disposition. If a transferee fails to meet the withholding requirement, IRC Section 1446(f)(4) provides that the partnership is required to deduct and withhold an amount equal to the amount the transferee failed to withhold (10% of the amount realized on the transfer) plus interest from the transferee’s future partnership distributions. In April 2018, the IRS issued Notice 2018-29, which announced its intent to issue regulations that would establish rules and procedures for executing the provisions of IRC Section 1446(f) and provide guidance until those rules are issued. The notice established an express presumption that all transferors of a partnership interest are treated as foreign transferors unless they provide a certification of nonforeign status, thereby creating a trap for the unwary by requiring the generation of documentation on virtually every transfer of a partnership interest.

Proposed regulations

The proposed regulations retain the foreign transferor presumption as well as many of the other provisions of Notice 2018-29. Under the proposed regulations, as in the notice, the certification of nonforeign status can be satisfied with Form W-9, “Request for Taxpayer Identification Number and Certification,” or an affidavit containing certain information required by the proposed regulations. The certification must be provided between 30 days before the transfer and the date of transfer. A transferee that does not receive certification of an exemption from withholding, including certification that a transferor is a U.S. person, must withhold 10% of the amount received as payment for the partnership interest, deposit the amount withheld with the IRS, and comply with reporting requirements with respect to the withholding.  

The enforcement of partnership-level withholding from future distributions to the transferee is deferred until final regulations are issued. 

In addition to the certification of nonforeign status, proposed Section 1.1446(f)-2 provides exemption from withholding in the following situations:

• The transferor certifies it will not realize a gain from the transaction.
• The transferor certifies that a sale of all of the partnership’s assets at fair market value would result in ECI of less than 10% of the total gain.
• The transferor certifies that for the three preceding years, the transferor was a partner, reported all ECI activity on a U.S. tax return, and the ECI was less than the lesser of $1 million or 10% of the transferor’s net partnership income each year.
• The transferor certifies that a nonrecognition provision applies to the transfer.
• The transferor certifies that the transfer is not subject to tax under the provisions of a U.S. tax treaty and includes a valid Form W-8BEN, “Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals),” or Form W-8BEN-E, “Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities).”

Although IRS Notice 2018-29 and the proposed regulations provide a trap for the unwary, it is possible for potential partners and partnership managers to avoid the trap if they build the appropriate documentation measures into their transfer procedures. 

 

¹Rev. Rul. 91-32.
²Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (July 13, 2017).