On November 30, 2020, the Internal Revenue Service (IRS) published in the Federal Register final regulations implementing the withholding requirements of Internal Revenue Code section 1446(f) (the Final Regulations). The Final Regulations provide guidance on the obligation of a transferee (e.g., the buyer) of a partnership interest to withhold on the proceeds of the transfer. The new withholding tax rules generally apply to transfers of partnership interests on or after January 29, 2021.
The Final Regulations distinguish between publicly-traded partnerships and non-publicly-traded partnerships, providing different rules for when withholding applies and the documentation required to reduce or avoid withholding. Nonetheless, this alert focuses on the documentation and other requirements for transferors of interests in non-publicly-traded partnerships, particularly on an actual transfer of a partnership interest from an existing partner to another (new or existing) partner.
Significance of the Final Regulations
The scope of the Final Regulations is broad. If a partnership--whether domestic or foreign--is considered to be engaged in a trade or business within the United States, any person who transfers an interest in the partnership must comply with the Final Regulations. Compliance with the Final Regulations does not necessarily mean the buyer (or other transferee) has to withhold; the Final Regulations include several exceptions to the withholding requirement. However, for the transferor to avoid having the proceeds of the transfer withheld by the transferee, the transferor or partnership (sometimes in combination) must prove eligibility for an exception identified in the Final Regulations.
The Final Regulations work in coordination with separate, recently-published regulations that provide guidance for determining the amount of gain or loss treated as effectively connected with the conduct of a trade or business within the United States under Internal Revenue Code section 864(c)(8). More specifically, the Final Regulations provide guidance regarding when (and how much) a buyer or other transferee must withhold on the transfer of a partnership interest. The separate Internal Revenue Code section 864(c)(8) regulations provide guidance regarding how much US federal income tax the seller or other transferor has to pay on the transfer of a partnership interest, irrespective of whether the buyer was required to withhold on the transfer of the partnership interest.
A buyer or other transferee cannot ignore these rules simply because the transferee thinks it highly unlikely that there would be any gain subject to US tax. As the preamble to the Final Regulations notes, the transferee must presume that a transfer is subject to withholding unless it obtains a certification from the transferor or the partnership establishing otherwise. Granted, a transferee that fails to obtain the required documentation or that does not withhold despite receiving inadequate documentation from the transferor can avoid paying the amount that should have been withheld to the IRS if the transferee establishes that there was no gain subject to US tax. However, proving this to the IRS will be just as difficult, if not more, than obtaining the certification from the transferor. So, failure to obtain the required information prior to sale is risky for a transferee, not matter how “obvious” the lack of US taxation may be to the parties.
Changes from Existing Guidance
The Final Regulations make some welcome changes to the proposed regulations issued in May 2019 (the Proposed Regulations). The changes made by the Final Regulations, however, are relatively minor, and the Final Regulations generally do not relax the measures the Proposed Regulations took to tighten the exceptions to withholding first set forth in Notice 2018-29. Accordingly, buyers and other transferees of partnership interests will need to undertake significant documentation and information-gathering requirements and, if required as a result of the documentation received (or not received), generally withhold at a 10% rate on the amount not just received but deemed to be received by the transferor.
The issuance of the Final Regulations therefore results in two important changes for any buyer or other transferee that may have been following prior guidance. First, the transferor and transferee must follow the rules in the Final Regulations; the transferor and transferee can no longer choose to follow the rules in the Proposed Regulations or Notice 2018-29, whichever is more favorable. Second, the Final Regulations activate the partnership withholding provisions of Internal Revenue Code section 1446(f)(4) which had been suspended by Notice 2018-29. Accordingly, failure by the transferee to comply with the Final Regulations not only will subject the transferee to penalties and interest until the amount required to be withheld is paid to the IRS, but also, beginning in 2022, will subject transferees to withholding on distributions by the partnership.
Exceptions to Withholding
The Final Regulations, like the Proposed Regulations and Notice 2018-29 which preceded them, permit the transferee of a non-publicly-traded partnership not to withhold if the transferee receives any of the following certifications:
- The transferor certifies that the transferor is not a foreign person and provides documentation (e.g., a Form W-9) that states the transferor’s name, Taxpayer Identification Number, and address, and is signed under penalties of perjury.
- The transferor certifies that the transfer of the partnership interest would not result in any realized gain (including ordinary income arising from the application of Internal Revenue Code section 751 and Treasury Regulations section 1.751-1) to the transferor as of the determination date (this will often require the partnership to certify that the transfer of the partnership interest would not result in any ordinary income arising from the application of Internal Revenue Code section 751 and Treasury Regulations section 1.751-1 to the transferor as of the determination date).
- The partnership makes one of the following certifications:
- If the partnership sold all of its assets at fair market value as of the determination date, the partnership would have no gain that would have been effectively connected with the conduct of a trade or business within the United States;
- If the partnership sold all of its assets at fair market value as of the determination date, the partnership would have a net amount of such effectively-connected gain, but the amount of the partnership’s net gain that would have been effectively connected with the conduct of a trade or business within the United States would be less than 10% of the total net gain;
- If the partnership sold all of its assets at fair market value as of the determination date, the transferor would not have a distributive share of net gain from the partnership that would have been effectively connected with the conduct of a trade or business in the United States;
- If the partnership sold all of its assets at fair market value as of the determination date, the transferor would have a distributive share of effectively-connected gain from the partnership, but the transferor’s distributive share of net gain from the partnership that would have been effectively connected with the conduct of a trade or business within the United States would be less than 10% of the transferor’s distributive share of the total net gain from the partnership; or
- The partnership was not engaged in a trade or business within the United States at any time during the taxable year of the partnership through the date of transfer.
- The transferee certifies all of the following:
- The transferor was a partner in the partnership throughout the look-back period (generally transferor’s immediately prior taxable year and the two preceding taxable years);
- The transferor’s distributive share of gross effectively connected income from the partnership, as reported on a Schedule K-1 (or similar statement to be furnished by the partnership) and any gross effectively connected income included in the distributive share of any person related to the transferor (generally, a person that bears a relationship to the transferor described in Internal Revenue Code sections 267(b) or 707(b)(1)), was less than $1 million for each of the taxable years within the look-back period;
- The transferor’s distributive share of gross effectively connected income from the partnership, as reported on a Schedule K-1 (or similar statement required to be furnished by the partnership), for each of the taxable years within the look-back period was less than 10% of the transferor’s total distributive share of gross income from the partnership reported on the Schedule K-1 (or similar statement required to be furnished by the partnership) for that year; and
- The transferor’s distributive share of income or gain from the partnership that is effectively connected with the conduct of a trade or business within the United States or deductions or losses properly allocated and apportioned to that income in each of the taxable years within the look-back period has been reported on a federal income tax return (either filed by the transferor or, in the case of transferor that is a partnership, filed by its direct or indirect nonresident alien individual or foreign corporate partners) on or before the due date (including extensions), and all amounts due with respect to the reported amounts have been timely paid to the IRS, provided that the return was required to be filed when the transferor furnishes the certification (taking into account any extensions of time to file).
- The transferor certifies that the transferor is not required to recognize any gain or loss with respect to the transfer due to a nonrecognition provision of the Internal Revenue Code and describes the transfer and basis for concluding that the transfer is within the nonrecognition provision.
- The transferor certifies (on a Form W-8BEN) that 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 and, within 30 days after the date of the transfer, the transferee mails a copy of the certification to the Internal Revenue Service.
The Final Regulations include a variety of definitions and special rules that must be taken into account in applying these exceptions. These include rules addressing when a transfer is partly (but not wholly) within a nonrecognition provision of the Internal Revenue Code or partly exempt by an income tax treaty.
Other Provisions of the Final Regulations
The Final Regulations address far more than just whether a buyer needs to withhold on its payment to the seller of a partnership interest. The Final Regulations require withholding in certain instances when the partnership is considered the transferee, and they impose specific reporting obligations on the partnership when it is notified by the selling partner of a transfer. The Final Regulations also include rules for determining the base on which the 10% withholding is applied.
Failure of a transferee to comply with these withholding requirements will result in the transferee being subject to withholding on distributions by the partnership under new Treasury Regulations section 1.1446(f)-3. There is an 11-month grace period in the new partnership (as opposed to transferee) withholding rules, however. Unlike the transferee withholding rules, which are effective for transfers on or after January 29, 2021, a partnership’s requirement to withhold under Internal Revenue Code section 1446(f)(4) on distributions to a partner applies to transfers that occur on or after January 1, 2022.
Transferors and, especially, transferees of partnership interests need to understand the impact of the Final Regulations and apply the new rules carefully to their transfers. Transferors will be subject to US withholding tax unless they provide the relevant documentation to the transferee, and transferees will be subject to interest and penalties unless they determine the amount of withholding required and remit it timely. The required documentation will not always be within the possession of the transferor. Non-US owners of interests in entities that are classified as partnerships for US tax purposes (regardless of how the entities are classified for foreign tax purposes) therefore must make sure that those entities can--and will--provide the certifications and information required by the Final Regulations.
- T.D. 9926. ↩
- T.D. 9919. See https://www.federalregister.gov/documents/2020/11/06/2020-21165/gain-or-loss-of-foreign-persons-from-sale-or-exchange-of-certain-partnership-interests.↩
- 84 FR 21198. For a description of the proposed regulations for non-publicly-traded partnerships, see Dentons alert: https://www.dentons.com/en/insights/alerts/2019/may/9/irs-issues-proposed-regulations-on-withholding-requirements-for-transfers-of-partnership-interests.↩
- 2018-16 I.R.B. 495.↩