US residents and citizens pay taxes on their worldwide income, and special rules apply when there is substantial US ownership in foreign business entities such as partnerships or corporations. This article will discuss the specific laws and policies governing how controlled foreign partnerships (CFPs) are taxed. US persons with ownership interests in a CFP may be subject to additional tax obligations, such as filing Forms 8865 or 5471, both of which carry substantial penalties if missed. The IRS closely monitors these partnerships to prevent tax avoidance and evasion by US taxpayers. Thus, stakeholders must understand the complexities of IRS regulations on CFPs and which forms must be filed, as noncompliance can result in significant tax consequences.
Key Takeaways
- A foreign partnership is classified as a controlled foreign partnership (CFP) if more than 50% of its interests, either in terms of value or voting power, are owned by U.S. individuals who each own 10% or more of the partnership at any point during its tax year.
- Foreign partnerships, including CFPs, are exempt from federal income taxation. CFP’s income, gains, losses, deductions, and other credits pass through directly to partners, who must report their share of the partnership’s tax items in their tax returns and pay any tax due.
- A CFP with “effectively connected income” or “US source income” is generally required to file Form 1065.
- US partners of CFP are required to file Forms 8865 or 5471, depending on how the foreign partnership is structured in the country of organization.
What is a controlled foreign partnership (CFP)?
A controlled foreign partnership (CFP) is a foreign partnership that has US persons who own 10% or more of the foreign partnership and collectively own greater than 50% of the partnership’s interests on any given day during its taxable year.
What is the definition of a foreign partnership?
A “foreign partnership” is generally defined by the IRC as one that is not formed or organized in the United States or under the laws of any state in the Union. Limited partnerships and LLCs organized in foreign countries are typically considered corporations rather than partnerships under US law.
Definition of Partnership for US tax purposes
The Internal Revenue Code (IRC) defines a “partnership” as any syndicate, group, pool, joint venture, or other unincorporated organization that is not a corporation, trust, or estate and through which any kind of business, financial operation, or venture is conducted. A partnership is when two or more individuals enter into business together as opposed to as a corporation. Limited liability companies (LLCs) owned by two or more individuals in the United States are treated as partnerships for tax purposes by default, whereas foreign LLCs are treated as corporations.
Tax Obligations of Controlled Foreign Partnership (CFP)
Federal Income Tax
A foreign partnership with US citizens as owners must file an informational return, but the partnership is exempt from paying federal tax on its income. Instead, the CFP’s income, gains, losses, deductions, and other credits are passed on to the partners, who must report their portion of the partnership’s tax items on their tax returns and pay any applicable taxes.
Withholding on a Foreign Partner’s Effectively Connected Taxable Income
IRC Section 1446 requires the partnership to report and pay a withholding tax to the IRS if the CFP has taxable income related to conducting business or trade with the US that can be allocated to a foreign partner. This requirement applies regardless of the foreign partners’ final U.S. tax liability and whether the partnership distributes any money to them during the tax year. The withholding tax rate is contingent upon whether the foreign partner is a corporation, in which case it is 21%, the highest tax rate allowed under IRC 11(b). In the case of non-corporate foreign partners, the rate is 37%, the highest tax rate specified in IRC 11.
The amount a partnership must withhold is based on the effectively connected taxable income that is allocable to its foreign partners for the tax year. The following is deducted from the foreign partner’s portion of the partnership’s gross effectively connected income:
- The partner’s share of partnership deductions connected to that income for the year, and
- The partner’s tax treaty benefits relate to that income.
If a nonresident alien partner’s investment in the partnership is the only activity producing effectively connected income and the IRC section 1446 tax is less than $1,000, the partnership is not required to withhold.
Withholding on a Foreign Partner’s Fixed or Determinable Annual or Periodic Income (FDAP)
A partnership may have to withhold a 30% tax on a foreign partner’s gross distributive share of FDAP not effectively connected with a U.S. trade or business, as well as any other FDAP income paid to a foreign person, regardless of whether he is a partner.
Tax Obligations of US Partners of CFP
Partnership Income Inclusion
A US citizen is generally liable for worldwide income taxes, which also applies to US individuals who are partners in foreign partnerships (including CFPs). Thus, US persons who are partners in a CFP must include their share of the partnership’s income on their US tax returns, regardless of whether the income is distributed or not. If not registered in the foreign country as a limited partnership, then the CFP will file Form 8865 to pass through the partnership income to the US persons.
Controlled Foreign Corporation (CFC)
When a foreign partnership is a limited partnership or LLC in a foreign country, it is treated as a corporation for US tax purposes and reported in the owners’ tax returns using Form 5471. Subpart F income, which includes passive income like dividends, interest, rent, and some gains, is the usual classification for this type of income.
Global Intangible Low-Tax Income (GILTI)
GILTI generally refers to the foreign income CFCs receive from intangible assets like copyrights, trademarks, and patents. Shareholders of CFCs who own 10% or more of a CFC are subject to the GILTI Tax, which is levied at ordinary income rates on US individuals and 10.5% on US corporations.
Tax Obligations of Foreign Partners of CFP
Foreign partners are only taxed on income earned from sources within the United States by the foreign partnerships. Different tax rates apply depending on the kind of income received within the US. Tax treaties between the United States and their home countries also come into play.
Foreign partners of CFPs who are nonresident aliens are subject to two different rates.
- Unless a tax treaty specifies a lower tax rate, the gross FDAP income not substantially related to a trade or business in the US is subject to a flat rate of 30%. Non-residents are ineligible to claim standard deductions and tax credits that are typically available to citizens and resident aliens.
- The ECI (after allowable deductions) and personal service income earned in the U.S., such as wages or self-employment income, are taxed at the same graduated or progressive rates that apply to US persons.
Tax Filing Requirements of Controlled Foreign Partnership
Foreign partnerships, including CFPs, are typically required to file an annual information return on Form 1065 if their gross income is “effectively connected with the conduct of a trade or business within the U.S.” or if their gross income is derived from U.S. sources.
Under the First Exception to General Rule—Foreign Partnerships with US Partners, a CFP is not required to file Form 1065 if:
- It had no ECI during its tax year.
- Its US source income was $20,000 or less during the taxable year.
- Less than 1% of any partnership item of income, gain, loss, deduction, or credit was allocable in the aggregate to direct US partners at any time during its tax year,
- A foreign partnership that has signed a withholding agreement with the Internal Revenue Service is not the same as a foreign partnership that is subject to withholding.
Here is a list of some forms to be filed by a controlled foreign partnership.
| Form | Deadline For Filing | Penalties |
| Form 1065 (US Return of Partnership Income) | – Generally, by the 15th day of the 3rd month following the date its tax year ended. – For calendar year: March 15 – If a due date falls on a Saturday, Sunday, or legal holiday, file by the next business day. | – $220 for each month or part of a month (for a maximum of 12 months), the failure continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due. |
| Schedule K-1 (The Partner’s Share of Income, Deductions, Credits, etc.) | – Partners must receive their K-1 by March 15. | – $290 penalty for each Schedule K-1 that the partnership failed to provide on time or did not contain all of the required information, with a maximum penalty of $3,352,500 for all such failures. – If the requirement to report correct information in K-1 is willfully disregarded, each $290 penalty is increased to $580 or 10% of the total amount of the items required to be reported, whichever is greater. When there is willful disregard, the penalty has no upper limit. – If a partnership with more than 100 partners is required to file their return electronically and fails to do so, a penalty of $260 will be assessed for each Schedule K-1 over 100. |
| Schedule K-2 (Partner’s Distributive Share Items–International) | – By the due date of Form 1065 (including extensions). | – Schedule K-2 is subject to the same penalties as Form 1065. |
| Schedule K3 (Partner’s Share of Income, Deductions, Credits, etc.–International) | – By the due date (including extensions) of Form 1065. | – Schedule K-3 is subject to the same penalties as Schedule K-1. |
| Form 7004 (The Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns) | – By the due date (including extensions) of Form 1065. | |
| Beneficial Ownership Information (BOI) | – The first BOI report is due before January 1, 2025, if the reporting company was established, incorporated, or registered before January 1, 2024. – The initial BOI report is due 30 days after the secretary of state or a comparable body confirms (actually or through public notice) the reporting company’s formation, incorporation, or registration if it happened after January 1, 2024. | – In willful attempts to provide false or fraudulent beneficial ownership information to FinCEN, or in willful failure to provide FinCEN with complete or updated BOI, you may be penalized with up to $500 for each day the violation persists, or you may be criminally penalized with up to $10,000 in fines and/or two years in jail. |
| Form 8804 (Annual Return for Partnership Withholding Tax) | – Generally, on or before the 15th day of the 3rd month following the close of the partnership’s tax year. | – For each month (or a portion of a month) that the return is late, 5% of any unpaid withholding taxes will be assessed, with a maximum of 25% of the unpaid taxes. If filed more than 60 days late, the minimum penalty will be $450 or the amount of any tax owed, whichever is smaller. |
| Form 8805 (The Foreign Partner’s Information Statement of Section 1446 Withholding Tax) | – On or before the 15th day of the 3rd month following the close of the LLC’s tax year. | – $290 for each failure to file a correct Form 8805, with a maximum penalty of $3,532,500. |
| Form 8813 (Partnership Withholding Tax Payment Voucher) | – File on or before the 15th day of the 4th, 6th, 9th, and 12th months of the partnership’s tax year. | – ½ of 1% of the unpaid tax for each month or part of a month that the tax is unpaid. – The penalty can’t exceed 25% of the unpaid tax. – The partnership may be liable for paying the tax, penalties, and interest. |
Tax Filing Requirements of U.S. Partners of Controlled Foreign Partnership
- Form 1040, U.S. Individual Income Tax Return
- The due date is April 15.
- 5% of the taxes that are not paid for each month or portion of a month will be charged if a tax return is filed late without a valid reason. The penalty cannot exceed 25% of your unpaid taxes.
- A 5% combined penalty is imposed for each month or portion of a month that your return is late. If a penalty for both failing to file and failing to pay is assessed in the same month, the amount of the failure to file penalty is deducted from the penalty for failing to pay.
- If you still haven’t paid after five months, the Failure to File penalty will max out, but the Failure to Pay penalty continues until the tax is paid, up to its maximum of 25% of the unpaid tax as of the due date.
- If the return is more than 60 days late, the minimum failure to file penalty is the amount shown below or 100% of the underpayment, whichever is less.
- Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return
- To get an automatic 6-month extension, file Form 4868 by the due date of Form 1040.
- Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. If the foreign partnership is organized as a limited partnership or LLC in the foreign country, Form 5471 is filed. Certain US persons serving as officers, directors, or shareholders in foreign corporations use it. To comply with Sections 6038 and 6046’s reporting requirements and the associated regulations, the form and schedules are utilized.
- Deadline: File your income tax return by the due date (including extensions) and include Form 5471.
- Penalties:
- Failure to timely file a Form 5471 is typically subject to a $10,000 penalty per information return.
- If the failure continues for more than 90 days after the date the IRS has mailed a notice of the failure, an additional $10,000 penalty will apply for each 30-day period, or a portion thereof, during which the failure continues after the 90-day period has expired. The additional maximum penalty is limited to $60,000 per return.
- Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships
- Form 8865 must be filed by any US citizen who is a partner in a general liability foreign partnership, whether it is registered or not. This is to show their interest in the partnership and other details about controlled foreign partnerships (IRC Section 6038), transfers to foreign partnerships (IRC Section 6038B), and acquisitions, dispositions, and changes in foreign partnership interests (IRC Section 6046A).
- There are four (4) categories of US persons who are required to file Form 8865:
- Category 1 Filers: A US citizen who, at any point during the partnership’s tax year, controlled the foreign partnership is classified. Control of a foreign partnership is defined as having ownership of more than 50% of the partnership.
- Category 2 Filers: Any US person who, at any point during the foreign partnership’s tax year, held a 10% or larger interest in the company while it was controlled by US citizens who each held a minimum of 10% of the company
- Category 3 Filers: Any US person who contributed property to a foreign partnership during their tax year in exchange for an interest in the partnership, provided they either immediately owned at least 10% of the partnership or their contribution valued more than $100,000 when added to all other property they gave to the partnership during the 12-month period ending on the transfer date.
- Category 4 Filers: US persons who, during their tax year, experienced a reportable event under Internal Revenue Code Section 6046A, which typically involves certain acquisitions, dispositions, and changes in proportionate interests with regard to a foreign partnership.
- You must submit all the necessary paperwork for each category you qualify for if you meet more than one requirement for a specific foreign partnership. The schedules required for each category of filer are listed in the Filing Requirements for Categories of Filers chart on the IRS website.
- Deadline: File by the tax return’s due date (including extensions).
- Penalties:
- $10,000 per year for each partnership return that is not filed.
- If a 10% partner contributes property to a foreign partnership without disclosing the transfer, they could be fined 10% of the transferred amount up to $100,000.
Can Cleer help us file our CFP income tax return?
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If you need assistance on how to navigate the very complex multi-tiered income tax system of being a foreign founder in the US, schedule a consultation, or feel free to contact us and let our team of tax professionals take care of your tax needs.
