In Part 1, we reviewed the tax structures available to many U.S. businesses (C-corporation, S-corporation, or Partnerships) faced with answering the question, “do you plan to include a Non-U.S. Investor in your Business?” We also discussed the fact that a U.S. business with a foreign investor is not eligible to elect to be taxed as an S-corporation. Instead, it must choose between being taxed as a C Corporation (should it organize as a Corporation) or a Partnership (should it organize as a General Partnership, Limited Partnership, or Limited Liability Company).
If the business is taxed as a C-Corporation, the presence of a foreign investor will not make much of a difference to the operations of the business. The business will still pay tax on its own income at the corporate tax rates. The investors will not be taxed unless there are dividends.
However, in some situations the overall tax burden will be lower if the business is taxed as a Partnership. This is because a partnership does not pay tax on its income—instead, each Partner reports his or share of the Partnership’s income on his or her personal return. For example, a Partner who owns a 25% interest in a Partnership with taxable income of $100,000 will report $25,000 of that income on the Partner’s tax return. This is true even if no distributions are made to the partners.
While most Partners would likely prefer to receive distributions to cover their tax liabilities, there may be circumstances—such as the need to pay off a maturing loan or make a capital investment—that prevent a profitable Partnership from amassing enough cash to make any Partner distributions. If all of the Partners are U.S. taxpayers (i.e., U.S. citizens, permanent resident aliens, or businesses domiciled in the U.S.), this is perfectly acceptable from a Partnership tax point of view (if not from the point of view of the Partners). After all, the Partners, not the Partnership, have to come up with the money to pay the tax.
But the situation becomes more complicated if the Partnership includes any non-U.S. Partners. While each Partner is still ultimately responsible for his or her share of the Partnership’s taxable income, the Partnership is required by Section 1446 of the Internal Revenue Code to withhold and pay over an amount equal to the foreign Partner’s share of the Partnership’s net income multiplied by the highest marginal income tax rate in effect—currently 39.6% for individuals. The idea is that the non-U.S. Partner can recover the difference between the amount withheld and his or her actual tax liability by filing a U.S. federal tax return. (Of course, this assumes that the partnership’s taxable income is treated as effectively connected to a U.S. trade or business—a subject that is beyond the scope of this discussion.)
But while “all’s well that ends well” in the sense that the non-U.S. investors will end up paying no more than their fair share of Partnership taxes, the practical effect of this requirement is that the Partnership must maintain enough cash on hand to pay the required tax withholdings. From the Partnership’s perspective, the withholding requirement really amounts to mandatory cash distributions to the non-U.S. Partners via the IRS. And a Partnership that makes distributions to its non-U.S. Partners (by way of the IRS) will need to make pro-rata distributions to its U.S. Partners. The alternative is to risk violating the rights of the U.S. Partners (who generally have the right to be treated the same as any other Partners) and upsetting the carefully-calibrated system of capital accounts provided by the Internal Revenue Code to track the distributions made to each Partner and each Partner’s share of taxable income.
This is just a basic overview and is not legal advice specific to your situation. If you would like to speak with Jonathan about your situation, please email him at email@example.com or call him at 925-217-3255.