Section 1446 Withholding: What Partnerships Need to Know

Foreign partners in U.S. partnerships are subject to tax withholding rules under Section 1446 of the Internal Revenue Code. This ensures the IRS collects taxes on income connected to a U.S. trade or business, even if the foreign partner does not file a U.S. tax return. Partnerships must comply with these rules to avoid penalties and ensure proper tax reporting.

Understanding Section 1446 is essential for partnerships with foreign investors. Compliance involves determining which income requires withholding, calculating the correct amounts, and meeting reporting obligations.

Partnerships Subject to Section 1446

Any partnership with foreign partners must determine if it falls under Section 1446 withholding requirements. This applies to both domestic and foreign partnerships that generate income connected to a U.S. trade or business.

A domestic partnership includes entities formed under U.S. law, such as limited liability companies (LLCs) classified as partnerships for tax purposes. If these entities earn income connected to a U.S. business and have foreign partners, they must withhold tax on the foreign partner’s share. Foreign partnerships, organized outside the U.S., must also withhold if they have effectively connected income (ECI) and at least one foreign partner.

Withholding is required whether or not the partnership distributes the income. Even if earnings remain in the business, the IRS mandates withholding based on the foreign partner’s allocable share to prevent deferring U.S. tax liabilities.

Types of Income Requiring Withholding

Partnerships must withhold tax on income effectively connected with a U.S. trade or business when allocated to a foreign partner. This includes revenue from services performed in the U.S., rental income from real estate, and gains from selling business assets. Unlike passive income such as dividends or interest—subject to different withholding rules—ECI arises from active business operations and is covered by Section 1446.

Real estate transactions frequently trigger withholding. If a partnership owns rental properties, net income after expenses is considered ECI and must be allocated accordingly. Gains from selling U.S. real estate are also taxable to foreign partners and require withholding under the Foreign Investment in Real Property Tax Act (FIRPTA).

Some income, even if not traditionally business-related, still requires withholding. For example, income from licensing intellectual property or leasing equipment within the U.S. is classified as ECI. Even if a foreign partner resides outside the U.S. and is not involved in daily operations, their share of these earnings remains subject to withholding.

Determining the Withholding Amount

Calculating the correct withholding involves identifying the foreign partner’s allocable share of taxable income and applying the appropriate tax rate. The baseline rate is generally the highest applicable to the partner’s classification—37% for individuals and 21% for corporations in 2024. If a partner qualifies for a lower rate due to deductions or credits, the partnership must still withhold at the statutory rate unless the partner provides documentation supporting a reduction.

Adjustments may be needed when a partnership projects annualized income. If a foreign partner’s estimated taxable income changes significantly, withholding may need recalculating. Partnerships can use Form 8804-C, “Certificate of Partner-Level Items to Reduce Section 1446 Withholding,” to request a reduction if a foreign partner demonstrates a lower actual tax liability. The IRS requires substantial supporting evidence, such as prior-year tax returns or estimated payments, before approving a reduction.

Reporting Requirements

Compliance with Section 1446 includes timely and accurate reporting to the IRS and foreign partners. Partnerships must file Form 8804, “Annual Return for Partnership Withholding Tax (Section 1446),” summarizing the total tax withheld for the year. This form is due by the 15th day of the third month after the partnership’s tax year ends—March 15 for calendar-year partnerships. Form 8805 must also be provided to each foreign partner, detailing their share of withheld tax, which they can claim as a credit on their U.S. tax return.

In addition, partnerships must make quarterly estimated tax payments using Form 8813. These payments are due on the 15th day of the fourth, sixth, ninth, and twelfth months of the tax year. Late payments can result in penalties and interest under IRC 6655. The IRS may assess penalties based on the amount underpaid and the duration of the shortfall, making it essential for partnerships to monitor income projections throughout the year.

Distribution Procedures for Foreign Partners

Partnerships must withhold the required tax before distributing cash or property to foreign partners. The withheld amount is remitted to the IRS, and the foreign partner receives the net distribution. If a partnership fails to withhold correctly, it may be held liable for the unpaid tax, along with penalties and interest.

For non-cash distributions, such as real estate or partnership interests, the fair market value of the property determines the withholding amount. If the value exceeds the partner’s share of previously withheld tax, additional withholding may be required. Foreign partners can later claim a credit for the withheld tax on their U.S. tax return, potentially receiving a refund if their actual liability is lower than the amount withheld.