Section 875: Tax Rules for Foreign Partners & Beneficiaries

U.S. tax law has specific provisions for foreign individuals and corporations that invest in domestic partnerships or are beneficiaries of U.S. trusts and estates. A principle of U.S. international taxation is that the business activities of an entity can be attributed to its foreign owners or beneficiaries. This means the U.S. business presence of a partnership or trust can extend to its foreign participants, directly impacting their U.S. tax status.

Attribution of U.S. Business Activities to Foreign Persons

The attribution rule is found in Internal Revenue Code Section 875. This section establishes that if a partnership is engaged in a trade or business within the U.S. (a status known as ETBUS), all its foreign partners are also considered ETBUS. This applies to both nonresident alien individuals and foreign corporations that are partners. The determination of ETBUS status hinges on business activities being “considerable, continuous, and regular,” distinguishing them from isolated transactions.

This attribution principle is not limited to partnerships. A parallel rule applies to foreign beneficiaries of trusts and estates. If a trust or estate is engaged in a U.S. trade or business, any foreign beneficiary is also treated as being engaged in that business. This prevents foreign persons from using a trust or estate to insulate themselves from the tax implications of U.S. business operations.

The result of Section 875 is the attribution of status, not just income. The classification of being engaged in a U.S. trade or business is imputed to the foreign partner or beneficiary. This distinction triggers a range of U.S. tax consequences and filing obligations that would not otherwise apply, effectively treating the foreign person as if they were directly conducting the business activities of the U.S. entity.

Tax Implications of Attributed Business Activities

Once a foreign person is deemed to be engaged in a U.S. trade or business, their share of the income from that entity is generally classified as Effectively Connected Income (ECI). This classification dictates how the income is taxed. ECI is not subject to the flat withholding taxes that apply to more passive forms of income.

The tax treatment of ECI mirrors that for U.S. persons. A nonresident alien individual’s share of ECI is subject to the same graduated tax rates that apply to U.S. citizens and residents. For a foreign corporation, the ECI is taxed at the standard U.S. corporate income tax rate. This system allows income from active business operations to be taxed on a net basis, after deductions.

This method contrasts with the taxation of Fixed, Determinable, Annual, or Periodical (FDAP) income. FDAP income, which includes passive sources like interest and dividends, is typically taxed at a flat 30% rate (or lower by treaty) and collected through withholding at the source. The ECI rules prevent foreign investors from using a partnership or trust to earn active business profits while being subject to the lower tax rates intended for passive investments.

U.S. Filing and Withholding Requirements

The designation as ETBUS and having ECI creates a U.S. tax return filing requirement for the foreign person. This obligation exists regardless of whether tax is due or if a tax treaty exempts the income. A nonresident alien individual must file Form 1040-NR, “U.S. Nonresident Alien Income Tax Return,” to report their ECI. A foreign corporation files Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation.”

Compliance duties also extend to the U.S. partnership. Under Internal Revenue Code Section 1446, the partnership must pay a withholding tax on the ECI allocable to its foreign partners. This withholding is calculated at the highest applicable tax rate—37% for non-corporate partners and 21% for corporate partners. The partnership reports and pays this tax using Form 8804.

The partnership must also provide each foreign partner with Form 8805, “Foreign Partner’s Information Statement of Section 1446 Withholding Tax.” This form details the ECI allocated to the partner and the U.S. tax withheld on their behalf. The foreign partner then claims this withheld amount as a credit against their U.S. tax liability when filing their tax return. This credit mechanism ensures the partner is not double-taxed.