Learning About the IRS’ Guidelines for a Foreign Partnership–Especially Foreign Partnership Tax Requirements

While involvement in a foreign partnership is an exciting journey for people to experience, especially with respect to their global purpose and function; figuring out the foreign partnerships’ tax obligations is often complicated and detailed. The Internal Revenue Service (IRS) treatment of foreign partnerships and foreign partnership tax obligations is multifaceted and requires knowledge of what a foreign partnership involves. Understanding what the IRS’ rules are for United States persons involved in foreign partnerships is important in knowing what the foreign partnership tax reporting and requirements entail. This article will explain what the IRS considers a partnership in general, and a foreign partnership in specific. The IRS’ treatment of foreign partnerships will be discussed, along with the required steps for reporting necessary information to the IRS regarding foreign partnership tax obligations. The article will also review IRS form 1065 and IRS form 8865 while also explaining the reasons why IRS form 1065 is filed and why IRS form 8865 is filed.

How Does the IRS Define a Partnership?

The IRS describes a partnership simply as a relationship between two or more people to do a trade or a business together. The partnership concept, as explained by the IRS, is that each person contributes money, property or labor, etc., and the individuals in the partnership share in the profits and losses of the business. Although a foreign partnership sounds much more interesting and exotic, the IRS definition of a foreign partnership is very similar.

What Makes a Partnership a Foreign Partnership According to the IRS?

The IRS considers a foreign partnership to be any partnership which is not created under the laws of the United States. Essentially, a foreign partnership is any business which was formed outside of the U.S. The business is considered a foreign partnership if it has two or more owners. The IRS expounds on the foreign partnership definition by describing that a foreign partnership includes any partnership which is treated as a foreign partnership for income tax purposes.

The IRS has specific regulations regarding how foreign partnerships are treated, and how foreign partnership tax is assessed.

How Does the IRS Treat Foreign Partnerships and Assess Foreign Partnership Tax?

The IRS requires that any U.S. person or U.S. resident who owns an interest in a foreign partnership  is required to report their share of the partnerships’ distributive items, or distributive income. This means the U.S. person is required to report the net amount of income, gain, deduction or loss of the foreign partnership for the tax year in question. The IRS has specific requirements and processes regarding how a foreign partnership is treated and how a foreign partnership tax is determined. Accurately completing and filing IRS form 1065 and IRS form 8865 is critical to the IRS’ process of dealing with foreign partnerships as well as the foreign partnership tax. Further, knowledge of the concept of flow-through entity is important as part of a comprehensive understanding of how the IRS treats foreign partnerships and how foreign partnership tax is assessed. The following are some of the specific ways the IRS treats foreign partnerships.

• Requiring IRS form 1065 to be filed by the foreign partnership. Officially called S. Return of Partnership Income , IRS form 1065 is used to report gains or losses on each foreign partnership tax returns According to the IRS, form 1065 is used by the IRS as an information return form, which means it is used to report the foreign partnerships items of income, gains, losses, deductions, credits etc. as well as other foreign partnership tax information.  The foreign partnership is required to file IRS form 1065
• Requiring partners to file IRS form 1065 (Schedule K-1). While only one IRS form 1065 needs to be filed for the partnership; each partner is required to file with the IRS an individual tax return, IRS form 1065, (Schedule K-1), Partner’s Share of Current Year Income, Deductions, Credits, and Other Items.
• Describing a foreign partnership as a flow-through entity. Interestingly, the IRS does not require a foreign partnership to pay a foreign partnership tax on its income, rather, the foreign partnership tax is passed through to its partners with respect to any profits or losses. This is sometimes called a flow-through entity by tax professionals.
• Taxing partners on profits. The IRS considers a foreign partnership as a flow-through entity for foreign partnership tax purposes.  Investopedia describes a flow-through entity as a business entity which passes any income it earns directly to its partners.  Subsequently, the partners are taxed on the profits, rather than an actual foreign partnership tax being assessed on the foreign partnership. As noted, the necessary information regarding the foreign partnership is provided to the IRS utilizing IRS form 1065.
• Requiring IRS form 8865. As part of the foreign partnership tax process, the IRS requires IRS form 8865 to be filed by any U.S. person who owns an interest in a foreign partnership. Officially called Return of U.S. Person with Respect to Certain Foreign Partnerships , this form is required to be filed to report the activities of the foreign partnership to the IRS. IRS form 8865 is filed with the U.S. persons 1040 IRS form.  The details required on IRS form 8865 are extremely specific and complex. It is definitely recommended to consult with a tax professional prior to filing IRS form 8865.

Understanding the differences between IRS form 1065 and IRS Form 8865 is essential to properly handling foreign partnership tax requirements.

What are the Differences Between IRS Form 1065 and IRS Form 8865 for Foreign Partnership Tax Obligations?

While both IRS forms 1065 and IRS form 8865 are a necessary part of complying with the IRS requirements for foreign partnership tax reporting, there are substantial differences between each form.

• Filed by U.S. persons. IRS form 8865 is filed by U.S. persons who have an interest in a foreign partnership. IRS form 8865 is required by the IRS in order to be able to keep track of U.S. persons who have an interest in a foreign partnership.
• Filed by foreign partnerships. IRS form 1065 is filed for the foreign partnership and only one is required per foreign partnership. As the IRS explains, foreign partnerships do not pay taxes on their income, rather they pass through any profits or losses to the partners.
• Filed by each individual Each partner is also responsible for filing an individual tax return to address their foreign partnership tax and in order to report the individual partners share of income, loss deductions etc. This form is IRS form 1065, Schedule K-1.

As the world has become more interconnected, ownership in foreign partnerships and similar endeavors seems to have also become more common. While the opportunities have grown for global business involvement; also, the IRS’ efforts in monitoring foreign partnerships for compliance have also become more complicated and intense. Understanding the intricacies of the IRS’ foreign partnership tax obligations is complex and challenging. The best strategy for a foreign partner is to focus on the business requirements of the foreign partnership while allowing the international tax experts to figure out the tax obligations. Leave the foreign partnership tax research to the knowledgeable tax professionals at American Expatriate Tax Professionals.