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IRS Withholding Tax Guidance Helpful, But Not Perfect

Author: Steven D. Bortnick

4/26/2018
IRS Withholding Tax Guidance Helpful, But Not Perfect

This article was published in the April 26, 2018 issue of Middle Market Growth, a weekly newsletter published by Association of Corporate Growth (ACG). It is reprinted here with permission.

As we previously reported, following the tax reform package passed in December, private equity limited partner investors based outside the United States are now subject to tax on gains from the sale of partnership interests. See “Foreign Partners Fall Victim to Tax Reform,” http://middlemarketgrowth.org/foreign-partners-fall-victim-to-tax-reform/. Moreover, transferees of these interests are required to withhold 10 percent of the gross proceeds and remit the proceeds to the IRS. If the transferee fails to withhold, the partnership itself must withhold. A recent IRS Notice attempts to mitigate some of the glaring concerns with the new legislation, including:

  • inclusion of de minimis rules that excuse withholding when ECI is insignificant

  • delay of the requirement for withholding by partnerships whose interests are transferred

  • instructions on how to deal with liabilities

  • specific procedures related to withholding, previously lacking.

While quite helpful in smoothing the way for certain secondaries market transactions, problems still exist and are described in this article.

Lack of Actual Gain

Under the statute, withholding is required even if the transferor would not recognize gain on the transfer. However, under the Notice, the transferee need not withhold if the transferor certifies that the transfer will not result in any recognized gain. Pending additional guidance from the IRS, the transferor need not apply to the IRS for a withholding certificate establishing that no withholding is required (as is required in the case of FIRPTA withholding). Special rules apply if there is gain inherent in the partnership interest, but the gain is not recognized, because the transfer falls into a non-recognition provision. The IRS is considering the proper treatment of non-recognition transactions under the rules requiring foreign partners to pay tax on the transfer of partnership interests.

De Minimis Rules

The statute, as drafted, requires withholding on the transfer of a partnership interest by a foreign person unless none of the gain would be treated as ECI. However, the Notice excuses withholding (but not the requirement that the transferor file a tax return and pay tax on any ECI) in the following instances:

  • The transferor certifies to the transferee that the transferor was a partner in the partnership for the entirety of the tax year preceding the transfer and the two years preceding that year, and the transferor’s allocable share of ECI was less than 25 percent of the transferor’s total distributive share of income for that year. For this purpose, the preceding year is defined as the year for which the Form 8805 and Schedule K-1 were due or filed. Thus, until the Form 8805 and Schedule K-1 for 2017 are due or filed, the de minimis test would be determined looking at the 2016, 2015 and 2014 tax years. The Notice does not provide guidance as to whether the transferee in a tax-free (or other) transaction within the three-year period may provide the certification, even if it has sufficient information to make the certification for all three years. It also does not provide any help when the target partnership has not been in existence for three years.

  • The partnership whose interests are transferred certifies to the transferee that if the partnership had sold all of its assets at their fair market value, the gain that would have been treated as ECI (including FIRPTA gain) would be less than 25 percent of total gain.

The Notice is interim guidance, and indicates that future guidance will reduce the threshold for withholding below the 25 percent amount for purposes of both rules.

Delay in Application to Target Partnerships

While transferees of partnership interests must withhold tax to the extent required by the Notice, partnerships whose interests are transferred will not be required to withhold until regulations (or further guidance) are provided by the IRS.

Liabilities

Liabilities create unique issues for partnerships. Generally, a partner’s basis in its partnership interest includes the partner’s share of liabilities, and the amount realized upon the sale of a partnership interest includes the liabilities that the partner no longer shares. As tax must be withheld on the gross amount recognized on the sale, this includes a partner’s share of liabilities. The Notice provides that the transferee may rely on a certification of either the transferor or the partnership whose interests are transferred to determine the transferor’s share of partnership liabilities.

The transferor certification must be based on the most recently received Schedule K-1 from the partnership for a taxable year that closed no more than 10 months before the transfer date. The transferor also must certify that it does not have actual knowledge of events occurring after the Schedule K-1 was issued that would cause its share of the partnership liabilities to be significantly different (i.e., a difference of more than 25 percent) than the liabilities shown on the K-1. A partner that owned at least 50 percent of the capital, profits, deduction or losses of the partnership in the 12 months preceding the transfer may not issue the transferor certification. In our experience, the 10-month restriction will become an issue for transfers early or late in a year. For example, if a transferor sells its interest in a partnership in February 2019, it will not have received a 2018 K-1, and the 2017 tax year will have closed more than 10 months before the transfer.

The partnership itself may supply a certification that provides the amount of the transferor’s liabilities, which may be based on the most recently issued K-1. The certification also must state that the partnership does not have actual knowledge of events occurring after its determination of the amount of the transferor’s share of partnership liabilities that would cause the liabilities at the time of the transfer to be significantly different (i.e., a difference of more than 25 percent) than the amount shown on the certification.

Absent knowledge of the transferor’s share of liabilities or a certification, the transferee must withhold the entire amount realized, without regard to the liabilities (i.e., all cash and other property).

Certifications Generally

The certifications described herein must be provided no more than 30 days before the transfer. They also must be signed under penalties of perjury. This is standard for certifications that avoid withholding, as well as forms that are filed with the IRS. The attestations of these certifications will be based on the signatories’ knowledge and belief, and are not absolute assurances. Nevertheless, partnerships whose interests are transferred may be hesitant to provide such certifications.

Withholding Procedures

The Notice provides that transferees should withhold and remit tax to the IRS using the rules and forms applicable to FIRPTA withholding (revising such forms to refer to the appropriate Code section). Although these rules generally require tax to be reported and remitted to the IRS within 20 days of the transfer, penalties and interest will not be asserted if the forms are filed and amounts paid over by May 31, 2018.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.