What is the 1446 Withholding Rule?

The 1446 withholding rule, governed by Internal Revenue Code Section 1446(a), is a critical U.S. tax regulation that ensures foreign partners pay U.S. income tax on their share of a partnership's U.S. business income.

Understanding the Core Principle

At its heart, Section 1446 is a mechanism for the U.S. government to collect income tax from foreign persons who derive income from a U.S. trade or business through a partnership. Specifically, a partnership (whether it's based in the U.S. or abroad) that earns income effectively connected with a U.S. trade or business (or income treated as effectively connected) is required to pay a withholding tax. This tax applies to the effectively connected taxable income (ECTI) that is allocated to its foreign partners.

This withholding acts as a prepayment of the foreign partner's U.S. income tax liability. Without such a rule, it would be challenging for the IRS to ensure that foreign partners, who may not otherwise have a U.S. tax filing obligation, fulfill their tax responsibilities.

Who is Affected by Section 1446?

The rule impacts two primary groups:

• Partnerships: Both U.S. domestic and foreign partnerships that generate income effectively connected with a U.S. trade or business are obligated to withhold.
• Foreign Partners: This includes any partner (an individual, corporation, trust, or estate) that is not considered a "U.S. person" for tax purposes. These partners are the ultimate beneficiaries whose share of the ECTI is subject to the withholding.

What is "Effectively Connected Taxable Income" (ECTI)?

ECTI refers to income earned by a partnership from its U.S. trade or business activities. This income is treated as if it were directly earned by a U.S. person and is therefore subject to U.S. income tax. Examples of ECTI often include:

• Income from sales of goods or services within the U.S.
• Rental income from U.S. real estate if considered a trade or business.
• Gains from the disposition of U.S. real property interests.

Withholding Rates

The amount of tax to be withheld under Section 1446 varies depending on the type of foreign partner. For tax years 2023 and 2024, the general withholding rates are:

• 37% for foreign individual partners (the highest individual income tax rate).
• 21% for foreign corporate partners (the corporate income tax rate).

Responsibilities of the Partnership

Partnerships subject to Section 1446 have several key responsibilities:

1. Calculate ECTI: Accurately determine the partnership's effectively connected taxable income.
2. Allocate to Foreign Partners: Identify the portion of ECTI that is allocable to each foreign partner.
3. Withhold Tax: Apply the appropriate withholding rate to each foreign partner's allocable share of ECTI.
4. Deposit Tax: Make timely deposits of the withheld tax with the U.S. Treasury, generally using electronic funds transfer (EFTPS). These deposits are typically due quarterly.
5. File Forms:
   • Form 8804, Annual Return for Partnership Withholding Tax (Section 1446): This form reports the total Section 1446 tax for the partnership's tax year.
   • Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax: A separate Form 8805 must be issued to each foreign partner, providing them with information about the tax withheld on their behalf. This form is crucial for the foreign partner to claim a credit for the withheld tax.
   • Form 8813, Partnership Withholding Tax Payment (Section 1446): This form accompanies each payment of Section 1446 withholding tax.

How Foreign Partners Receive Credit

Foreign partners use the information provided on Form 8805 to claim a credit for the withheld tax on their own U.S. income tax returns (e.g., Form 1040-NR for individuals or Form 1120-F for corporations). The withheld amount reduces their overall U.S. tax liability. If the amount withheld exceeds their actual U.S. tax liability, they may be eligible for a refund.

Penalties for Non-Compliance

Failure to comply with Section 1446 rules, including failing to withhold, failing to deposit tax timely, or failing to file required forms, can result in significant penalties for the partnership. These penalties can include interest and various fines.

Practical Example

Imagine a U.S.-based partnership, "Global Tech Ventures," that operates a software development business in the U.S. One of its partners is "Innovate Global Inc.," a corporation incorporated and tax resident in Ireland.

• In 2023, Global Tech Ventures earns \$1,000,000 in effectively connected taxable income (ECTI).
• Innovate Global Inc. has a 20% interest in the partnership's profits and losses.
• Therefore, \$200,000 (20% of \$1,000,000) of ECTI is allocable to Innovate Global Inc.
• Global Tech Ventures, as the withholding agent, must withhold tax at the corporate rate of 21% on Innovate Global Inc.'s share.
• The withholding tax due is \$42,000 (21% of \$200,000).
• Global Tech Ventures will make quarterly deposits of this tax, file Form 8804 annually, and provide Innovate Global Inc. with Form 8805.
• Innovate Global Inc. will then use this Form 8805 to claim a \$42,000 credit on its U.S. income tax return (Form 1120-F).

Key Aspects of Section 1446 Withholding