By Cynthia
When nonresident aliens (NRAs) and foreign entities invest in U.S. entities, the tax consequences upon liquidating their interests can vary significantly based on whether the investment is in a partnership, corporation, or LLC. Here’s a detailed analysis:
1. Partnership
Investing in a Partnership:
- Pass-Through Entity: Partnerships are typically treated as pass-through entities for tax purposes. This means the partnership itself is not taxed, but the income is passed through to the partners, who report it on their individual tax returns.
- ECI: If the partnership is engaged in a U.S. trade or business, the NRA’s or foreign entity’s share of the income is considered effectively connected income (ECI) and is subject to U.S. taxation.
Liquidating Partnership Interest:
- ECI on Sale: Under IRC Section 864(c)(8), when an NRA or foreign entity sells their partnership interest, the gain attributable to the partnership’s U.S. trade or business is treated as ECI. This means the gain is subject to U.S. tax.
- Withholding Requirements: IRC Section 1446(f)mandates that the buyer generally withhold 10% of the amount realized when the partnership is engaged in a U.S. trade or business, unless an exception applies — for example, a certification that the ECI would be less than 10% of the gain (Treas. Reg. §1.1446(f)-2(b)). If the partnership holds U.S. real property, IRC §897(g) can also apply.
- Example: If an NRA or foreign entity sells their partnership interest for $1,000,000, and $600,000 is deemed ECI, the buyer must withhold $100,000. The seller must report the $600,000 ECI on their U.S. tax return and pay tax on it.
2. Corporation
Investing in a Corporation:
- Corporate Tax: The corporation itself pays taxes on its income at the corporate tax rate of 21%.
- Dividends: Dividends paid to foreign shareholders are subject to a 30% withholding tax unless reduced by an applicable tax treaty.
Liquidating Corporate Stock:
- Capital Gains Tax: Generally, capital gains from the sale of U.S. corporation stock by an NRA or foreign entity are not subject to U.S. tax unless the corporation owns U.S. real property (USRPI) under IRC Section 897(FIRPTA).
- FIRPTA Withholding: If the corporation owns U.S. real estate, the buyer must withhold 15% of the amount realized on the sale.
- Example: If an NRA or foreign entity sells stock in a U.S. corporation for $2,000,000, and the corporation is a U.S. real property holding corporation — U.S. real property makes up at least 50% of its real property and business assets (IRC §897(c)(2)) — the buyer must withhold $300,000. Note also that a redemption of stock can be taxed as a dividend (IRC §302), and an NRA present in the U.S. 183 days or more in the year is taxed on U.S.-source capital gains (IRC §871(a)(2)). If the corporation does not own U.S. real estate, the gain is not subject to U.S. tax.
3. LLC
Investing in an LLC:
- Tax Election: An LLC can choose to be taxed as a partnership or a corporation. If taxed as a partnership, the same rules as above for partnerships apply. If taxed as a corporation, the corporate rules apply.
- ECI: For an NRA or foreign entity investing in an LLC taxed as a partnership, their share of the income from a U.S. trade or business is ECI.
Liquidating LLC Interest:
- As a Partnership: The gain from the sale of an LLC interest taxed as a partnership is treated as ECI if the LLC is engaged in a U.S. trade or business, subject to the same rules and withholding requirements under IRC Section 864(c)(8)and Section 1446(f).
- As a Corporation: If the LLC is taxed as a corporation, the sale of LLC membership interests is treated similarly to the sale of corporate stock, with FIRPTA withholding applying if the LLC owns U.S. real estate.
- Example: If an NRA or foreign entity sells their interest in an LLC taxed as a partnership for $1,000,000, and $600,000 is ECI, the buyer must withhold $100,000. If the LLC is taxed as a corporation and owns significant U.S. real estate, the buyer must withhold 15% of the sale price. If the LLC is taxed as a corporation and does not own significant U.S. real estate, then the capital gains from the sale are not subject to U.S. tax.
How the taxable amount on a partnership sale is measured
Section 864(c)(8) does not tax the whole gain automatically. It asks a hypothetical question: if the partnership had sold all of its assets at fair market value on the day you sold your interest, how much of your share of that gain would have been effectively connected with its U.S. business? Only that amount, and no more than your actual gain, is treated as ECI. If the partnership holds a lot of foreign assets, or assets with little built-in gain, the ECI piece can be much smaller than the total gain. Getting a deemed-sale computation from the partnership before closing is the single most useful thing a foreign seller can do.
What if the buyer does not withhold?
The 10% is withheld from the amount realized, not from the gain, so it can be far more than the tax actually owed. The seller then files a U.S. return and claims a refund of the excess. If the buyer fails to withhold, the statute shifts the job to the partnership: it must withhold the missing amount, plus interest, from future distributions to the buyer (IRC §1446(f)(4)). Buyers and partnerships therefore tend to insist on the paperwork, and foreign sellers should expect it.
Ways to reduce or avoid the 10% withholding
The regulations allow the buyer to rely on certain certifications instead of withholding the full 10% (Treas. Reg. §1.1446(f)-2(b)). The main ones are:
- the seller certifies that it is not a foreign person;
- the seller certifies that it has no realized gain on the sale;
- the partnership certifies that, on a deemed sale of its assets, effectively connected gain would be less than 10% of the total gain;
- the seller certifies that its share of effectively connected income from the partnership was less than 10% of its total share in each of the prior three tax years, and it held the interest throughout that period;
- the seller certifies that the transfer qualifies for nonrecognition, or that a tax treaty exempts the gain.
A foreign seller can also give the buyer a certification of its maximum tax liability, which caps the withholding at the tax it actually expects to owe (Treas. Reg. §1.1446(f)-2(c)(4)). Each certification has its own content and timing rules, so they should be prepared with the purchase agreement, not on the closing date.
Corporations: the five-year look-back and the “cleansing” rule
Whether a U.S. corporation is a U.S. real property holding corporation is tested over the shorter of the seller’s holding period or the five years before the sale (IRC §897(c)(1)(A)(ii)). A company that sold its last building two years ago can still be a USRPHC today. There is an exception: if the corporation holds no U.S. real property interests on the date of the sale, and every interest it held during the look-back period was disposed of in a transaction in which all gain was recognized, its stock is no longer a U.S. real property interest (IRC §897(c)(1)(B)). The exception does not apply if the corporation or a predecessor was a RIC or a REIT during that period.
Liquidating a U.S. subsidiary into a foreign parent
When a U.S. corporation liquidates into its 80% parent, the parent normally takes the assets tax-free under IRC §332, and the subsidiary recognizes no gain under §337. But when the parent is a foreign corporation, §367(e)(2) turns off the §337 nonrecognition rule, except as regulations provide. In practice, the U.S. subsidiary is generally taxed as if it sold its appreciated assets, and the regulations carve out limited exceptions, for example for certain U.S. real property and for property the foreign parent will keep using in a U.S. business. A foreign group that plans to wind up a U.S. subsidiary should model this before deciding whether to sell the stock, sell the assets or liquidate.
Summary
- Partnership: Gain from the sale is ECI, subject to withholding.
- Corporation: Capital gains generally not subject to U.S. tax unless USRPI is involved, with potential FIRPTA withholding.
- LLC: Tax consequences depend on whether the LLC is taxed as a partnership or a corporation, following the respective rules.
Additional Considerations for Foreign Entities
- Tax Treaties: Many countries have tax treaties with the U.S. that can affect withholding rates and tax obligations. Foreign entities should consult these treaties to understand potential benefits and obligations.
- Reporting and Compliance: Foreign entities must ensure proper reporting and compliance with U.S. tax regulations to avoid penalties and ensure efficient tax management.
