IRS Delays New Withholding Requirement for Dispositions of Publicly Traded Partnership Interests

In response to public comments, the IRS today issued Notice 2018-08 that delays indefinitely withholding under new Code section 1446(f) with respect to dispositions of certain publicly traded partnerships.  Section 13501 of the enacted tax reform bill added a new Code section 1446(f) to impose a 10% withholding requirement on the amount of gain treated as effectively connected income under new Code section 864(c)(8).  (See earlier coverage here.)  Code section 864(c)(8) treats a portion of the gain or loss on the sale or exchange of a partnership interest by a foreign person as effectively connected income if that partnership is engaged in a U.S. trade or business.   The new provisions are generally effective for sales and exchanges on or after November 27, 2017, and the withholding provisions are effective for sales or exchanges after December 31, 2017.

 

In recognition of the significant practical problems that withholding under section 1446(f) with respect to the disposition of publicly traded partnership interests (such as the inability of the transferee to determine whether the transferor is foreign or domestic or whether any amount would be treated as effectively connected income).  The legislation addresses this by permitting a broker to deduct and withhold on behalf of the transferee for dispositions of publicly traded partnerships through a broker.  However, new withholding and reporting systems will be required before such withholding can be effectuated.

 

Notice 2018-08 provides that withholding will not be required under new section 1446(f) with respect to the disposition  publicly traded partnership interests until regulations or other guidance have been issued.  Withholding is required, however, with respect to dispositions of non-publicly traded partnership interests.  According to the notice, future regulations or guidance under section 1446(f) with respect to dispositions of publicly traded partnerships will be prospective and include transition rules to allow sufficient time for implementation.

Analysis of the Final Tax Reform Bill – Part III: New Source Rules and Tax Reporting and Withholding Requirements

On December 15, the House-Senate Conference Committee released the joint explanatory statement and final legislative text (the “Final Bill”) resolving differences between the House- and Senate-passed versions of the Tax Cuts and Jobs Act (the “House Bill” and “Senate Bill,” respectively).  The provisions of the Final Bill related to health reform, equity and executive compensation, deductions and exclusions for employee meals and other fringe benefits, private retirement plan benefit, paid leave, and various reporting, withholding, and income sourcing rules, largely track the bill passed by the Senate.  Many of the changes included in the House Bill but not the Senate Bill were dropped from the Final Bill. (Our earlier coverage of the House and Senate bills can be seen in a series of posts here.)

This post is the third in a series of three posts analyzing provisions of the Senate Bill. (Part I analyzes the elimination of the penalty for failing to maintain minimum essential coverage under the ACA and changes to equity and executive compensation.   Part II analyzes changes to deductions and exclusions for employee meals and other fringe benefits, changes to private retirement plan benefits, and a new paid leave credit.)

This post analyzes the new reporting and withholding requirements and source rules. Specifically, the Senate Bill will: change the methodology for determining the appropriate amount of federal income tax withholding on wages; require reporting for deductible amounts paid with respect to fines and penalties; require reporting for certain life insurance transactions; modify the reporting rules for Alaska Native Corporations; modify the sourcing rule for sale of inventory items; (f) modify the sourcing rule for U.S. possessions; and impose withholding under section 1446 for sale of an interest in a U.S. partnership by a foreign person that is treated as effectively connected income under new Code section 864(c)(8).

These changes generally will be effective after 2017, except as otherwise noted below.

Wage Withholding. The Final Bill follows the Senate Bill and will raise the standard deduction and suspend personal exemptions, which currently allow individuals to reduce their taxable income.  However, the suspension of personal exemptions will no longer apply for tax years beginning after December 31, 2025.  In recognition of the suspension of personal exemptions, the Final Bill will also change the method of determining the proper amount of federal income tax withholding on an employee’s wages, a change not reflected in the House or Senate bills.  Under current law, the amount of wages taken into account for withholding purposes is the amount by which the wages exceed the number of withholding exemptions claimed, multiplied by the amount of one such exemption, the value of which equals one personal exemption under Code section 151(b).  The Final Bill will amend Code section 3402(a)(2) to require withholding on the amount by which wages exceed the employee’s withholding allowance prorated to the payroll period.  The Final Bill amends Section 3402(f) to instruct the Treasury to issue regulations specifying the methodology for determining an employee’s withholding allowance based on (A) whether the employee can be claimed as a dependent on another return; (B) whether the employee’s spouse is entitled to a withholding allowance (if the spouse does not have in effect a Form W-4 claiming the allowance); (C) the number of individuals for whom the employee may be entitled to a credit under Code section 24(a); (D) any other allowances that the employee elects to take into account (such as estimated itemized deductions, estimated tax credits, and additional deductions); (E) the standard deduction allowable to the employee (one-half the standard deduction in the case of married employee whose spouse is receiving wages); and whether the employee has a Form W-4 in effect for more than one employer.

These changes will likely require the IRS to develop a new Form W-4, and employers to collect new Forms W-4 from employees.  As highlighted in an earlier post, the IRS has indicated that it is delaying its annual update to guidance on employer withholding pending the passage of tax reform.   The IRS has indicated that transition relief will be provided.

Withholding on Periodic Payments from Retirement Plans.  In recognition of the elimination of personal exemptions, the Final Bill instructs the Treasury to promulgate regulations for determining the amount of federal income tax to withhold on periodic payments from a qualified retirement plan, IRA, or other account subject to withholding under section 3405(a) when no Form W-4P is in effect.  Under current law, such payments were subject to wage withholding as though the payee was a married individual with 3 withholding exemptions.

Reporting of Deductible Amounts Paid with Respect to Fines and Penalties.  As in the Senate Bill, the Final Bill will adopt a new Code section 6050X requiring government agencies (or entities treated as government agencies) to report to the IRS and taxpayer on a new information return the amount of each settlement agreement or order entered into, where the aggregate amount required or directed to be paid or incurred exceeds a threshold ($600 in the statute, but subject to adjustment by Treasury).  The return must identify any amounts for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement. These changes will generally apply to amounts paid or incurred on or after the date of enactment, except that the changes will not apply to binding orders or agreements entered into or subject to court approval before that date.

Reporting of Certain Life Insurance Transactions. As in the Senate Bill, the Final Bill will also adopt a new Code section 6050Y that will create a new information reporting requirement for certain life insurance contract transactions. This includes: (a) a return filed and furnished by every person who acquires a life insurance contract or any interest in a life insurance contract in a “reportable policy sale”; (b) a return filed and furnished by each issuer of a life insurance contract upon notice of a transaction reported under (a); and (c) a return filed and furnished by every payor of “reportable death benefits.”  A “reportable policy sale” is generally the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship to the insured.  A “reportable death benefit” is an amount paid by reason of death of the insured under a life insurance contract that was transferred in a reportable policy sale.  The buyer must file the return required under (a) with the IRS and furnish copies of the return to the insurance company that issued the contract and the seller.  The insurance company that bears the risk with respect to a life insurance contract that receives a copy of a return required under (a) must file the return required under (b) with the IRS and furnish a copy of the return to the seller.  The payor insurance company must file the return required under (c) with the IRS and furnish a copy of the return to the payee.  The reporting requirements will apply for reportable death benefits paid and reportable policy sales after 2017.

Reporting Requirements of Alaska Native Corporations. Under current law, Alaska Native Corporations may deduct donations of cash or assets to “settlement trusts,” which are entities that manage Native lands.  Section 13821(c) of the Final Bill follows the Senate Bill and modifies the reporting requirements imposed on Native Corporations with respect to such deductions.  Specifically, Native Corporations that have made contributions to a settlement trust and elected to deduct those contributions will be required to provide the settlement trust a statement regarding the election not later than January 31 of the calendar year after the calendar year in which the contribution was made.  The statement will be required to include: (i) the amount of the contribution to which the election applies; (ii) whether the contribution was made in cash; (iii) for contributions of property other than cash, certain details about the property; (iv) the date of the contribution; and (v) any other information required by Treasury.

Sourcing Rule for Sale of Inventory Property. Under Code section 863(b), sales of inventory property produced in one jurisdiction and sold in another are currently sourced by allocating 50% of the sales income to one jurisdiction and 50% to the other.  Like the House and Senate Bills, Section 14304 of the Final Bill will change this sourcing rule so that the entire amount will be sourced to the jurisdiction of production.

Sourcing Rule for U.S. Possessions. As in the Senate Bill, Section 14503 of the Final Bill will change two provisions affecting the sourcing rules related to U.S. possessions.  First, Code section 937(b), which controls whether income of U.S. citizens and residents is treated as possession source income, generally provides that income treated as U.S. source or effectively connected with a U.S. trade or business is not treated as income from sources within a possession or effectively connected with a trade or business in that possession.  The bill will amend Code section 937(b)(2) so that only U.S. source or effectively connected income attributable to a U.S. office or fixed place of business is excluded from possession source income.  Second, the bill will amend Code section 865, which sets forth the sourcing rules for personal property sales, so that capital gains earned by a U.S. Virgin Islands resident would always be U.S. Virgin Islands source income.

Withholding on Gain from the Sale by Foreign Persons of Interests in Certain Partnerships. Section 13501 of the Final Bill follows the Senate Bill and adds a new Code section 864(c)(8) that treats a portion of the gain or loss on the sale or exchange of a partnership interest by a foreign person as effectively connected income if that partnership is engaged in a U.S. trade or business. Under the provision, if a foreign corporation or nonresident alien individual owns, directly or indirectly, an interest in a partnership engaged in a U.S. trade or business, a portion of the gain or loss on the sale or exchange of such interest is treated as effectively connected with the conduct of a U.S. trade or business to the extent such gain or loss does not exceed: (1) in the case of a gain, the portion of the partner’s distributive share of the amount of gain which would have been treated as effectively connected if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange of the partnership interest (or zero, if no such deemed sale would have been effectively connected) or (2) in the case of a loss, the portion of the partner’s distributive share of the amount of loss on the deemed sale described in (1) which would have been effectively connected (or zero, if no such deemed sale would have been effectively connected).  The gain or loss treated as effectively connected under the provision is reduced by the amount so treated with respect to United States real property interests under section 897.

The Final Bill will also amend Code section 1446 to impose a 10% withholding requirement on the amount of gain treated as effectively connected income under Code section 864(c)(8), similar to the existing rules under Code section 1445. Upon request by the transferor (generally, the seller) or the transferee (generally, the buyer), the Treasury may prescribe a reduce rate of withholding if the Secretary determines it is appropriate.  In addition, no withholding is required if a transferor furnish to the transferee an affidavit signed under penalty of perjury stating that the transferor is not a foreign person and providing the transferor’s U.S. TIN.  In the absence of such an affidavit (or if the transferee has actual knowledge that a provided affidavit is false or receives a notice from the transferor’s agent or transferee’s agent that such affidavit is false, similar to agent’s notice obligations under section 1445(d)), the transferee of the partnership interest is liable for satisfying the withholding obligation, but in the event that the transferee fails to withhold the required tax, the partnership must withhold an amount equal to the amount the transferee failed to withhold (plus interest) from distributions to the transferee.  The Final Bill clarifies the grant of authority to the Secretary of the Treasury, instructing the Secretary to issue regulations appropriate to implement the new section.  Specifically, the conferees intend that the Secretary may issue guidance permitting a broker, as agent of the transferee, to perform the 10 percent withholding with respect to a partnership interest.

The changes will generally be effective for sales and exchanges on or after November 27, 2017, though the Final Bill provides that the withholding provisions are effective for sales or exchanges after December 31, 2017.

Analysis of the Senate Tax Reform Bill – Part III: New Source Rules and Tax Reporting and Withholding Requirements

Early Saturday morning, the Senate voted 51-49 to approve a modified version of the Tax Cuts and Jobs Act (the “Senate Bill”). The Senate Bill differs from the House bill (discussed in an earlier series of posts here) passed last month in several respects, and a final negotiated bill will need to pass both chambers before the President can sign it into law. Given the difficulty of moving legislation through the Senate, it seems likely that any enacted legislation would likely be similar to the version passed by the Senate.

This post is the third in a series of three posts analyzing provisions of the Senate Bill. (Part I analyzes the elimination of the penalty for failing to maintain minimum essential coverage under the ACA and changes to equity and executive compensation.   Part II analyzes changes to deductions and exclusions for employee meals and other fringe benefits, changes to private retirement plan benefits, and a new paid leave credit.)

This post analyzes the new reporting and withholding requirements and source rules. Specifically, the Senate Bill would: (a) eliminate personal exemptions for income tax purposes but retain them for income tax withholding purposes; (b) require reporting for deductible amounts paid with respect to fines and penalties; (c) require reporting for certain life insurance transactions; (d) modify the reporting rules for Alaska Native Corporations; (e) modify the sourcing rule for sale of inventory items; (f) modify the sourcing rule for U.S. possessions; and (g) impose withholding under section 1446 for sale of an interest in a U.S. partnership by a foreign person that is treated as effectively connected income under new Code section 864(c)(8).

These changes generally would be effective after 2017, except as otherwise noted below.

Withholding Exemptions. The Senate Bill would raise the standard deduction and eliminate personal exemptions, which currently allow individuals to reduce their taxable income.  However, section 11041(c) of the Senate Bill would keep the value of the personal allowance in place for purposes of determining the correct amount of federal income tax withholding.

Reporting of Deductible Amounts Paid with Respect to Fines and Penalties. As we previously covered, section 13306(b) of the Senate Bill would adopt a new Code section 6050X requiring government agencies (or entities treated as government agencies) to report to the IRS and taxpayer on a new information return the amount of each settlement agreement or order entered into, where the aggregate amount required or directed to be paid or incurred exceeds a threshold ($600 in the statute, but subject to adjustment by Treasury).  The return must identify any amounts for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement. These changes would generally apply to amounts paid or incurred on or after the date of enactment, except that the changes would not apply to binding orders or agreements entered into or subject to court approval before that date. The House bill did not include any similar provision.

Reporting of Certain Life Insurance Transactions. As we previously covered, section 13520 of the Senate Bill would also adopt a new Code section 6050Y that would create a new information reporting requirement for certain life insurance contract transactions. This includes: (a) a return filed and furnished by every person who acquires a life insurance contract or any interest in a life insurance contract in a “reportable policy sale”; (b) a return filed and furnished by each issuer of a life insurance contract upon notice of a transaction reported under (a); and (c) a return filed and furnished by every payor of “reportable death benefits.”  A “reportable policy sale” is generally the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship to the insured.  A “reportable death benefit” is an amount paid by reason of death of the insured under a life insurance contract that was transferred in a reportable policy sale.  The buyer must file the return required under (a) with the IRS and furnish copies of the return to the insurance company that issued the contract and the seller.  The insurance company that bears the risk with respect to a life insurance contract that receives a copy of a return required under (a) must file the return required under (b) with the IRS and furnish a copy of the return to the seller.  The payor insurance company must file the return required under (c) with the IRS and furnish a copy of the return to the payee.  The reporting requirements would apply for reportable death benefits paid and reportable policy sales after 2017. The House bill did not include any similar proposal.

Reporting Requirements of Alaska Native Corporations. Under current law, Alaska Native Corporations may deduct donations of cash or assets to “settlement trusts,” which are entities that manage Native lands. Section 13821(c) of the Senate Bill would modify the reporting requirements imposed on Native Corporations with respect to such deductions. Specifically, Native Corporations that have made contributions to a settlement trust and elected to deduct those contributions would be required to provide the settlement trust a statement regarding the election not later than January 31 of the calendar year after the calendar year in which the contribution was made. The statement would be required to include: (i) the amount of the contribution to which the election applies; (ii) whether the contribution was made in cash; (iii) for contributions of property other than cash, certain details about the property; (iv) the date of the contribution; and (v) any other information required by Treasury.

Sourcing Rule for Sale of Inventory Property. Under Code section 863(b), sales of inventory property produced in one jurisdiction and sold in another are currently sourced by allocating 50% of the sales income to one jurisdiction and 50% to the other.  Section 14304 of the Senate Bill would change this sourcing rule so that the entire amount would be sourced to the jurisdiction of production.

Sourcing Rule for U.S. Possessions. Section 14503 of the Senate Bill would change two provisions affecting the sourcing rules related to U.S. possessions.  First, Code section 937(b), which controls whether income of U.S. citizens and residents is treated as possession source income, generally provides that income treated as U.S. source or effectively connected with a U.S. trade or business is not treated as income from sources within a possession or effectively connected with a trade or business in that possession.  The Senate Bill would amend Code section 937(b)(2) so that only U.S. source or effectively connected income attributable to a U.S. office or fixed place of business is excluded from possession source income.  Second, the Senate Bill would amend Code section 865, which sets forth the sourcing rules for personal property sales, so that capital gains earned by a U.S. Virgin Islands resident would always be U.S. Virgin Islands source income.

Withholding on Gain from the Sale by Foreign Persons of Interests in Certain Partnerships. Section 13501 of the Senate bill would add a new Code section 864(c)(8) that treats a portion of the gain or loss on the sale or exchange of a partnership interest by a foreign person as effectively connected income if that partnership is engaged in a U.S. trade or business. Under the provision, if a foreign corporation or nonresident alien individual owns, directly or indirectly, an interest in a partnership engaged in a U.S. trade or business, a portion of the gain or loss on the sale or exchange of such interest is treated as effectively connected with the conduct of a U.S. trade or business to the extent such gain or loss does not exceed: (1) in the case of a gain, the portion of the partner’s distributive share of the amount of gain which would have been treated as effectively connected if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange of the partnership interest (or zero, if no such deemed sale would have been effectively connected) or (2) in the case of a loss, the portion of the partner’s distributive share of the amount of loss on the deemed sale described in (1) which would have been effectively connected (or zero, if no such deemed sale would have been effectively connected).  The gain or loss treated as effectively connected under the provision is reduced by the amount so treated with respect to United States real property interests under section 897.

The Senate Bill would also amend Code section 1446 to impose a 10% withholding requirement on the amount of gain treated as effectively connected income under Code section 864(c)(8), similar to the existing rules under section 1445. Upon request by the transferor (generally, the seller) or the transferee (generally, the buyer), the Treasury may prescribe a reduce rate of withholding if the Secretary determines it is appropriate.  In addition, no withholding is required if a transferor furnish to the transferee an affidavit signed under penalty of perjury stating that the transferor is not a foreign person and providing the transferor’s U.S. TIN.  In the absence of such an affidavit (or if the transferee has actual knowledge that a provided affidavit is false or receives a notice from the transferor’s agent or transferee’s agent that such affidavit is false, similar to agent’s notice obligations under section 1445(d)), the transferee of the partnership interest is liable for satisfying the withholding obligation, but in the event that the transferee fails to withhold the required tax, the partnership must withhold an amount equal to the amount the transferee failed to withhold (plus interest) from distributions to the transferee.

The changes would generally be effective for sales and exchanges on or after November 27, 2017.

IRS Issues Regulations Relating to Employees of Disregarded Entities

Yesterday, Treasury and the IRS released final and temporary regulations under Section 7701 meant to clarify issues related to the employment of owners of disregarded entities.  In 2009, the IRS issues regulations that required disregarded entities be treated as a corporation for purposes of employment taxes including federal income tax withholding and Federal Insurance Contribution Act (FICA) taxes for Social Security and Medicare.  The regulations provided that a disregarded entity was disregarded, however, for purposes of self-employment taxes and included an example that demonstrated the application of the rule to an individual who was the single owner of a disregarded entity.  In the example, the disregarded entity is treated as the employee of its employees but the owner remains subject to self-employment tax on the disregarded entity’s activities.  In other words, the owner is not treated as an employee.

Rev. Rul. 69-184 provides that partners are not employees of the partnership for purposes of FICA taxes, Federal Unemployment Tax Act (FUTA) tax, and federal income tax withholding.  This is true even if the partner would qualify as an employee under the common law test.  This made it difficult—if not impossible—for partnerships to allow employees to participate in the business with equity ownership such as options even if the employee owned only a very small portion of the partnership.  The 2009 regulations raised questions, however, provided some hope that a disregarded entity whose sole owner was a partnership could be used to as the employer of the partnership’s partners. Doing so would have allowed partners in the partnership to be treated as employees of the disregarded entity and participate in tax-favored employee benefit plans, such as cafeteria plans.  The final and temporary regulations clarify that that an individual who owns and portion of a partnership may not be treated as an employee of the partnership or of a disregarded entity owned by the partnership.

As a result, payments made to partners should not be reported on Form W-2, but should be reported on Schedule K-1.  Such payments are not subject to federal income tax withholding or FICA taxes, but will be subject to self-employment taxes when the partner files his or her individual income tax return.  In addition, if partners are currently participating in a disregarded entity’s employee benefit plans, such as a health plan or cafeteria plan, the plan has until the later of August 1, 2016, or the first day of the latest-starting plan year following May 4, 2016.