With the Internet and constant worldwide connectivity of modern day life, entrepreneurship and business ownership has become global. It is no longer rare for a United States based small business to have a partnership with a foreign company or business owner. With the onset of global partnerships, it is important for business owners to know the tax laws associated with working with a foreign partner. If the proper tax laws and withholding guidelines are not followed, a small business owner can find himself paying an exorbitant amount of taxes or answering to the IRS.
Tax penalties and secondary taxes are never helpful when a business owner is trying to make a profit, so learning how to navigate foreign business tax laws will be crucial to a company’s success. As an experienced tax and accounting firm, we stay on top of all foreign tax laws and regulations to ensure our clients are properly withholding taxes from their foreign partners. Here are two important questions that are frequently asked by small business owners with foreign partners.
What are the general tax rules of a foreign partnership?
Foreign residents are subjected to paying a United States tax when they earn an income that was effectively connected to a United States trade or business. This type of income is called effectively connected income (ECI) and is the most common type of taxation a foreign person must pay. Additionally, a foreign resident will need to pay a United States tax when he or she has earned fixed or determinable annual or periodic (FDAP) income.
ECI net income is taxed using a graduated rate, so the calculation may be different depending on the amount and other circumstances. Gross FDAP income is taxed at a flat rate of 30 percent, unless there is a treaty in place that replaces that standard taxation rate. ECI is not generally subject to withholding when a foreign resident makes a profit. However, if the foreign resident is in a partnership with a United States business or person, the ECI may be subjected to withholding. This ensures the IRS will receive its tax payment before the money leaves the country. For non-corporate partners, the general withholding rate for ECI is 39.6 percent, and for corporate partners, the withholding rate is 35 percent. This withholding serves as a credit towards the taxes the foreign partner will owe on the total ECI, once properly calculated.
What is ECI?
Unfortunately, the definition of ECI is not as cut and dry as “effectively connected income.” There are many IRS regulations in effect that may skew the definition of ECI. For example, income from the disposition of a United States real property interest by a foreign resident is considered ECI and is subject to withholding. The sale of stock in a United States real property investment company by a foreign partner is also considered ECI, and withholding may occur once income is earned. The sale of partnership interest by a foreign partner may also be defined as ECI, and can be subject to withholding. With such a liquid definition of ECI and strict rules on withholding and the taxes that must be paid by foreign partners, it is important for small business owners to consult with a tax professional before completing any business transactions with foreign partners or investors.
If you are currently in business with a foreign partner or considering a foreign partnership, our office can help ensure that you are setting yourself up for a successful year. The IRS tax rules about ECI and FDAP will need to be followed closely so there are no surprises when it is time to file at the end of the year. If you are looking for a tax or accounting professional to assist with your small business or individual taxes and finances, call 212 Tax & Accounting Services today.