On May 7, 2019, the IRS issued proposed regulations that provide guidance for provisions enacted as part of the Tax Cuts and Jobs Act. The 2017 provisions impose US income tax on non-US partners selling interests in partnerships that are considered to be engaged in the conduct of a trade or business in the United States and impose withholding obligations of buyers of such interests.

Generally, under new Internal Revenue Code Section 864(c)(8), a non-US person who owns an interest in a partnership (or another entity, such as a limited liability company, that is classified as a partnership for US tax purposes) is subject to US income tax on a portion of the gain from the sale of its partnership interest. The new gain recognition rule applies to the extent the non-US person would have been subject to US income tax on its share of “effectively connected income” (ECI) had the partnership sold all of its assets at their fair market value on the date of the sale of the partnership interest.

Recognizing that non-US persons may not have much of an incentive to file US tax returns and pay tax on gain from the sale of a partnership interest, the Tax Cuts and Jobs Act also added Internal Revenue Code Section 1446(f). This section turns the buyer of the partnership interest (or, for a partnership distribution in excess of the partner’s basis, the partnership, and, in the case of certain sales of interests in publicly traded partnerships, a broker or clearing organization) into a tax collector: Unless an exception applies, the transferee partner must withhold 10 percent of the sales proceeds and remit this withheld amount to the IRS.

The proposed regulations build on two previously issued notices, Notice 2018-08 and Notice 2018-29, that were intended to provide guidance—and, in some cases, relief—to buyers of partnership interests. In particular, Notice 2018-29 provided exceptions to a buyer’s obligations to withhold. Under the notice, the transferee partner generally need not withhold if any of the following apply:

• The transferor partner is a US person
• The transferor partner realized no gain on the transfer
• The transferee partner receives a certification from the partnership that, if the partnership sold all of its assets at fair market value, the amount of net ECI from the deemed sale would be less than 25 percent of the total net gain
• The transferor partner’s distributive share of ECI during the previous three taxable years was less than 25 percent of the transferor’s total distributive share income in each year
• The transfer of the partnership interest was tax-free for US tax purposes

The proposed regulations retain, but tweak, these exceptions. For example, the proposed regulations clarify that a valid IRS Form W-9 is sufficient to certify the transferor partner’s non-foreign status. The proposed regulations also clarify that, with respect to the second exception above, even if a transferor does not have a net gain upon the disposition of an interest, withholding is still required if the transferor has ordinary income arising from the application of the “hot asset” provisions.

One change goes beyond a tweak, however. While Notice 2018-29 suggested that follow-up guidance might reduce the thresholds in the third and fourth exceptions above, the proposed regulations do just that, reducing these thresholds to 10 percent and thus making these exceptions a little harder to meet.

In addition, compared to the notices, the proposed regulations would make several significant changes.

• They activate the partnership withholding provision that Notice 2018-29 suspended. To ensure that transferee partners properly withhold, Section 1446(f)(4) requires the partnership to withhold on distributions to the transferee partner until the entire amount of the amount that should have been withheld, plus interest, is remitted to the IRS.
• They impose a requirement that the transferring partner notify the partnership within 30 days of transfer.
• They permit non–publicly traded partnerships flexibility in determining which date to use to make certain measurements for withholding tax purposes.
• To reduce over-withholding in certain circumstances, the proposed regulations establish a procedure to limit the amount withheld to the transferor partner’s “maximum tax liability,” based on the gain allocable to the transferor partner.
• If the amount to be withheld exceeds the amount of cash to be received in the transfer, the amount realized is determined without regard to any decrease in the transferor partner’s share of partnership liability.

The proposed regulations generally do not apply until they are finalized. Accordingly, in most cases, buyers can continue to rely on Notice 2018-29, with its more generous safe harbors and lack of partnership withholding mechanism. However, partners should assume that the IRS will move to finalize these regulations and that the tougher rules will apply to transfers of partnership interests, possibly even later this year.

Non-US owners of interests in entities that are classified as partnerships for US tax purposes (regardless of how they are classified for foreign tax purposes) that earn, directly or indirectly, ECI therefore should make sure that the entities in which they are invested can comply with the requirements in the proposed regulations. Otherwise, they may get stuck with higher or unnecessary withholding when final regulations are issued. Similarly, any non-US person considering investment in a partnership that may earn ECI (through however many tiers) needs to make sure that the partnership can provide the certifications and information required by the proposed regulations.

In short, the partnership needs to be able to tell the transferring partner the amount of ECI the partner would have on a deemed sale of partnership assets at a given point in time. Providing this information is likely an unwelcome burden on a partnership, especially a foreign partnership with only indirect links to the United States. However, if a non-US partner cannot obtain the needed information from the partnership, it is the partner that pays the US tax price.