An In Depth Look at the IRS Form 8865 and the Foreign Partnership Reporting Provisions of the Internal Revenue Code

By Anthony Diosdi

This article discusses most of the Form 8865 questions and schedules. This article is designed to supplement the instructions promulgated by the Internal Revenue Service (“IRS”) for Form 8865. Foreign partnerships controlled by U.S. persons have informational reporting requirements that are similar to the information reporting rules that have been applied to controlled foreign corporations or CFCs. Under Internal Revenue Code Section 6038(a), a U.S. partner that controls a foreign partnership must annually file a Form 8865 with the IRS. A U.S. partner is considered to be in control of a foreign partnership if the U.S. partner holds, directly or indirectly, a greater than 50 percent interest in the capital, profits, or, to the extent provided in the regulations, deductions or losses of the partnership. See IRC Section 6038(e)(3). Where there is no single controlling partner, but the partnership is controlled by a number of U.S. persons each holding at least a 10 percent interest in the partnership, similar reporting is required of one or more of the 10 percent U.S. partners. See IRC Section 6038(a)(5).

The IRS may assess civil and/or criminal penalties for failure to comply with the international informational return filing requirements of Sections 6038. A civil penalty may be assessed for failing to file, or for delinquent, incomplete or materially incorrect filing of a Form 8865. Internal Revenue Code Section 6038 imposes a flat penalty of $10,000 per tax year for which failure exists, with additional $10,000 penalties accruing (ninety days after notification of failure by the IRS) every thirty days thereafter to a $50,000 maximum. There may also be an additional 5 percent reduction of foreign tax credits made for each 3-month period, or fraction thereof for 90 days.

Furthermore, there are reporting requirements for U.S. persons who transfer property to a foreign partnership. These reporting requirements apply if the U.S. person owns, directly or indirectly, at least 10 percent interest in the partnership. Any person that fails to properly report a contribution to a foreign partnership that is required to be reported under Section 6038B and the regulations under that section is subject to a penalty equal to 10 percent of the fair market value of the property at the time of the contribution. This property is subject to a $100,000 limit, unless the failure is due to intentional disregard. In addition, any person who fails to report all the information requested by Internal Revenue Code Section 6046A is subject to a $10,000 penalty. If the failure continues for more than 90 days after the IRS mails notice of the failure, an additional $10,000 penalty will apply for each 30 day period (or fraction thereof) during which the failure continues after the 90 day period has expired.

The Form 8865 consists of a number of schedules such as Schedule B, K and K-1, K-3, L, M-1, and M-2. Whether or not a filer of a Form 8865 is required to complete a specific schedule depends on a category of filer can be classified. Currently, there are four general categories of filers. They are:

Category 1- A Category 1 filer is a U.S. person who controls the foreign partnership at any time during the partnership’s tax year. Control of a partnership is ownership of more than a 50 percent interest in the partnership. A Category 1 filer also includes a U.S. transferor who must report certain information to a Section 721(c) partnership for the tax year of contribution and subsequent years. (The Section 721(c) regulations generally provide that a U.S. transferor must recognize gain upon the transfer of appreciated property (tangible or intangible property) to certain partnerships whose partners include foreign persons related to the U.S. Transferor).

Category 2- A Category 2 filer is a U.S. person who at any time during the tax year of the foreign partnership owned a 10 percent or greater interest in the partnership while the partnership was controlled by U.S. persons each owning at least a 10 percent interest. However, if the foreign partnership had a Category 1 filer at any time during that tax year, no person will be considered a Category 2 filer.

Category 3- A Category 3 filer is a U.S. person who contributed property during that person’s tax year to a foreign partnership in exchange for an interest in the partnership (a Section 721 transfer), if that person either: 1) Owned directly or constructively at least a 10 percent interest in the foreign partnership immediately after the contribution, or 2) The value of the property contributed (when added to the value of any other property contributed to the partnership by such person, or any related person, during the 12-month period ending on the date of transfer) exceeds $100,000.

If a domestic partnership contributes property to a foreign partnership, the domestic partnership’s partners are considered to have transferred a proportionate share of the contributed property to the foreign partnership. However, if the domestic partnership files Form 8865 and properly reports all the required information with respect to the contribution, its partners will not be required to report the transfer.

Category 3 filer also includes a U.S. person that previously transferred appreciated property to the partnership and was required to report that transfer under Section 6038B, if the foreign partnership disposed of such property while the U.S. person remained a direct or indirect partner in the partnership.

Category 4- A Category 4 filer is a U.S. person that had a reportable event under Section 6046A (A “reportable event” occurs if a U.S. person acquires a direct 10-percent (or greater) interest in a foreign partnership, or experiences a 10 percent (or greater) proportional change in any such direct interest). There are three categories of reportable events under Section 6046A: acquisition, dispositions, and change in proportional interests.

Acquisitions- A U.S. person that acquires a foreign partnership interest has a reportable event if: 1) the person did not own a 10 percent or greater interest in the partnership and, as a result of the acquisition, the person owns a 10 percent or greater direct interest in the partnership. For purposes of this rule, an acquisition includes an increase in a person’s direct proportional interest; or 2) compared to the person’s direct interest when the person last had a reportable event, after the acquisition the person’s direct interest has increased by at least a 10 percent interest.

Dispositions- A U.S. person that disposes of a foreign partnership interest has a reportable event if: 1) the person owned a 10 percent or greater direct interest in the partnership before the disposition and, as a result of the disposition, the person owns less than a 10 percent direct interest. For purposes of this rule, a disposition includes a decrease in a person’s direct proportional interest; or 2) compared to the person’s direct interest when the person last had a reportable event, after the disposition the person’s direct interest has decreased by at least a 10 percent.

Changes in proportional interests- A U.S. person has a reportable event if compared to the person’s direct proportional interest the last time the person had a reportable event, the person’s direct proportional interest has increased or decreased by at least the equivalent of a 10 percent in the partnership.

Exceptions to Filing

If during the year of the foreign partnership more than one U.S. person qualifies as a Category 1 filer, only one of these Category 1 partners is required to file Form 8865. A U.S. person with a controlling interest in the losses or deductions of the partnership is not permitted to be the filer of Form 8865 if another U.S. person has a controlling interest in capital or profits. A U.S. person who qualifies for this exception to the Category 1 filing requirement would still have to file a separate Form 8865 if that person is also subject to the filing requirements of Category 3 or 4.

Constructive Ownership in a Partnership

Internal Revenue Code Section 318 treats an individual as “owning” another entity that is actually owned by various related parties. The attribution rules in Section 318 fall into the following categories.

Family Attribution. An individual is considered as owning stock owned by his spouse, children, grandchildren, and parents.

Entity to Beneficiary Attribution. Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in the proportion to their beneficial interests.

Beneficiary to Entity Attribution. Stock owned by partners is considered as owned by the partnership.

A Category 1 or 2 filer that does not own a direct interest in the partnership and that is required to file this form solely because of constructive ownership from a U.S. person(s) is not required to file Form 8865 if: 1) Form 8865 is filed by the U.S. person(s) through which the indirect partner constructively owns an interest in the foreign partnership; 2) The U.S. person through which the indirect partner constructively owns an interest in the foreign partnership is also a constructive owner and meets all the requirements of this constructive ownership filing exception, or 3) Form 8865 is filed for the foreign partnership by another Category 1 filer under the multiple Category 1 filers exception.

A Category 1 or 2 filer that does not own a direct interest in the partnership

Members of an Affiliated Group of Corporations Filing a Consolidated Return

If one or more members of an affiliated group of corporations filing a consolidated return qualify as Category 1 or 2 filers for a particular foreign partnership, the common parent corporation may file one Form 8865 on behalf of all the members of the group required to report.

Relief for Category and 2 Filers When the Foreign Partnership Files Form 1065

If a foreign partnership files Form 1065 for its tax year, Category 1 and 2 filers may use a copy of the completed Form 1065 schedules in place of the equivalent schedules of Form 8865.

A Closer Look at the Form 8865’s Questions

Page 1 and 2 Part H.

Question 5. Asks the preparer of the Form 8865 during the year, did the foreign partnership pay or accrue any interest or royalty for which the deduction was not allowed under Section 267A? Question 5 also asks the preparer of the Form 8865 to enter the amount of the deduction disallowed.

Line 5 was added to Form 8865 to aid reporting under Section 267A. The 2018 Tax Cuts and Jobs Act added new Section 267A, which states that a deduction for certain interest or royalty paid or accrued to a related party pursuant to a hybrid transaction or by, or to, a hybrid entity may be disallowed to the extent the related party, under its laws, does not include in income or is allowed a deduction with respect to the amount. The term, “hybrid entity” includes an entity that is fiscally transparent for U.S. federal income tax purposes, but is regarded for foreign law purposes.

The final Section 267A regulations provide the “exclusive circumstances in which a deduction is disallowed under Section 267A.” See Treas. Reg. Section 1.267A-1(b). First, the Section 267A deduction disallowance applies to “specified parties” only. A “specified party” is defined as any one of the following: a “tax resident of the United States; a controlled foreign corporation; or a U.S. taxable branch.”

A specified party’s deduction for any interest or royalty, paid or accrued, is disallowed under Section 267A if it qualifies as a “specified payment.” A “specified payment” is the amount paid or accrued with respect to the specified party. The 267A regulations describe three types of “specified payments:” 1) a “disqualified hybrid amount; 2) a “disqualified imported mismatch amount;” and 3) payments that satisfy the requirements of the Section 267A anti-avoidance rule.

The 2018 Proposed Regulations disallowed a deduction for any specified payment to the extent that the specified payment produced a “deduction/no-inclusion” (“D/NI”) outcome as a result of a hybrid or branch arrangement. Several provisions of the 2018 Proposed Regulations addressed long-term deferral, which results when there is deferral beyond a taxable period ending more than 36 months after the end of the specified party’s taxable year. In addition, the 2018 Proposed Regulations deemed a specified payment made pursuant to a hybrid transaction if differences between the U.S. tax law and the tax law of a specified recipient of the payment (such as differences in tax accounting treatment) resulting in more than a 36 month deferral between the time the deduction would be allowed under U.S. tax law and the time the payment was taken into account in income under the specified recipient’s tax law. Furthermore, a D/NI outcome is considered to occur with respect to a specified payment if under a relevant foreign tax law the payment is not included in income within the 36-month period. The final Section 267A regulations retain most of the long-term provisions. See Baker McKenzie, Tax News and Developments North America, May 15, 2020 Jeff Rubinger and Summer Ayers LePREE.

In general, the 2018 Proposed Regulations provided that a disregarded payment was a disqualified hybrid amount to the extent it exceeded the specified party’s dual inclusion amount. For this purpose, an item of income of a specified party was dual inclusion income only if it was included in the income of both the specified party and the tax resident or taxable branch to which the disregarded payment was made. In response to a comment, Treasury and the IRS concluded in the final Section 267A regulations that an item of income of a specified party should be dual inclusion income even though, by reason of a participation exemption or other relief particular to a dividend, the item is not included in the income of the tax resident taxable branch to which the disregarded payment is made, provided that the application of the participation exemption or other relief relives double taxation. The final regulations provide a similar rule.

The Section 267A anti-avoidance rules, as it appears in the final Section 267A regulations, disallows a specified party’s deduction for a specified payment to the extent that the payment satisfies the following test: 1) the payment (or income attributable to the payment) is not included in the income of a tax resident or taxable branch under Treas. Reg. Section 1.267A-3(a); and 2) “A principal purpose of the terms or structure of the arrangement (including the form and the tax laws of the parties to the arrangement) is to avoid the application of the regulations in this part under Section 267A in a manner that is contrary to the purpose of Section 267A and the regulations in this part under Section 267A.

If the filer paid or accrued interest or royalty for which a deduction is not permitted under Section 267A, the preparer should check “Yes” next to Question 5 and state the amount that is disallowed under Section 267A.

Question 6. Asks if the partnership is a Section 721(c) partnership. In order to answer this question, it is important to understand the Section 721(c) rules. These rules provide that if a U.S. person contributes appreciated property to a foreign partnership, the U.S. person will be allocated any gain when the foreign partnership disposes of that appreciated property. Internal Revenue Code 721(c) empowers the Treasury Department to write regulations dealing with an outbound transfer to a foreign partnership. Under Section 721(c), a U.S. taxpayer will realize gain when he or she contributes “Section 721(c) property” to a “Section 721(c) partnership.” Section 721(c) property is, generally, appreciated property. A Section 721(c) partnership is a partnership in which the U.S. taxpayer and one or more related foreign persons own 50 percent or more of the partnership interest. The regulations under Section 721(c) also expands the definition of a Section 721(c) partnership. Under the regulations, a Section 721(c) partnership is a partnership in which the contributing U.S. taxpayer and one or more foreign persons own 80 percent or more of partnership interests. A taxpayer owns interests that it actually and constructively owns. The taxpayer’s constructive ownership is determined under Section 267.

If the partnership was a Section 721(c) partnership, the preparer should check “Yes” for Question 6.

Question 7. Asks if there were any special allocations made by the foreign partnership.
Under Section 702(a) of the Internal Revenue Code, each partner is required to take into account his or her distributive share of separately stated items and nonseparately computed income or loss. Unless otherwise provided in the Internal Revenue Code, a partner’s “distributive share” of these items is determined by the partnership agreement. If the partnership agreement is silent on the issue, the partners’ distributive shares are determined in accordance with their interests in the partnership.

A special allocation is a financial arrangement that is set up in a partnership that restructures the manner in which profits and losses are distributed to the partners in a way that does not correspond to their actual percentage interests in the partnership.

If the partnership made any special allocations during the tax year, the preparer should check “Yes” for Question 7.

Question 8. Asks the preparer to enter the number of Forms 8858 that are attached to this return. A Form 8858 is filed for foreign disregarded entities. The Form 8858 is a disclosure form for U.S. taxpayers who have formed a business entity outside of the U.S. that can be treated as a disregarded entity for U.S. income tax purposes. A disregarded entity is one that is not seen as a separate entity from its owner. In other words, all income and expenses of the foreign company are considered the income and expenses of the owner.

If the filer filed any Form 8858s during the tax year, the number of Form 8858 should be disclosed to the IRS for Question 8.

Question 9. Asks how is the partnership classified under the law of the country in which it’s organized? The characterization of foreign business entities will have an important impact on U.S. taxes for U.S. participants. A U.S. partner in a foreign partnership (or a U.S. member of a foreign limited liability company that is treated as a partnership for U.S. tax purposes) will be taxed immediately on its share of the entity’s income. In some instances, an entity that is characterized as a company under the laws of the country where it is organized (such as a civil law limited liability company) may nevertheless be characterized as a partnership, and therefore not a taxpayer, for U.S. tax purposes.

For Question 9, the preparer should state how the partnership is classified under the law of the country in which it is organized.

Question 10a and 10b. Asks if the filer has an interest in the foreign partnership or an interest through the foreign partnership, that’s attributable to a foreign branch and if the separate unit had a dual consolidated loss. Defining a foreign branch that may be subject to the consolidated rules is no simple matter. But, it is necessary to understand how to answer Questions 10a and 10b. In order to answer question 10a and 10b, the preparer must understand the rules governing dual consolidated losses. Opportunities for tax savings through international tax arbitrage can arise when there are inconsistencies between the rules in two relevant countries for determining the residence of corporations. For example, a corporation organized in the United States is treated as a U.S. resident, subject to U.S. tax on its worldwide net income with losses whenever incurred being deductible. Under Section 1501 of the Internal Revenue Code, a U.S. corporation is permitted to file a consolidated tax return with other U.S. corporations in an affiliated group. An affiliated group consists of one or more chains of U.S. corporations connected by stock ownership (in some cases excluding preferred stock) of at least 80 percent of the vote and value with a common parent. If two or more U.S. corporations are members of an affiliated group that files a consolidated return, the losses of any one of the group generally may offset eliminate tax on the income of another member of the group.

Inconsistencies arise because some other countries use criteria other than place of incorporation to determine whether a corporation is a domestic resident for their tax purposes. For example, countries, such as the United Kingdom and Australia, treat a corporation as a domestic resident if it is managed or controlled there, regardless of where the corporation is incorporated. If a corporation is a resident under this test, it will typically be taxed by the country of residence on its worldwide net income with losses wherever incurred being deductible. If certain conditions are met, these countries allow losses of a resident corporation to reduce or eliminate tax on income of other commonly controlled domestic corporations. See generally Staff of Joint Comm. on Tax’n, 100th Cong., 1st Sess., General Explanations of the Tax Reform Act of 1986, at 1063 (1987).

Because of the application of differing criteria for determining corporate residence it is possible for a U.S. corporation to incorporate a foreign subsidiary under the laws of a foreign country that determines the residence of a corporation not on the basis that it is incorporated there but on the basis of where the corporation’s management or control is located. If the foreign corporation’s top management is located in the United States, the corporation might be exempt from income tax in the United States and in the country in which it is incorporated.

A dual resident corporation is frequently the U.S. parent corporation of one affiliated group of corporations in the United States and another affiliated group in the foreign country that also treats the group as a taxable resident. Such a dual resident corporation might find opportunities to engage in “double-dipping” with respect to losses and expense items that may be deducted under the tax laws of both the United States and the foreign country concerned.

To deal with the double-dip international tax arbitrage opportunities for dual resident corporations, Congress enacted Internal Revenue Code Section 1503(d). Section 1503(d) provides that the dual consolidated loss of a dual resident corporation for any tax year cannot reduce the taxable income of any other U.S. member of the affiliated group for that or any other tax year. A dual consolidated loss is defined essentially as a net operating loss of a U.S. corporation that is taxed by a foreign country on its worldwide income or on a residence basis. See IRC Section 1503(d)(2)(A). The Staff of the Joint Committee describes Section 1503(d) as follows:

Section 1503 provides that if a U.S. corporation is subject to a foreign country’s tax on worldwide income, or on a residence basis as opposed to a source basis, any net operating loss it incurs cannot reduce the taxable income of any other member of a U.S. affiliated group for that or any other taxable year. (A net operating loss of such a corporation is referred to as a “dual consolidated loss”). A company may be subject to foreign tax on a residence basis because its place of effective management is in a foreign country or for other reasons. Where a U.S. corporation is subject to foreign tax on a residence basis, then, under Section 1503, for U.S. purposes, its loss will be available to offset income of that corporation in other years, but not income of another U.S. corporation. See Taxation of International Transactions, Thomson West (2006), Charles H. Gustafson, Robert J. Peroni, and Richard Crawford Pugh.

Congress did not perceive any relevant distinction between a deduction that arises on account of interest expense and one that arises on account of some other expense, or between a deduction for a payment to a related party and one for a payment to an unrelated party. Therefore, the provision applies to any dual consolidated loss regardless of the type of deductions that caused it. Since the enactment of Section 1503(d), the Department of Treasury has issued a number of regulations, which have been updated over the years. The regulations state the general principle that a dual consolidated loss cannot offset the taxable income of any U.S. affiliate for the tax year of the loss or any other tax year. The same limitation on loss use applies to a separate unit of a U.S. corporation as if the separate unit were the corporation’s wholly owned subsidiary. See Treas. Reg. Section 1.1503-2(b)(1). “Separate unit” for purposes of Section 1503(d) includes a foreign branch, a partnership interest, a trust interest and an interest in a hybrid entity treated as a corporation under foreign law. See Treas. Reg. Section 1.1503-2(c)(i).

The dual consolidated loss limitations is illustrated in the regulations under Section 1505(b) in the following example:

Let’s assume P carries on business operations in Country X that constitutes a permanent establishment under the U.S. Country X permanent establishment, as determined under Section 1.1503(d)-5.

Under Sections 1.1503(d)-1(b)(4)(i)(A) and 1.367(a)-6T(g)(1), P’s Country X permanent establishment constitutes a foreign branch separate unit. Therefore, the year 1 loss attributable to the branch separate unit constitutes a dual consolidated loss pursuant to Section 1.1503(d)-1(b)(5)(ii). The dual consolidated loss rules apply to the dual consolidated unit in Country X, because it is still possible that all or a portion of the dual consolidated loss can be put to a foreign use. For example, there may be a foreign use with respect to a Country X affiliate acquired in a year subsequent to the year in which the dual consolidated loss was incurred. Accordingly, unless an exception under Section 1.1503(d)-6 applies (such as a domestic use election), the year 1 dual consolidated loss attributed to P’s Country X permanent establishment is subject to the domestic use election), the year 1 dual consolidated loss attributable to P’s Country X permanent establishment is subject to the domestic use limitation rule of Section 1.503(d)-6. As a result, pursuant to Section 1.1503(d)-4(c), the year 1 dual consolidated loss cannot offset income of P that is not attributable to its Country X foreign branch separate unit, nor can it offset income of any other domestic affiliate. The loss can, however, offset income of the Country X foreign branch separate unit, subject to the application of Section 1.1503-4(c). The result would be the same even if Country X did not have a consolidation regime that includes as members of consolidated groups Country X branches or permanent establishments of nonresident corporations. The dual consolidated loss rules apply even in the absence that all or a portion of a dual consolidated loss can be put to a foreign use by other means, such as through sale, merger, or similar transaction. See Treas. Reg. Section 1.1503(d)-6(a)(2).

If the partnership had a foreign branch and dual consolidated losses, the preparer should disclose this information in Questions 10a and 10b.

Question 11. Asks if the partnership total receipts were less than $250,000 and the partnership’s value of its total assets were less than $1 million.

Question 12a. Asks if filer of the Form 8865 is claiming a foreign-derived intangible income (“FDDEI”) deduction under Section 250 with respect to any amounts listed on Schedule N. In certain cases, an entity that sells goods and/or provides services to foreign customers can claim a deduction pursuant to Section 250 that reduces the effective tax rate on qualifying income to 13.125 percent.

In order to understand how to answer Question 12a through 12d, it is important to know how DII is calculated. FDII is a type of income that when earned by a U.S. domestic C corporation is entitled to a deduction equal to 37.5 percent of the FDII. The determination of the FDII deduction is a mechanical calculation that rewards a corporation that has minimal investment in tangible assets such as machinery and buildings. Specifically, FDII was designed to provide a tax benefit to income that is deemed to be generated from the exploitation of intangibles. The mechanical computation assumes that investments in tangible assets should generate a return on investment no greater than 10 percent. Thus, a corporation’s income that is eligible for the FDII deduction (known as deduction eligible income or “DEI”) is reduced by an amount that equals 10 percent of the corporation’s average tax basis in its tangible assets, an amount that is known as qualified business asset investment or “QBAI.” The resulting amount is known as the domestic corporation’s “deemed intangible income” or “DII.” Because the FDII benefit only applies to deemed intangible income that is foreign derived, the DII is multiplied by a ratio (known as the “foreign-derived ratio”) designed to determine the corporation’s percentage of income that is foreign derived. The foreign derived ratio is the corporation’s foreign derived deduction eligible income (FDDEI) over its total deduction eligible income. See FDII for All: Practical Strategies for U.S. and non-U.S. Businesses for a Related Tax Rate under the FDII Regime (2021) Steven Hadjilogiou.

FDDEI is DEI that is 1) derived in connection with property sold (including property leased, licensed, or exchanged) by a U.S. corporation to a foreign person for foreign use or 2) services provided to any foreign person. The preparer must notify the IRS if the partnership is claiming a Section 250 under the FDDEI provisions of the Internal Revenue Code for Question 12a.

Question 12b. Asks the preparer to enter the amount (if any) of the gross income derived from sales, losses, exchanges, or other dispositions (but not licenses) from transactions with or by the foreign partnership that the filer included in its computation of FDDEI.

In order for income to be classified as income derived from FDDEI sources, the income must derive from property sold to a foreign person for foreign use. Foreign persons are non-U.S. persons, foreign governments, and international organizations. The sale of the property must be for foreign use. The preparer must notify the IRS the amount of gross income derived from sales, losses, or dispositions (but not licenses) from transactions with or by the foreign partnership that is included in its FDDEI computation.

Question 12c. Asks the preparer to enter the amount of gross income (if any) from a license of property to or by the foreign partnership that the filer included in its computation of FDDEI.

For purposes of determining gross income from a license of property for FDDEI purposes, intangible property such as licenses must be sold to a foreign person for foreign use. Foreign use is determined by where the end user will generate revenue from the exploitation of the intangible property. Therefore, a sale of a license for exploitation outside of the U.S. will be considered to be for foreign use. FDDEI would include a license by a U.S. corporation of intangible property to its foreign subsidiary for use outside of the United States.

For Question 12c, the preparer must state the amount of gross income received from a license of property to or by the foreign partnership that the filer included in its computation of FDDEI.

Question 12d. Asks the preparer to enter the amount of gross income derived from services (if any) provided to or by the foreign partnership that the filer included in the computation of FDDEI.

For services to qualify as FDDEI, the services must be provided to a person located outside of the United States to non-U.S. consumers or non-U.S. businesses. The general rule is that services provided to foreign related parties is not foreign use and does not qualify for FDDEI treatment. A foreign related party is any foreign person related to the provider of the services.

For Question 12d, the preparer must state the amount of gross income derived from services provided to or by the foreign partnership that the filer included in its computation of FDDEI.

Question 13. Asks to enter the number subject to Section 864(c)(8) as a result of transferring all or a portion of an interest in the partnership or of receiving a distribution from the partnership. If a foreign person conducts a trade or business in the United States, the net income effectively connected with the U.S. business activity will be taxed at the usual U.S. rates. The trade or business regime for taxing a foreign person’s U.S. trade or business income applies to income that is “effectively connected” with the conduct of the U.S. trade or business, as determined in Section 864(c). Section 864(c)(8) determines when foreign partners have effectively connected income to the extent that the transferor would have had effectively connected gain or loss if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange.

For Question 13, the preparer should disclose the foreign partner’s distribution subject to the Section 854(c)(8) rules.

Question 14. Asks at any time during the tax year were there any transfers between the partnership and the partners subject to the disclosure requirements of Treasury Regulation 1.707-8.

The legislative history of Section 707(a)(2)(B) warned the Treasury to be on the lookout for situations where a partner or the partnership borrowers against property in connection with a transfer and related distribution. When the borrowed funds end up in the transferring partner’s pocket, the overall transaction may be equivalent to a sale, at least to the extent that the other partners (through the partnership) assume primary responsibility for repayment of the loan. The regulations responded to the Congressional challenge with an elaborate set of special rules relating to liabilities. In general, if a liability incurred by a partner in anticipation of a transfer is assumed (or taken subject to) by a partnership, the partnership is treated as transferring consideration to the partner (as part of a sale) to the extent that responsibility for repayment of the transferred liability is shifted to the other partners. Liabilities incurred within two years of a transfer are presumed to be in anticipation of the transfer. Liabilities incurred by a partner more than two years before a transfer are called “qualified liabilities” by the regulations. The assumption of these and certain other qualified liabilities are treated as consideration paid in a sale only to the extent that the transferring partner is otherwise treated as having sold a portion of that property.

To illustrate, assume that on the formation of the equal AB partnership A transfers a building which has a fair market value of $100,000 and is subject to a $80,000 recourse liability that A incurred immediately before the transfer, and B contributes $20,000 cash. A uses the loan proceeds to pay personal expenses. The partnership assumes the liability, which is classified as recourse under the 752 regulations, and thus $40,000 of the debt is allocated to B. On these facts, the regulations treat the partnership as transferring $40,000 of consideration (the amount of the liability shifted to B) to A in connection with a sale of the property. As a result, A is treated as having sold a 40 percent interest in the building to the partnership for $40,000 and having contributed the remaining 60 percent. See Reg. Section 1.707-5(f) Example 2.

To give the IRS a fighting chance to uncover disguised sales Treas. Reg. Section 1.707-8 requires disclosure on a prescribed form when a partnership transfers money or property to a partner within two years of a transfer of property by the partner to the partnership and the partner has treated the transfer as other than a sale for tax purposes. For question 14, the preparer should state if the partnership had any transactions between the partners and partnership (similar to the example provided above) that should be disclosed to the IRS under Treas. Reg. Section 1.707-8.

Question 15a. Asks if there were any transfers of property or money within a 2-year period between the partnership and any of its partners that would require disclosures under Regulations 1.703-3 or 1.707-6. Rather than provide a detailed discussion regarding the Section 1.703-3 and 1.707-6 regulations, below please find an example of how these rules operate.

Sales and exchanges of property between partners and their partnership raise classification issues. In general, a bona fide sale or exchange of property by a partner to a partnership, or vice versa, is treated for tax purposes as a Section 707(a)(1) transaction between unrelated parties. Opportunities for collusion have prompted the Treasury to enact the anti-avoidance provisions of Treasury Regulations 1.703-3 and 1.707-6. Partners may seek to sell a loss asset to their partnership in order to recognize a paper loss without parting with effective control of the asset. Section 267(a)(1), which disallows losses with respect to many transactions between related parties, does not apply to partner/partnership sales or exchanges, but Section 707(b)(1) fills the statutory gap by disallowing losses on sales or exchanges of property between partnerships and partners who own directly or indirectly a more than 50 percent interest in partnership capital or profits. These types of transactions must be disclosed to the IRS under the treasury regulations.

The preparer should state for Question 15a if the partnership was subject to the requirements of Treas. Reg. Section 1.707-8.

Question 15b. Asks did the partnership assume a liability or receive property subject to a liability where such liability was incurred by a partner within a two year period of transferring the property to the partnership? If yes, attach a statement identifying the property transferred, the amount or value or value of each transfer, the debt assumed or taken by the partnership, and explanation of the tax treatment.

For Question 15b, the preparer should disclose if the partnership assumed a liability or received property subject to the liability within a two year period of transferring the property to the partnership.

Form 8865 Schedules

The next portion of this article will discuss preparing the schedules of the Form 8865 as per the IRS’s instructions.

Schedule A. Constructive Ownership of Partnership Interest

Schedule A asks the preparer of the Form 8865 to disclose the constructive ownership in the partnership. All filers must complete Schedule A.

Each partner must indicate whether they own a direct or constructive ownership in the partner. For classification purposes, a U.S. person is constructively treated as owning an interest in the partnership that is owned by certain entities or individuals that are related to the U.S. person.

Schedule A-1 Certain Partners of Foreign Partnership

All Category 1 and certain Category 3 filers must complete Schedule A-1

Category 1 filers must list all U.S. persons who owned at least a 10 percent direct interest in the foreign partnership during the partner’s tax year listed on the Form 8865.

Category 3 filers must list: 1) each U.S. person that owned a 10 percent or greater direct interest in the foreign partnership during the Category 3 filer’s tax year, and 2) any other person related to the Category 3 filer that was a direct partner in the foreign partnership during that tax year.

Category 3 filers who only transferred cash and did not own a 10 percent or greater interest in the transferred partnership after the transfer are not required to complete Schedule A-1.

Schedule A-2 Foreign Partners of Section 721(c) Partnership

Schedule A-2 must be completed if Question 6 is answered “Yes” and during the current tax year, a gain deferral contribution occurred, or a gain deferral contribution occurred in a prior tax year. (A gain deferral contribution requires the U.S. transferor to recognize built-in gain with respect to Section 721(c) property).

The preparer must insert the 2-letter country code for the country of organization for any foreign partner, other than an individual. See country codes on IRS.gov/CountryCodes.

The preparer must check the box if the partner is directly or indirectly related to the U.S. transferor (within the meaning of Section 267(b) or 707(b)(1) and is not a U.S. person.

The preparer must include the foreign partner’s percentage of interest in the partner’s capital and profits immediately after the gain deferral contribution. If multiple gain deferral contributions occurred during the tax year, enter the percentage immediately after the last gain deferral contribution.

Schedule A-3 Affiliation Schedule

For Schedule A-3, the preparer must list all partnerships (foreign or domestic) in which the foreign partnership owns a direct interest or indirectly acquired a 10 percent interest.

All filers must complete Schedule A-3. List on Schedule A-3 all partnerships (foreign or domestic) in which the foreign partnership owned a direct interest, or a 10 percent indirect interest (under the rules of Section 267(c)(1) and (5)) during the partnership tax year.

Only Category 1 filers must complete the ordinary income or loss column. In that column, report the foreign partnership’s share of ordinary income (even if not received) or loss from partnership in which the foreign partnership owns a direct interest. The total amount of ordinary income or loss from each partnership must also be included on Schedule B, line 4.

Schedule B Income Statement- Trade or Business Income

Schedule B is the partnership’s income statement.

All Category 1 filers in partnerships engaged in a domestic or foreign trade or business must complete Form 8865, Schedule B.

If the partnership is a Section 721(c) partnership and gain deferral method is applied, Schedule B must include any remedial items (remedial allocations are tax allocations of income or gain that are created by the partnership, and are offset by similarly created tax allocations of loss or deductions by the partnership) with respect to Section 721(c) property, including an offsetting remedial item relating to contributed Section 197(f)(9) property.

Schedule D Capital Gains and Losses

All Form 8865 Category 1 filers in partnerships having partnership items described in the Instructions for Schedule D (Form 1065) Capital Gains and Losses, must complete that schedule.

Schedule G Statement of Application of the Gain Deferral Method Under Section 721(c)

A U.S. transferor uses Schedule G to comply with the reporting requirements that must be satisfied in applying the gain deferral method. If the gain deferral method is applied to Section 721(c) property, a U.S. transferor must file Schedule G for the tax year of a gain deferral contribution, as well as for each subsequent tax year to which the gain deferral method is applied to Section 721(c) property.

On Schedule G, information must be provided with respect to Section 721(c) property that was 1) contributed to the partnership in a gain deferral contribution that occurred during the current tax year; or 2) contributed to the partnership in a gain deferral contribution that occurred during a prior year, provided that the gain deferral method is applied to the property in the current tax year.

In Parts I through V, information must be provided on a property by property basis. In Part 1, reportable Section 721(c) properties and accompanying information must be listed in descending order of the fair market value of the property (measured at the time of contribution).

In Parts II through IV, the line on which information is provided with respect to a reportable Section 721(c) property must correspond to the line on which the property is listed in Part I.

Part 1. Section 721(c) Property

Column 4. Section 197(f)(9) Property- The preparer must check the box with respect to the reportable Section 721(c) property if the property is an intangible described in Section 197(f)(9).

Column 5. Effectively Connected Income Property- The preparer must check the box with respect to the reportable Section 721(c) property if 1) all distributive shares of income and gain with respect to the property for all direct and indirect partners that are related foreign persons with respect to the U.S. transferor will be subject to taxation as income effectively connected with a trade or business within the United States (under Section 871 or 882), and 2) neither Section 721(c) partnership nor a related foreign person that is a direct or indirect partner in the partnership claims benefits under an income tax treaty.

Column 6(a). Fair Market Values- The preparer must enter the fair market value of the reportable Section 721(c) property, measured as of the date of contribution.

Column 6(b) Basis- The preparer must enter the adjusted tax basis of the reportable Section 721(c) property on the date of the contribution.

Column 7. Events- The preparer must check the box for each of columns 7(a) and 7(e) which describe an event that occurred during the tax year with respect to the reportable Section 721(c) property.

Part II. Remaining Built-in Gain, Remedial Income, and Gain Recognition

Column (a). Remaining built-in gain at beginning of tax year- with respect to a reportable Section 721(c) property, the preparer should enter the amount of remaining built-in gain at the beginning of the tax year. If the property was contributed in the current year, enter the property’s built-in gain on the date of the contribution (Part i, column 6(c)).

Column (b). Remaining built-in gain at end of tax year- with respect to a reportable Section 721(c) property, the preparer should enter the remaining built-in gain at the end of the tax year, figured under the gain deferral method.

Column (c). Remedial Income Allocated to the U.S. transferor- with respect to a reportable Section 721(c) property, the preparer should enter the remedial income allocated to the U.S. transferor under the remedial allocation method. When the gain deferral method applies to a Section 721(c) property, the partnership must use the remedial allocation method described in Treas. Regs Sections 1.721(c)-4 and 1.721(c)-5 for events constituting an acceleration event or partial acceleration event and for the consequences of such events.

Column (e). Gain recognition due to Section 367 transfer- with respect to a reportable Section 721(c) property, the preparer should enter the amount of gain recognized by the U.S. transferor pursuant to Regulation Section 1.721(c)-5(e). Gain recognized under Section 367 should not be included in column 5. Instead, column 5 should list only the amount of gain equal to the remaining built-in gain (if any) that would have been allocated to the U.S. transferor if the partnership had sold the remaining portion of the property immediately before the transfer for fair market value.

Part III. Allocation Percentages of Partnership Items With Respect to Section 721(c) Property

For each reportable Section 721(c) property, the preparer should enter the percentage of income, gain, deduction, and loss allocated to the U.S. transferor, related domestic partners, and related foreign persons.

Part IV. Allocation of Items to U.S. Transferor With Respect to Section 721(c) Property

For each reportable Section 721(c) property, the preparer should enter the amount (both book and tax) of income, gain, deduction, and loss allocated to the U.S. transferor under the gain deferral method.

Part V. Additional Information

Part V provides questions relating to whether certain events have occurred in the current tax year with respect to one or more reportable Section 721(c) property and information relating to treaty benefits.

Lines 1 through 6b- if the answer is “Yes” to any of the questions on lines I through 6b of Part V, the preparer should also complete and attach to Form 8865, Schedule H, Acceleration Events and Exceptions Reporting Relating to Gain Deferral Method Under Section 721(c).

Line 7a. If the answer is “Yes,” the preparer should attach to Form 8865 a copy of the waiver of treaty benefits with respect to the reportable Section 721(c) property.

Part VI. Supplemental Information

Information to be reported- when providing any information in Part VI, the preparer should indicate the Part, Part column, and line for which the information is provided.

Additional Part Rows- if an attached statement is used in Parts 1 through IV, the preparer should include the statement “Additional Section 721(c) Property statements is/are attached” in the area provided in Part VI.

Other information- the preparer should use the Supplemental Information section to provide any additional information required by Regulations Section 1.721(c)-6 that is not captured in Parts 1 through IV above.

Schedule H. Acceleration Events and Exceptions Reporting Relating to Gain Deferral Method Under Section 721(c)

Schedule H must be filed if certain events occur with respect to Section 721(c) property to which the gain method is applied.

Part 1. Acceleration Event

An acceleration event is any event that either would reduce the amount of the remaining built-in gain that a U.S. transferor would have recognized under the gain deferral method if the event had not occurred or could defer the recognition of the remaining built-in gains.

Column (b). The preparer should provide a description of the acceleration event, including the citation in the case of a partial or deemed acceleration event.

Column (d). The preparer should enter the amount of the gain recognized by the U.S. transferor with respect to the Section 721(c) property resulting from the acceleration event.

Column (e). The preparer should enter the amount that Section 721(c) partnership will increase its basis in the Section 721(c) property as a result of the acceleration event.

Column (f). The preparer should check the box if there is a partial acceleration event and the U.S. transferor recognizes a partial gain with respect to the Section 721(c) property.

Part II. Termination Event

A termination event causes the gain deferral method to no longer apply with respect to the affected Section 721(c) property on a property-by-property basis.

Column (b). The preparer should provide a description of the termination event, including the citation to the relevant paragraph in Treas. Reg. Section 1.721(c)-5(b).

Part III. Successor Event

A successor event allows for the continued application of the gain deferral method with respect to the affected Section 721(c) property on a property-by-property basis by a successor U.S. transferor or a successor Section 721(c) partnership. However, if the successor doesn’t continue the gain deferral method, the event is an acceleration event and must be reported in Part I above. Successor events are applicable on a property-by-property basis. If only a portion of an interest in a partnership is transferred in a successor event, the rules of Treas. Reg. Section 1.704-3(a)(7) is applied to determine the remaining built-in gain in the Section 721(c) property that is attributable to the portion of the interest that is transferred and the portion that is retained. Treas. Reg. Section 1.721(c)-5(c) identifies the successor events, including special rules for transactions involving tiered partnerships

If more than one successor event occurs in the tax year, provide the required information for each event separately in Part IV in chronological date order.

Column (b). The preparer should provide a description of the successor event, including the citation to the relevant paragraph in Regulations section 1.721(c)-5(c). See Treas. Reg. Section 1.721(c)-6(b)(3)(v). The preparer should use Part VI, Supplemental Information, if additional space is needed to describe the transaction.

Column (d). The preparer should enter the identifying information of the relevant successor, as applicable. In certain successor events, a domestic corporation becomes the successor U.S. transferor. In other successor events, a partnership becomes the successor Section 721(c) partnership. A successor Section 721(c) partnership may be a new, upper-tier, or lower-tier partnership. The identifying information must include the name, address, and U.S. taxpayer identification number, if any, of the successor U.S. transferor or successor Section 721(c) partnership.

Part IV. Taxable Disposition of a Portion of an Interest in Partnership Event

Part IV reports the information relating to a fully taxable disposition of a portion of an interest in a Section 721(c) partnership. The preparer should complete this Part if a U.S. transferor or a partnership in which a U.S. transferor is a direct or indirect partner disposes of (directly or indirectly through one or more partnerships) a portion of an interest in a Section 721(c) partnership in a transaction in which the gain or loss, if any, is recognized. This will not be an acceleration event with respect to the portion of the interest transferred. The gain deferral method will continue to apply with respect to the Section 721(c) property of the Section 721(c) partnership. The rules of Treas. Reg.  Section 1.704-3(a)(7) is applied to determine the remaining built-in gain in the Section 721(c) property on a property-by-property basis that is attributable to the portion of the interest in the Section 721(c) partnership that is retained. See Treas. Reg Section 1.721(c)-5(f).

Column (a). The preparer should provide a description of the disposition of the interest in the partnership, including whether the interest was a direct or indirect interest (through one or more partnerships). If more than one taxable disposition event occurs in the tax year, provide the required information for each event separately in Part IV in chronological date order. If additional space is needed, provide the information in Part VI, Supplemental Information.

Column (c). The preparer should enter the percentage of partnership interest that was disposed of in the event to which all gain or loss, if any, is recognized.

Column (d). The preparer should enter the percentage of the partnership interest (directly or indirectly through one or more partnerships) that the U.S. transferor retained immediately after the event.

Column (e). The preparer should enter the aggregate amount of the remaining built-in gain with respect to all of the Section 721(c) properties that is attributable to the portion of the interest in the Section 721(c) partnership that is retained. The preparer should attach a detailed supporting schedule to Schedule H that separately states each remaining Section 721(c) property and its respective remaining built-in gain allocable to the U.S. transferor included in the aggregate amount reported in column (e).

Part V. Section 367 Transfer Event

Part V reports the information relating to a transfer described in Section 367 of Section 721(c) property to a foreign corporation. See Treas. Reg. Section 1.721(c)-5(e). All outbound transfers by U.S. persons of appreciated property to foreign corporations and to certain foreign persons will give rise to recognitized gain to the extent required under Section 367. Internal Revenue Code Section 721(c) provides regulatory authority to require gain recognition on a transfer by a U.S. person of appreciated property to a partnership in the situation where the gain when recognized by the partnership would be allocable to a foreign person.

After considering the tax consequences under Section 367, the remaining built-in gain, if any, with respect to the Section 721(c) property is recognized by the U.S. transferor to the extent that would have been allocated to the U.S. transferor had the section 721(c) partnership sold that portion of the property immediately before the transfer for fair market value.

Column (b). The preparer should provide a description of the Section 367 transfer, including whether the transfer was a direct or indirect transfer (through one or more partnerships) of Section 721(c) property to a foreign corporation. If more than one section 367 transfer occurs in the tax year, provide the required information for each transfer separately in Part IV in chronological date order. If additional space is needed, the preparer should provide the information in Part VI, Supplemental Information.

Column (d). The preparer should enter the amount of the remaining portion of built-in gain recognized by the U.S. transferor under Section 721(c). The amount of gain equals the remaining portion of the built-in gain that would have been allocated to the U.S. transferor if the Section 721(c) partnership had sold that portion of the Section 721(c) property immediately before the transfer for fair market value. This amount should not include any gain or income recognized by the U.S. transferor pursuant to section 367 that is reported elsewhere on the return. See Treas. Reg. Section 1.721(c)-5(e). After the section 367 transfer, the transferred Section 721(c) property will no longer be subject to the gain deferral method.

Column (e). The preparer should enter the identifying information of the foreign transferee corporation that received the Section 721(c) property in the Section 367 transfer. The identifying information includes the name, address, and U.S. taxpayer identification number, if any.

Part VI. Supplemental Information

Information to be reported. When providing any information in the Supplemental Information, indicate the part, column, row, and line for which the information is provided.

If additional rows are needed to enter information in Parts I through V in the Supplemental Information, the preparer should provide the information in an attachment or attachments to Schedule H in the same format as required for the row on the Part at issue. If separate supplemental schedules are used for any Part of Schedule H for specific Section 721(c) properties, use the same corresponding identification line number from the Part I of Schedule G for such property on the supplemental schedule for Schedule H.

The preparer should use the Supplemental Information section to provide any additional information required by Treas. Reg. Section 1.721(c)-6 that is not reported in Parts I through V above.

Schedules K, Partners’ Distributive Share Items, and K-1, Partner’s Share of Income, Deductions, Credits, etc

Schedule K

Form 8865, Schedule K, is a summary schedule of all of the partners’ shares of the partnership income, credits, deductions, etc. Only Category 1 filers must complete Form 8865, Schedule K.

Schedule K-1

Schedule K-1 (Form 8865) is used to report a specific partner’s share of the partnership income, deductions, credits, etc.

All Category 1 and 2 filers must complete Schedule K-1 (Form 8865) for any direct interest they hold in the partnership. A Category 1 or 2 filer that doesn’t own a direct interest is not required to complete Schedule K-1 (Form 8865).

Category 1 filers must also complete Schedule K-1 (Form 8865) for each U.S. person that directly owns a 10 percent or greater direct interest in the partnership.

Provide the partner’s beginning and year-end percentage interest in partnership profits, losses, capital, or deductions. These percentages should include any interest constructively owned by the filer.

Complete boxes 1 through 21 for any direct interest that the partner owns in the partnership.

If the gain deferral method is applied and a Section 721(c) partnership does not have a filing obligation under Section 6031, the U.S. transferor must obtain a Schedule K-1 (Form 8865) for each direct or indirect partner that is related to the U.S. transferor (within the meaning of Section 267(b) or 707(b)(1)) and that is not a U.S. person (related foreign partner). See Treas. Reg. Section 1.721(c)-6(c)(3). The Schedule K-1 (Form 8865) for each related foreign partner must be filed and attached to the Form 8865 as part of the annual reporting relating to the gain deferral method pursuant to Treas. Reg. Section 1.721(c)-6(b)(3)(xi).

Schedule K-1 (Form 8865) for related foreign person

If the gain deferral method is applied and a Section 721(c) partnership does not have a filing obligation under section 6031, the U.S. transferor must obtain a Schedule K-1 (Form 8865) for each direct or indirect partner that is related to the U.S. transferor (within the meaning of Section 267(b) or Section 707(b)(1)) and that is not a U.S. person (related foreign partner). See Treas Reg. Section 1.721(c)-6(c)(3). The Schedule K-1 (Form 8865) for each related foreign partner must be filed and attached to the Form 8865 as part of the annual reporting relating to the gain deferral method pursuant to Regulations section 1.721(c)-6(b)(3)(xi). The instructions that apply to Schedule K-1 (Form 8865) for all other partners also apply to a Schedule K-1 (Form 8865) for a related foreign partner.

General Reporting Instructions for Schedule K-1

On each Schedule K-1, the preparer should enter the information about the partnership and the partner in Parts I and II (items A through F).

Item A2

The preparer should enter the reference ID number used on Form 8865, item G2(b). 

Part III—line 1. If the gain deferral method is applied to which the Section 721(c) partnership adopts the remedial allocation method, the amounts reflected on each partner’s Schedule K-1 for the allocations of income, gains, losses, deductions, or credits allocated to such partner must include any allocations of remedial items with respect to section 721(c) property. See Treas. Reg. Section 1.721(c)-3(c).

For example, if the partner is the U.S. transferor of section 721(c) property, Part III, line 1, would include any remedial income allocated to the U.S. transferor from Schedule G, Part II, column (c), Remedial Income Allocated to U.S. Transferor, as applicable. For partners other than the transferor, Part III, line 1, would include their share of ordinary business income (or loss) after taking into account any remedial items to such partner relating to section 721(c) property. However, Part III, line 1, would not include basis adjustments attributable to section 197(f)(9) for related foreign partners. 

Schedule L. Balance Sheets per Books

Schedule L is used to report a foreign partnership’s balance sheet. The balance sheets should agree with the partnership’s books and records. The preparer should attach a statement explaining any differences.

Only Category 1 filers are required to complete Form 8865, Schedule L.

Schedule L requires balance sheets prepared and translated into U.S. dollars in accordance with U.S. generally accepted accounting principles or “GAAP.”

Schedule M. Balance Sheets for Interest Allocation

All Category 1 filers must complete Schedule M, and it should reflect the book values of the partnership’s assets, as described in Temporary Regulations Sections 1.861-9T(g)(2) and 1.861-12T. Assets should be characterized as U.S. assets or foreign assets in one or more separate limitation categories as provided in Temporary Regulations Sections 1.861-9T(g)(3) and 1.861-12T. The balance sheets should be prepared in U.S. dollars.

Schedule M-1 Reconciliation of Income (Loss) Per Books With Income (Loss) per Return

Schedule M-1 is used to reconcile a foreign partnership’s income or loss. 

Only Category 1 filers are required to complete Form 8865, Schedule M-1.

Schedule M-2 Analysis of Partners’ Capital Accounts

Schedule M-2 is used to report the partner’s capital accounts. A partner’s capital account provides an annual running total of how much the partner has invested in the business.

Only Category 1 filers are required to complete Schedule M-2.

Schedule N. Transactions Between Controlled Foreign Partnership and Partners or Other Related Entities

Schedule N is used to report transactions between controlled foreign partnerships and partners or other related entities.

All Category 1 filers must complete Schedule N and report all transactions of the foreign partnership during the tax year of the partnership listed on the top of Form 8865, page 1. A Category 1 filer filing a Form 8865 for other Category 1 filers under the multiple Category 1 filers exception must complete a Schedule N for itself and a separate Schedule N for each Category 1 filer not filing Form 8865.

Category 2 filers are required to complete columns (a), (b), and (c) of Schedule N. Category 2 filers don’t have to complete column (d).

Column (a). Preparers should use column (a) to report transactions between the foreign partnership and the person filing the Form 8865.

Column (d). Preparers should use column (d) to report transactions between the foreign partnership and any U.S. person with a 10 percent or more direct interest in the foreign partnership. If such a person also qualifies under column (b), the preparer should report transactions between the foreign partnership and that person under column (d). 

For lines 6 and 16, the preparer should enter distributions received from other partnerships and distributions from the foreign partnership for which this form is being completed.

For lines 20 and 21, the preparer should enter the largest outstanding balances during the tax year of gross amounts borrowed from, and gross amounts lent to, the related parties described in columns (a) through (d). Preparers should enter aggregate cash flows, year-end loan balances, average balances, or net balances. Preparers should not include open account balances resulting from sales and purchases reported under other items listed on Schedule N that arise and are collected in full in the ordinary course of business.

Schedule O. Transfer of Property to a Foreign Partnership

Schedule O is used to report transfers of property to a foreign corporation for certain category filers. Only Category 3 filers must complete Schedule O.

For Section 721(c) partners, Treas. Reg. Section 1.721(c)-2 overrides Section 721(a) nonrecognition of gain upon a contribution of Section 721(c) property to a section 721(c) partnership occurring on or after August 6, 2015. A U.S. transferor must recognize gain unless the gain deferral method described in Regulations section 1.721(c)-3 is applied. To satisfy the reporting requirements of the gain deferral method, the U.S. transferor is required to report certain information for the year of the contribution and for subsequent years. 

Part 1. Transfers Reportable Under Section 6038

Part I is used to report the transfer of property to a foreign partnership. The preparer must provide the information required in columns (a) through (g) with respect to each contribution of property to the foreign partnership that must be reported. If a partner contributed property with an fair market value greater than its tax basis (appreciated property), or intangible property, provide the information required in columns (a) through (g) separately with respect to each item of property transferred (except to the extent you are allowed to aggregate the property under Treas. Reg. Sections 1.704-3(e)(2), (3), and (4)).

The preparer should provide a general description of each item of property in the Supplemental Information Required To Be Reported section. For all other properties contributed, aggregate by the categories listed in Part I.

Column (a). The preparer should enter the date of the transfer. If the transfer was composed of a series of transactions over multiple dates, enter the date the transfer was completed.

Column (b). The preparer should enter the description of the property transferred.

Column (c). The preparer should enter the fair market value of the property contributed (measured as of the date of the transfer).

Column (d). The preparer should enter the adjusted basis in the property contributed on the date of the transfer. See Internal Revenue Code Sections 1011 through 1016 for more information on the determination of adjusted basis.

Column (f). If a contribution of appreciated property was made to the partnership, the preparer should enter the method (traditional, traditional with curative allocations, or remedial) used by the partnership to make Section 704(c) allocations with respect to each item of property. See Treas. Reg. Sections 1.704-3(b), (c), and (d) for more information on these allocation methods. If the gain deferral method is applied, the remedial method must generally be used. See Treas. Reg. Section 1.721(c)-3(b)(1)(i). For an exception for certain property generating effectively connected income, see Treas. Reg. Section 1.721(c)-3(b)(1)(ii).

Column (g). The preparer should enter the amount of gain, if any, recognized on the transfer. See Sections 721(b) and 904(f)(3), and Treas. Reg. Section 1.721(c)-2.

Line 3. The preparer should enter the partner’s capital interests, by percentage, in the partnership immediately before and after the transfer. To the extent the partner’s capital interest in the partnership immediately before the transfer differs from any of the partner’s profit, loss, or deduction interests in the partnership at that time, enter in the supplemental information below partner’s interests, by percentage, in the profit, loss, and deductions at that time. To the extent the partner’s capital interest in the partnership immediately after the transfer differs from any of the partner’s profit, loss, or deduction interests in the partnership at that time, enter in the supplemental information below the partner’s interests, by percentage, in the profit, loss, and deductions at that time.

Part II. Dispositions Reportable Under Section 6038B

A preparer should use Part II to report certain dispositions by a foreign partnership. If the partner was required to report a transfer of appreciated property to the partnership, and the partnership disposes of the property while the partner is still a direct or constructive partner, the partner must report that disposition in Part II. If the partnership disposes of the property in a nonrecognition transaction and receives in exchange substituted basis property, the partner should report the subsequent disposition of the substituted basis property in the same manner as provided for the contributed property. A disposition by a partnership may be an acceleration event for purposes of applying the gain deferral method. The U.S. transferor may be required to recognize gain in an amount equal to the remaining built-in gain on the Section 721(c) property previously contributed to the Section 721(c) partnership. Acceleration events and exceptions to an acceleration event should be reflected in Part II. In addition, Schedules G and H are required to be filed.

Column (a). The preparer should provide a brief description of the property disposed of by the partnership. If the preparer is reporting the disposition of substituted basis property received by the partnership in a nonrecognition transaction in exchange for appreciated property contributed by the partner, the prepater should enter “See Attached” and attach a statement providing brief descriptions of both the property contributed by the partner to the partnership and the substituted basis property received by the partnership in exchange for that property.

Column (b). The preparer should enter the date that the partner transferred this property to the partnership. If the partner are reporting the disposition of substituted basis property received by the partnership in a nonrecognition transaction in exchange for property previously contributed by the partner, the preparer should enter “See Attached” and attach a statement showing both the date you transferred the appreciated property to the partnership and the date the partnership exchanged the property for substituted basis property in a nonrecognition transaction. See Regulations section 1.6038B-2.

Column (c). The preparer should enter the date that the partnership disposed of the property.

Column (d). The preparer should briefly describe how the partnership disposed of the property (for example, by sale or exchange).

Column (e). The preparer should enter the amount of gain, if any, recognized by the partnership on the disposition of property.

Column (f). The preparer should enter the amount of depreciation recapture, if any, recognized by the partnership on the disposition of property. 

Column (g). The preparer should enter the amount of gain from column (e) allocated to the partner.

Column (h). The preparer should enter the amount of depreciation recapture from column (f) allocated to the partner. If the partner recognizes any Section 1254 recapture on the partnership’s disposition of natural resource recapture property, the preparer should enter “See Attached” and attach a statement figuring the amount of recapture. See Treas. Reg. Section 1.1254-5.

Schedule P. Acquisitions, Dispositions, and Changes of Interests in a Foreign Partnership

A preparer should use Schedule P to report the acquisition, disposition, and change of interest in a foreign partnership. Every Category 4 filer must complete Schedule P.

Part. Acquisitions

Part I is completed by Category 4 filers required to report an acquisition of an interest in a foreign partnership.

Column (a). If a partner acquired the interest in the foreign partnership by purchase, gift, or inheritance, or in a distribution from a trust, estate, partnership, or corporation, the preparer should enter the name, address, and identifying number (if any) of the person from whom the partner acquired the interest.

Column (b). The preparer should enter the date of the acquisition. If the acquisition was composed of a series of transactions over multiple dates, enter the date the acquisition was completed.

Column (c). The preparer should enter the fair market value of the interest the partner acquired in the partnership (measured as of the date of acquisition).

Column (d). The preparer should enter the partner’s basis in the acquired partnership interest (measured as of the date of acquisition). 

Columns (e) and (f). The preparer should total direct percentage interest in the partnership both before and immediately after the acquisition. To the extent a partner’s direct percentage interest in the partnership differs among capital, profits, losses, or deductions, the preparer should enter “See Below” and state the different percentages in Part IV.

Part II. Dispositions

Part II is used to report partnership dispositions. This section is completed by U.S. persons who are Category 4 filers.

A disposition of a Section 721(c) partnership interest may be an acceleration event for purposes of applying the gain deferral method. The U.S. transferor may be required to recognize gain in an amount equal to the remaining built-in gain on the section 721(c) property previously contributed to the section 721(c) partnership. In this case, Schedule H must also be filed.

Column (a). The preparer should use this column unless the partner disposed of the interest by withdrawing, in whole or in part, from the partnership. In this case, the preparer should enter the name, address, and identifying number (if any) of the person to whom the partner transferred the interest in the foreign partnership.

Column (b). The preparer should enter the date of the disposition. If the disposition was composed of a series of transactions over multiple dates, the preparer should enter the date the disposition was completed.

Column (c). The preparer should enter the fair market value of the interest the partner disposed of in the partnership (measured as of the date of disposition). If the partner recognized gain or loss on the disposition, the preparer should state the amount of gain or loss in Part IV. 

Column (d). The preparer should enter the partner’s adjusted basis in the partnership interest disposed of immediately before the disposition. 

Columns (e) and (f). The preparer should enter the partner’s total direct percentage interest in the partnership both before and immediately after the disposition. To the extent the partner’s percentage interest in the partnership differs among capital, profits, losses, or deductions, the preparer should enter “See Below” and state the different percentages in Part IV.

Part III. Change in Proportional Interest

This section is completed by U.S. persons who are Category 4 filers because their direct proportional interest in the foreign partnership changed.

Column (a). The preparer should briefly describe the event that caused the partner’s interest in the partnership to change (for example, the admission of a new partner).

Column (b). The preparer should enter the date of the change. If the change resulted from a series of transactions over multiple dates, the preparer should enter the date the change was completed.

Column (c). The preparer should enter the fair market value of the partner’s interest in the partnership immediately before the change.

Column (d). The preparer should enter the partner’s basis in the partnership interest immediately before the change.

Columns (e) and (f). The preparer should enter the partner’s direct percentage interest in the partnership both before and immediately after the change. To the extent the partner’s percentage interest in the partnership differs among capital, profits, losses, or deductions, the preparer should enter “See Below” and state the different percentages in Part IV.

Part IV. Supplemental Information Required To Be Reported

The preparer should enter any information asked for in Part I, Part II, or Part III that must be reported in detail. The preparer should also Identify the applicable part number and column next to the information entered in Part IV.

Conclusion

The IRS Form 8865 is an incredibly complicated return. Each year an international tax attorney should review direct, indirect, and constructive ownership of the foreign partnership to determine the impact of any changes in percentages, filer categories, and partnership status. Workpapers should also be prepared and maintained for each U.S. GAAP adjustment and foreign exchange. It is extremely important to work with an international tax specialist to ensure accurate preparation of your Form 8865. Having the wrong professional complete your Form 8865 can result in significant penalties. We have substantial experience advising U.S. persons investing abroad of their compliance obligations. We have provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.