Different K-1s for different folks.

In theory, the mechanics of taxing income from partnerships are simple. The partnership reports to each partner his distributive share of partnership ordinary income or loss and any other "item, which if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately." In practice, difficulty arises because the same item is taxed to different partners in different ways, depending on (1) the type of entity (individual, corporation, etc.) the partner is, (2) the partner's citizenship or residence (domestic or foreign) and (3) other factors.

For example, assume a partnership is engaged only in simple investment (i.e., nontrading) activities. Even in an era when most partners were domestic, ordinary expenses of that partnership represented Sec. 162 deductions to C corporation partners, but represented Sec. 212 deductions to partners who were individuals, estates, trusts or even S corporations (all of whose shareholders must be individuals, estates or certain trusts). Similarly, a partner's share of an investment partnership's worthless debt (not represented by a security) is an ordinary Sec. 166(a) deduction to a corporate partner (other than an S corporation), but a Sec. 166(d)(1)(B) short-term capital loss to an individual partner. The reporting complexities grow if the investment partnership's activities rise to the level of trader status.

Perhaps this situation does not cause too much practical difficulty in reporting to various types of domestic partners. However, there are an ever-increasing number of foreign partners in partnerships (either domestic or foreign) and Schedule K-1 of Form 1065, U.S. Partnership Return of Income, does not really accommodate their needs. If foreign partners are involved, a number of additional complications are created, including:

1. Dividend and interest income from foreign sources are not gross income to foreign partners.

2. Capital gains (even those realized from the sale in the U.S. of securities of U.S. issuers) are generally not gross income to foreign partners, by reason of Sec. 865(i).

3. Interest on deposits in U.S. banks is not taxable to foreign partners, by reason of Secs. 871(i) and 881(d).

4. A foreign partner's share of partnership expenses is simply not a deduction of any type, as it does not relate to income "effectively connected" with a U.S. trade or business.

5. A foreign partner's share of foreign taxes withheld on dividends does not represent a potentially creditable tax for U.S. income tax purposes.

6. The partnership is required to withhold appropriate U.S. income taxes on the share of U.S.-source dividends and interest attributable to foreign partners.

The distinction between U.S. and foreign persons is even more pronounced for partnerships that are active traders (but not dealers) in securities to an extent sufficient to cause their domestic partners to be engaged in a trade or business. Presumably; the repeal of the "Ten Commandments" will result in foreign partners in such partnerships not being engaged in a trade or business, even though the domestic partners are so engaged. In addition to creating an anomalous situation, this would tax the capabilities of the software programs used to prepare Forms 1065.

The situation becomes even more complex if a partnership is engaged in a trade or business and also has investment activities. At present, Schedule K1 contains categories of "portfolio income" (items 4a to 4f). These categories are primarily directed toward domestic partners, to distinguish such portfolio income from business income potentially from a passive activity. However, while this distinction may also apply to a foreign partner, probably even more pertinent is the question of whether a specific item of investment income is "effectively connected." The resolution of this question determines whether the item of income is taxed on a gross basis, a net basis, or not at all.

The growth of tiered passthrough structures greatly expands the complexities involved.

Example: Domestic partnership A is a partner in domestic partnership B. B has no foreign partner, but A has one or more foreign partners. B would not necessarily know of A's foreign partners and would, therefore, be unaware of A's special needs for information relevant to foreign partners. Under these circumstances, the Schedule K-1 issued by B to A would be prepared on the basis of A's domestic status. A must request from B supplemental information to prepare its Form 1065 properly. If the supplemental information is forthcoming on a timely basis and sufficiently adequate, A will not have to file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request.

Experience already indicates that Schedule K-1 is not "user friendly" as to foreign partners. This adds to the necessity that all partnerships, at whatever tier, be alert not only to those circumstances that have been illustrated here, but also to many other situations in which the ultimate taxpayer needs particular information to comply with Code provisions.