   LB&I Concept Unit   Unit NameFlow-Through Entities Effects on FTC  Primary UIL Code9432.02-02Categorization of Income and Foreign Taxes     Library LevelTitle  Knowledge BaseInternational  ShelfIndividual Outbound  BookForeign Tax Credits Individual  ChapterCalculation of Amount of Allowable FTC      Document Control Number (DCN)INT-C-057 (formerly FTC/C/010_02-13)  Date of Last UpdateRevised: 09/01/20        Note: This document is not an official pronouncement of law, and cannot be used, cited or relied upon as such. Further, this document may not contain a comprehensive discussion of all pertinent issues or law or the IRS's interpretation of current law.  Table of Contents       (View this PowerPoint in “Presentation View” to click on the links below) General Overview Relevant Key Factors Detailed Explanation of the Concept Examples of the Concept Index of Referenced Resources Training and Additional Resources Glossary of Terms and Acronyms Index of Related Practice Units              2  General Overview          Flow-Through Entities Effects on FTC NOTE: This Practice Unit is updated to reflect the recent finalized Treas. Reg. 1.861-9.  Flow-through entities (FTEs) affect an individual’s Foreign Tax Credit (FTC) by impacting foreign source gross income, foreign source taxable income, worldwide gross income, worldwide taxable income and foreign taxes available for credit. Each U.S. partner of a partnership must report the partner’s distributive share of the partnership’s gains, income, deductions, losses, or credits on the partner’s return, and each U.S. shareholder of an S corporation must report the shareholder’s share of the S corporation’s gains, income, deductions, losses or credits on the shareholder’s return. IRC 704(b); IRC 1366. Partners and shareholders that are U.S. citizens, resident aliens, domestic corporations, domestic trusts, and domestic estates are generally taxed on their distributive shares of the partnership’s or S corporation’s worldwide income regardless of the source. Items flowing through to partners or shareholders generally retain their character in the hands of the partners or shareholders. S corporations are treated as partnerships and the shareholders of S corporations are treated as partners of a partnership for purposes of FTC. IRC 1373. When there is only a reference to a partner or partnership in this unit, the reference will also apply to S corporations and/or S corporation shareholders. This concept unit is applicable for individual taxpayers that receive Schedule K-1(s) from partnerships or S corporations that report foreign income, related deductions and taxes. Members of LLCs who file a Form 1065 and beneficiaries of a Trust which files a Form 1041 are also subject to the rules discussed in this Practice Unit.          Back to Table of Contents3  Relevant Key Factors            Flow-Through Entities Effects on FTC Key Factors The character of any item of income, gain, loss, deduction, or credit described in IRC 702(a)(1) through (7) in the hands of a partner, will be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership. IRC 702(b); IRC 1366(b). Limited partners who own an interest of less than 10 percent of the partnership, and S corporation shareholders who do not actively participate in the business of the S corporation and own an interest of less than 10 percent of the S corporation, generally categorize their distributive share of foreign source income from their respective entities, as passive income. See Treas. Reg. 1.904-5(h)(2) for additional details and exceptions. IRC 901 generally allows U.S. persons to elect to claim a credit for foreign income taxes paid or accrued by that person. In the case of foreign taxes paid or accrued by a partnership, IRC 703(a)(2)(B) and Treas. Reg. 1.703-1(a)(2)(iii) prohibit a partnership from deducting taxes described in IRC 901 that are paid or accrued to a foreign country, so the foreign taxes are passed through to the partners. IRC 702(a)(6) allows individual partners to take into account separately the partner’s distributive share of the foreign taxes paid or accrued by the partnership. Partners may elect to treat all of their qualifying foreign taxes for the year as either a deduction on Schedule A or as a credit on Form 1116. The election applies to taxes paid directly by the partner and taxes paid by the partnership. Each partner elects separately and the partnership has nothing to do with the partner’s choice. IRC 703(b)(3); Treasury Reg. 1.703-1(b)(2)(i).              Back to Table of Contents4  Detailed Explanation of the Concept          Flow-Through Entities Effects on FTC Reporting of Foreign Transactions on the K-1         AnalysisResources       Foreign transactions from partnerships are reported on Form 1065, Schedule K-1, lines 16A Form 1065, Schedule K-1 (2019)  through 16X. The information from this section of the K-1 is used to complete Form 1116, Form 1065, Schedule K-1  Foreign Tax Credit. On Page 2 of the Schedule K-1 under Foreign Transactions, the codesInstructions (2019)  identify where on Form 1116 the amount for each code should be input.    Foreign transactions from S Corporations are reported on Form 1120S, Schedule K-1, lines Form 1120S, Schedule K-1 (2019)  14A through 14V. The information from this section of the K-1 is used to complete Form Form 1120S, Schedule K-1  1116, Foreign Tax Credit. On Page 2 of the Schedule K-1 under Foreign Transactions, the    instructions (2019)  codes identify where on Form 1116 the amount for each code should be input.        The foreign transactions codes for line 16 of the Form 1065, Schedule K-1 and line 14 of Form 1065 Instructions (2019)    Form 1120S Instructions (2019)  the Form 1120S, Schedule K-1 are essentially the same.   −  Code A: Name of foreign country or U.S. possession. Form 1116 (2019)    Form 1116 Instructions (2019)  Code B: Gross income from all sources. Combine the distributive share of “gross income from all sources” with all other gross income and enter the total on line 3e. “Gross income from all sources” is a constant amount that will be entered on line 3e of all Form 1116s filed for each category of income.  Back to Table of Contents5  Detailed Explanation of the Concept (cont’d)         Flow-Through Entities Effects on FTC   AnalysisResources      −  Code C: Gross income sourced at partner or shareholder level. This line includes IRC 865   income from the sale of personal property other than inventory, depreciable property and Pub. 514 - Foreign Tax Credit for   certain intangible property. Include foreign source income in Part I of the applicable FormIndividuals   1116 for each category of income as provided.    As with all aspects of the FTC, properly sourcing income from FTEs is important to Practice Unit - Sourcing of Income   ensure taxpayers are not overstating the amount of foreign source income, which is a         critical component of the FTC computation. Sourcing rules are covered in other practice    units in greater detail, but are mentioned here to the extent they apply to FTEs.    The next slide provides a table that summarizes various types of income and how they    are generally sourced.   !CAUTION: The Schedule K-1 is being revamped to include more details to the    international transactions. The changes are projected for 2021.                      Back to Table of Contents6  Detailed Explanation of the Concept (cont’d)         Flow-Through Entities Effects on FTC   AnalysisResources              IRC 861       IRC 862   Item of IncomeSourcing Determination         IRC 863                 InterestResidence of payer            DividendsResidence of corporation, in general            RentsLocation of property            Royalties from natural resourcesLocation of property            Royalties from patents, copyrights, etc.Where property is used            Sale of real propertyLocation of property            Sale of personal propertyTax home of seller            Sale of purchased inventoryWhere property is sold            Sale of produced inventoryAllocate based on IRC 863(b)                       Back to Table of Contents7  Detailed Explanation of the Concept (cont’d)           Flow-Through Entities Effects on FTC  AnalysisResources    While the sourcing of a sale of non-inventory personal property is generally determined IRC 865(i)(5) by the tax home of the seller (except as provided in the regulations), the seller here  refers to the partner, not the partnership.  Example Domestic Partnership X formed in Nevada Two 50% partners, each a U.S. citizen Partner Y’s tax home is in the U.S. Partner Z’s tax home is in Germany Partnership X earns $50,000 from the sale of non-inventory personal property Partner Y’s $25,000 share is U.S. source income Partner Z’s $25,000 share is foreign source income (if Germany taxes the gain at a rate of at least 10%). U.S. citizens or resident aliens will not be treated as nonresidents, for purposes of thesale of personal property, unless they pay income tax to a foreign country of at least 10  IRC 865(g)(2) percent of the gain derived from the sale.           Back to Table of Contents8  Detailed Explanation of the Concept (cont’d)           Flow-Through Entities Effects on FTC   AnalysisResources       !CAUTION: Although all income reported on this line has been apportioned to separate IRC 865   categories of income, you must first determine whether the income on this line is U.S. Pub. 514 - Foreign Tax Credit for   or foreign source income, by determining the tax home of the seller. Then only enterIndividuals   foreign source income in part 1 of each of the applicable Forms 1116 for the category    of income received. For information on determining tax home, see the instructions for    Form 1116 or Pub. 514.    If the partnership or S corporation specifically identifies any capital gains or losses or    unrecaptured section 1250 gain on this line and the gains or losses are foreign source,    see the instructions for Form 1116 before entering any amount in Part I.    Codes D, E, F, G, H: Foreign gross income sourced at partnership or corporate level. Income on this line has already been sourced by the partnership or S corporation by country and category of income. Include these amounts in Part I of the applicable Form 1116 for each category of income as provided. Code I: Interest expense on this line must be allocated and apportioned as described in the instructions to Form 1116. Any interest expense allocated to U.S. source income should not be entered in Part I of Form 1116.           Back to Table of Contents9  Detailed Explanation of the Concept (cont’d)           Flow-Through Entities Effects on FTC  AnalysisResources      Rules of sourcing partnership interest deduction to individuals who are general partners   or partners whose interest in the partnership is 10% or more:   They first must classify their distributive share of partnership interest expense as interest Treas. Reg. 1.861-9T(d)(1)  in the following categories:    Interest incurred in the active conduct of a trade or business,    Passive activity interest, or    Investment interest.   Then they must apportion their interest expense under the following rules: Individuals who incur business interest apportion that interest expense using an asset method by reference to the individual's business assets,  Individuals who incur investment interest apportion that interest expense on the basis  Treas. Reg. 1.861-9(e)(4)(i) of the individual's investment assets, or Individuals who incur passive activity interest apportion that interest expense on the basis of the individual's passive activity assets. The individual’s assets for the purpose of these allocations include its proportionate share of the partnership’s assets. Limited partners whose interest in the partnership is 10 percent or less, generally allocate interest expense proportionately based on the partner’s distributive share of foreign source gross income in each limitation category.  Back to Table of Contents10  Detailed Explanation of the Concept (cont’d)            Flow-Through Entities Effects on FTC AnalysisResources   Code J: Other expenses. The amount on this line includes expenses (other than interest) of the partnership or S corporation that must be allocated at the partner or shareholder level. Research and experimental expenditure is one example. Codes K, L, M, N, O: Deductions allocated and apportioned at the partnership or S corporation level to foreign source income. These expenses have been allocated at the partnership or S corporation level and are reported by country and category of income. Include these amounts on line 2 of each Form 1116 for each category of income received. Codes P, Q: Total foreign taxes paid or accrued. Foreign taxes reported on this line should have already been allocated and apportioned by the partnership or S corporation, by country and category of income. These amounts are included in Part II of each applicable Form 1116 by category. If there are multiple foreign countries/U.S. possessions, or more than one category of foreign income, and there is no breakdown of foreign taxes paid or accrued by country and/or category of income, ask the taxpayer to provide such detailed breakdown. Code R: Reduction in taxes available for credit. The reduction in taxes reported on this line should have has already been allocated and apportioned by the partnership or S corporation, by country and category of income. Include these amounts on line 12 of each applicable Form 1116 by category.  CONSULTATION: Refer to the instructions to Form 1116, as well as Form 1065 and Form 1120S for more explanation. Back to Table of Contents11   Examples of the Concept           Flow-Through Entities Effects on FTC Examples Part III, Schedule K-1 (Form 1065)                                       Back to Table of Contents12  Examples of the Concept (cont’d)            Flow-Through Entities Effects on FTC Examples As mentioned earlier, the same codes apply to line 16 of the Form 1065, Schedule K-1 as to line 14 of the Form 1120S, Schedule K-1. For the purposes of this example, only the Form 1065, Schedule K-1 is illustrated. The amounts shown on the K-1 in the previous slide are reported on Form 1116 (next slide) as follows: Line 16 code B: Gross income from all sources, both U.S. and foreign, is reported on line 3e of Form 1116. If there are multiple Form 1116s, this amount will be the same on all Form 1116s. This example assumes the K-1 is the only income activity of the taxpayer. Line 16 code G: Foreign gross income sourced at partnership level - general category is reported on line 1a and 3d of the Form 1116 for general category income. Line 16 code N: Deductions allocated and apportioned at partnership level to foreign source income - general category is reported on line 2 of Form 1116 for general category income. Line 16 code Q: Total foreign taxes accrued is reported in the applicable columns in Part II of Form 1116 for the applicable category of income, in our example, the general category. The partnership reports this amount by category of income and country. The partnership is also required to report the exchange rates used and the amounts in both the foreign currency and the U.S. dollar, as well as the dates paid or accrued. CAUTION: The amount of $200,000 on line 1 of the K-1,ordinary business income (loss), is not reported directly on Form 1116. This amount should be included in the gross income from all sources. If any amount of the ordinary business income (loss) is foreign source, that amount should be included in foreign gross income sourced at partnership level in the appropriate category of income determined by the partnership.     Back to Table of Contents13  Examples of the Concept (cont’d)            Flow-Through Entities Effects on FTC Examples Form 1116, Part I                                      Back to Table of Contents14   Examples of the Concept (cont’d)           Flow-Through Entities Effects on FTC Examples Form 1116, Part II                                        Back to Table of Contents15  Index of Referenced Resources                          Flow-Through Entities Effects on FTC IRC 702 IRC 703 IRC 704(b) IRC 861 IRC 862 IRC 863 IRC 865 IRC 901 IRC 1366 IRC 1373 Treas. Reg. 1.703-1 Treas. Reg. 1.861-9 Treas. Reg. 1.861-9T Treas. Reg. 1.904-5(h)(2) Form 1065, Schedule K-1 Form 1116 Form 1120S, Schedule K-1  Back to Table of Contents16  Index of Referenced Resources (cont’d)              Flow-Through Entities Effects on FTC Form 1065, Schedule K-1 Instructions Form 1120S, Schedule K-1 Instructions Form 1065 Instructions Form 1116 Instructions Form 1120S Instructions Pub. 514 - Foreign Tax Credit for Individuals                             Back to Table of Contents17  Training and Additional Resources        Flow-Through Entities Effects on FTC  Type of ResourceDescriptions Saba Meeting Sessions How to Audit FTC - FTC Concepts - 2015 Saba Meeting    Issue Toolkits Audit Tool - FTC Workbooks    Databases / Research Tools Kuntz & Peroni - U.S. Int’l Tax Para B7.07    Other Training Materials YouTube - International Taxpayers - Foreign Tax Credit                            Back to Table of Contents18  Glossary of Terms and Acronyms    Term/AcronymDefinitionFTCForeign Tax Credit  FTEsFlow-Through Entities  IRCInternal Revenue Code                                    Back to Table of Contents19  Index of Related Practice Units    Associated UILsRelated Practice Unit9432.01FTC General Principles  9432.02-01Sourcing of Income                                       Back to Table of Contents20

IRS Updates Process Unit on Effects of Flow-Through Entities on FTC

IRS Updates Process Unit on Effects of Flow-Through Entities on FTC

Internal Revenue Service

The IRS has updated a prior practice unit on the effects of flow-through entities on the foreign tax credit, noting that the update reflects the finalization of reg. section 1.861-9.

The IRS has updated a prior practice unit on the effects of flow-through entities on the foreign tax credit, noting that the update reflects the finalization of reg. section 1.861-9.

The IRS has updated a <a href="/lr/resolve//2cl4c">prior practice unit</a> on the effects of flow-through entities on the foreign tax credit, noting that the update reflects the finalization of reg. section 1.861-9.