If your partnership, S corporation, or LLC taxed as a partnership has owners who live outside the state where the entity earns income, or has any foreign owners, the entity itself is usually on the hook to withhold tax on their share of the profits. Nonresident partner withholding for pass-through entities is a collection tool: because these entities don’t pay income tax at their own level, states and the federal government reach the out-of-state or out-of-country owner by making the entity deduct and remit tax before the money leaves. Roughly 38 states impose some version of this rule on partnerships, S corporations, and LLCs taxed as partnerships, and Section 1446 of the Internal Revenue Code adds a separate federal layer for foreign partners.
Who Has to Withhold, and on Whom
The rule reaches general and limited partnerships, S corporations, and LLCs that elect partnership tax treatment. Profits flow directly to owners’ personal returns, which is exactly what creates the withholding problem: the state has no entity-level return to tax, so it makes the entity itself collect on behalf of nonresident owners.
A “nonresident” is any partner or member whose tax home sits outside the state where the income originates. For individuals, that usually turns on where you keep a permanent home or spend most of the year. For entity owners like corporations or trusts, it turns on where the entity is organized or commercially domiciled. Getting this wrong is expensive; misidentifying a nonresident partner as a resident can shift the full tax liability, plus penalties, onto the entity.
The entity’s own connection to the state also has to be strong enough to trigger the obligation. States apply nexus standards that look at physical presence (an office, employees, or property) and economic activity. Income tax nexus for pass-through entities can be triggered by fairly modest activity, like a partner performing services in the state or the entity owning rental property there.
What Income Triggers Withholding
Withholding applies to a nonresident member’s distributive share of income sourced to the taxing state. That includes ordinary business income, net rental income from in-state property, and capital gains tied to in-state assets.
Here is the point that trips up entities most often: withholding runs on allocated income, not on cash distributions. A partner who receives nothing in a given year still generates a withholding obligation if the entity earned income allocated to them in that state. Guaranteed payments to partners for services performed inside a state also trigger withholding in that state.
How income gets apportioned depends on each state’s sourcing rules. Most states now use market-based sourcing, which assigns service and intangible income to where the customer receives the benefit; a shrinking minority still use cost-of-performance rules. For multi-state entities, the sourcing method can meaningfully change how much income any given state claims and therefore how much needs to be withheld.
State Withholding Rates and Thresholds
State withholding rates for nonresident partners generally track the state’s highest marginal individual income tax rate, though some states use a flat percentage. Rates across the country range from under 5% to over 12%. Using the top marginal rate is conservative by design: it is easier for a partner to claim a refund than for a state to chase down underpayment from someone who lives elsewhere.
Many states also set a minimum income threshold below which withholding isn’t required. These vary widely, from as little as $100 in annual state-sourced income to over $15,000. If a nonresident partner’s share of in-state income is trivial, check the specific state’s floor before assuming withholding applies.
Federal Withholding on Foreign Partners
Any partnership with foreign partners faces a separate federal requirement under Section 1446 of the Internal Revenue Code. If the partnership earns income effectively connected with a U.S. trade or business, and any portion is allocable to a foreign partner, the partnership must withhold and pay tax to the IRS on that partner’s share.1Office of the Law Revision Counsel. 26 USC 1446 – Withholding of Tax on Foreign Partners Share of Effectively Connected Income
The rate depends on what kind of foreign partner is receiving the allocation. For non-corporate foreign partners, the rate equals the highest individual income tax rate, currently 37%. For corporate foreign partners, the rate is the top corporate rate of 21%.1Office of the Law Revision Counsel. 26 USC 1446 – Withholding of Tax on Foreign Partners Share of Effectively Connected Income These rates apply whether or not the partnership actually distributes cash during the year.
A separate rule covers the sale of a partnership interest. When a foreign person sells a partnership interest and any portion of the gain would be treated as effectively connected income, the buyer must withhold 10% of the total amount realized on the sale. If the buyer fails to withhold, the partnership itself must deduct the missing amount from future distributions to that partner.1Office of the Law Revision Counsel. 26 USC 1446 – Withholding of Tax on Foreign Partners Share of Effectively Connected Income
Partnerships report Section 1446 withholding on Form 8804 (the annual return) and issue Form 8805 to each foreign partner showing the tax paid on their behalf. These forms are filed separately from Form 1065 and are due by the 15th day of the third month after the partnership’s tax year closes, which is March 15 for calendar-year partnerships.2Internal Revenue Service. Instructions for Forms 8804, 8805, and 8813 Form 7004 provides an automatic filing extension, but the extension doesn’t push back the payment deadline.
Payment Deadlines and Owner Statements
State withholding payments typically follow the same quarterly estimated tax schedule that applies to individual taxpayers. For 2026, the federal estimated tax deadlines are:
- First quarter: April 15, 2026
- Second quarter: June 15, 2026
- Third quarter: September 15, 2026
- Fourth quarter: January 15, 2027
Most states mirror these dates, though a few set their own schedules.3Taxpayer Advocate Service. Your Tax To-Do List – Important Tax Dates The entity collects each nonresident member’s SSN or EIN, calculates their share of state-sourced income, applies the state’s rate, and remits by the deadline. Most states require electronic filing and electronic funds transfer, particularly above certain payment thresholds.
After the tax year ends, the entity must give each nonresident member a withholding statement showing the amount paid on their behalf. That statement is what lets the member claim a credit on their nonresident personal return, so timely delivery matters. Without it, the member double-pays.
Ways to Reduce or Replace Withholding
States offer several off-ramps from routine withholding. Which one fits depends on the state and the member.
Composite Returns
Most states with an income tax let the entity file a single composite return on behalf of participating nonresident members and pay the total tax in one lump sum. Participating members are relieved from filing their own individual nonresident returns in that state. Eligibility rules vary; some states limit composite returns to members whose only in-state income comes through the entity.
Exemption Certificates
Many states let a nonresident member sign an exemption certificate agreeing to file their own returns and pay directly. In exchange, the entity is released from withholding on that member. The entity must keep the signed certificate on file and typically attach it to the entity’s own return each year. If the member later fails to file or pay, some states hold the entity retroactively liable for the withholding it would otherwise have collected, so the certificate is not a permanent release.
De Minimis Thresholds
States frequently set a floor below which withholding isn’t required, on the theory that collecting a few dollars of tax isn’t worth the administrative effort. Amounts run from a few hundred to several thousand dollars of annual state-sourced income.
The PTE Elective Tax
Over 35 states now offer an elective pass-through entity tax, which lets the entity pay state income tax on behalf of its owners at the entity level rather than through traditional withholding. The election is driven by the federal SALT deduction cap: because the cap applies to individuals rather than entities, state tax paid at the entity level is treated as a business deduction and effectively bypasses the cap. The IRS confirmed this treatment in Notice 2020-75, which states that entity-level payments are “not taken into account in applying the SALT deduction limitation” to any individual partner or shareholder.4Internal Revenue Service. Notice 2020-75
How the PTE election interacts with withholding varies. In some states, making the election satisfies the entity’s withholding obligation for participating members; in others, the two systems run in parallel and need careful coordination to avoid double payment. Participating members typically claim a credit on their personal return for their share of the entity-level tax, and unused credits can often carry forward for several years. The election is generally available to operating businesses; its use by pure investment partnerships is less settled, and not every state’s PTE statute covers investment entities. The election is usually annual and requires advance notice to or consent from the owners.
Tiered Partnerships
When one partnership owns an interest in another partnership, the withholding rules split along federal and state lines.
For federal Section 1446 purposes, when a domestic upper-tier partnership holds an interest in a lower-tier partnership, the lower-tier generally does not withhold on the upper-tier’s share of effectively connected income even if some of the upper-tier’s partners are foreign. The withholding obligation sits with the upper-tier partnership, which withholds when it allocates income to its own foreign partners.5eCFR. 26 CFR 1.1446-5 – Tiered Partnership Structures
The rules flip when the upper-tier partnership is foreign. The lower-tier must look through the upper-tier to its partners. The upper-tier submits a Form W-8IMY to the lower-tier, and if the lower-tier can reliably associate each partner’s share of income with proper documentation, it withholds based on each indirect partner’s status. If the documentation is incomplete, the lower-tier withholds at the highest applicable rate on the entire allocable share. A domestic upper-tier partnership can also voluntarily elect to have the lower-tier look through it to its partners by attaching a written statement to Form W-9; the lower-tier must consent in writing.5eCFR. 26 CFR 1.1446-5 – Tiered Partnership Structures
State rules on tiered structures are far less uniform. Some states require the lower-tier to withhold on all income flowing up to the upper-tier, which then applies those payments as credits against its own withholding. Others place the duty entirely on the upper-tier. A few states let the lower-tier elect. Any entity operating in a tiered structure across multiple states needs to trace the obligation at each level in each jurisdiction separately.
What Noncompliance Costs
An entity that ignores its withholding obligations faces exposure on multiple fronts. At the federal level, a partnership that fails to pay Section 1446 tax is liable for the unpaid tax itself plus interest from the original due date. The IRS applies estimated tax penalties under Section 6655 to underpaid installments, calculated from each quarterly due date until the shortfall is corrected.6eCFR. 26 CFR 1.1446-3 – Time and Manner of Calculating and Paying Over the 1446 Tax This liability exists even if the foreign partner ultimately owes no U.S. tax on their share.
Separately, partnerships and S corporations that fail to file their federal informational returns face a penalty of $255 per partner or shareholder per month, up to 12 months.7Internal Revenue Service. Failure to File Penalty For a 10-member entity that files six months late, that alone is $15,300 before any underlying tax is owed.
State penalties follow a similar pattern: the tax that should have been withheld, plus interest, plus a percentage-based penalty on the unpaid amount. Some states add per-member penalties for each missed payment. In most states, the entity cannot recover from the nonresident partner after the fact. Once the state fixes liability on the entity, the entity pays.