Form 1042-S for Funds: Portfolio Interest Exemption and Dividends

Which income goes on Form 1042-S, and which on Form 8805?

Dividends and interest go on Form 1042-S; business income goes on Form 8805. Under sections 1441 and 1442, a US fund withholds 30% of each foreign partner's share of US dividends and taxable interest, unless a treaty lowers the rate, even when it pays out no cash, and reports on Forms 1042 and 1042-S. A foreign partner's share of income effectively connected with a US business falls under section 1446 instead, and the 1441 rules do not apply to it (Reg. 1.1441-5(b)(2)(i)).

Section 1446 withholding is covered in Foreign partners: what a US partnership must withhold and file. Whether a credit fund's loan origination makes its income effectively connected is a separate question: see Blocker corporations for fund investors. For how fixed or periodic income and treaties work in general, see When foreign owners owe US tax.

Feeders, fund-held stock or warrants in a borrower, and missed years make it harder. Start with each partner's Form W-8 and the loan terms (full list under the investors question below).

Which fund income is not subject to this withholding?

Gains from selling stocks, bonds and other property are generally not subject to it, because they are not fixed or periodic income; gains from US real property follow separate rules. Interest on bank deposits that is not connected with a US business is also exempt, and so is interest and discount on debt payable 183 days or less from issue, such as Treasury bills, even without a Form W-8. Certain interest-related and short-term capital gain dividends from a US mutual fund or other regulated investment company are exempt too (Publication 515). Short-term interest generally does not go on Form 1042-S (Form 1042-S instructions).

Must the fund withhold on dividends and interest it allocates but does not distribute?

Yes. A US partnership withholds when it makes a distribution that includes income subject to withholding. For a foreign partner's share that it has not distributed, it must withhold on the earlier of two dates (Reg. 1.1441-5(b)(2)(i)(A)):

1. The date the fund sends the partner's Schedule K-1.
2. The date the Schedule K-1 is due. That is the due date of the fund's Form 1065, including extensions (Reg. 1.6031(b)-1T). For a calendar-year fund, Form 1065 is due March 15 of the next year (Form 1065 instructions).

The rate is 30% of the gross amount unless a treaty or an exemption applies (Publication 515). Once the fund withholds on an undistributed share, it does not withhold again when it later pays that amount out (Reg. 1.1441-5(b)(2)(v)).

Which year's Forms 1042 and 1042-S show it?

Usually the next year's. For shares not actually distributed, the fund reports no liability in the year it earns the income. It reports the liability on the following year's Form 1042, on the line for the period that includes the earlier of the K-1 date and the K-1 due date (Form 1042 instructions). The fund must reconcile each Form 1042 with its Forms 1042-S, so the partner's Form 1042-S usually goes with that same year.

Proposed regulations, which the IRS lets funds rely on until final rules are issued, offer another route (83 FR 64757; Form 1042 instructions). A fund that withholds in the next year on a partner's share of the prior year's income may designate the deposit as made for the prior year, and report the income and tax on the prior year's Forms 1042 and 1042-S. If it withholds after March 15, those Forms 1042-S are due to the IRS and the partner by September 15, and the fund checks box 7c, the box for this designation (Form 1042-S instructions). The same September 15 date applies when the fund allocates prior-year income after March 15 and no tax is due on it. If the prior year's Form 1042 is already filed, reporting there means filing an amended Form 1042.

When does the portfolio interest exemption apply?

Interest, including original issue discount, is portfolio interest, and exempt from the 30% tax, only if every test below is met (26 USC 871(h); 26 USC 881(c); Publication 515):

Some contingent interest still qualifies: for example, interest is not treated as contingent only because the timing of a payment depends on a contingency, or only because the loan is nonrecourse (26 USC 871(h)(4)(C)).

Other interest that does not qualify, and is not exempt bank deposit or short-term interest, is taxed at 30% unless a treaty applies (Publication 515). Portfolio interest is exempt only from that tax and its withholding under sections 1441 and 1442 (chapter 3). An entity partner may still face withholding under the separate foreign account rules (chapter 4), for example if it is a nonparticipating foreign financial institution or has not documented its chapter 4 status (Publication 515; Form W-8IMY instructions).

Interest on a loan to a foreign corporation or a foreign partnership is generally foreign-source income, so it is not subject to this US withholding at all. The exception is interest paid by, or allocable to, the borrower's US business. A foreign partnership borrower with a US business gets the same limit only if it is mainly engaged in an active business outside the US; otherwise all of its interest can be US-source (26 USC 861(a)(1); Publication 515).

How are fees, PIK and OID treated for withholding?

Each follows its own rule:

• Fees. A fee for a service, such as arranging a loan, is not interest, so the portfolio interest exemption, which covers interest and original issue discount, does not cover it. Whether US tax applies to a fee depends on what the fee pays for and where any service is performed, which is fact-dependent. Whether an upfront payment is a fee or discount is covered in Private credit fund tax and accounting.
• OID and PIK. For a foreign holder, original issue discount is taxed when the borrower makes a payment on the loan or when the loan is sold or exchanged, not as it accrues. Withholding is due when the borrower pays, including at redemption; on a sale to someone else, withholding applies only where the sale is part of a plan to avoid tax (Reg. 1.1441-2(b)(3)(ii)). The taxable amount is the discount that accrued while the foreign person held the loan, less any already taxed, and tax on a payment cannot exceed the payment (Reg. 1.1441-2(b)(3)). Paid-in-kind interest usually becomes original issue discount. Discount that qualifies as portfolio interest is exempt like cash interest.

How the regulation's timing applies inside a partnership, where the fund holds the loan and the partner holds a fund interest, is not spelled out in that rule and needs a review. How the fund accrues PIK and OID on its own books is covered in Private credit fund tax and accounting.

How do equity kickers and warrants affect the 10% shareholder test?

They can push a partner over the threshold. For a corporate borrower, ownership counts stock owned directly, indirectly and by attribution under section 318 (26 USC 871(h)(3)(C); Reg. 1.871-14(g)(2)). Under section 318, stock a partnership owns counts as owned by its partners in proportion, and a person who holds an option to buy stock counts as owning that stock (26 USC 318(a)). The statute loosens some of section 318's limits for this test, so more stock is attributed than usual. Similar rules apply to a partnership borrower.

Warrants the fund itself holds are harder. The statute says stock a person is treated as owning only because of an option is not then treated as owned by that person's partners or shareholders (26 USC 871(h)(3)(C)(iii)). Read literally, stock under warrants the fund holds may count for the fund but not for its partners. Neither the statute nor the regulation settles this case, so a fund holding warrants or conversion rights in a borrower should get a review before relying on the exemption.

The test runs partner by partner. For interest a fund receives, the regulation applies the test only at the level of each foreign partner, at the time the fund would have to withhold (Reg. 1.871-14(g)(3)). So for each loan, the fund works out each foreign partner's ownership of the borrower, counting:

1. The partner's share of borrower stock the fund holds, such as shares received as an equity kicker.
2. Borrower stock, warrants and options the partner holds directly or through other entities.
3. Stock attributed to the partner from related people and entities.

One partner can fail while every other partner passes. The fund then withholds only on the failing partner's share of that borrower's interest, unless a treaty lowers the rate. The facts the test needs are often outside the fund's records, so ask partners with large stakes, and affiliates of borrowers, to confirm their other holdings.

Which Forms W-8 does the fund need, and how does a feeder's Form W-8IMY work?

The fund needs one valid form from each foreign partner before it relies on any exemption or treaty rate. Without one, it cannot apply a lower rate and generally withholds at 30% (Reg. 1.1441-1(b)(3); Form W-8IMY instructions).

A foreign partnership is not the beneficial owner of its income; its partners generally are (Form W-8IMY instructions). That is why a partnership feeder passes up its partners' forms. A withholding foreign partnership withholds on the same timetable as a US partnership (Reg. 1.1441-5(c)(2)). An investor that earns effectively connected income gives Form W-8ECI instead. A Form W-8BEN or W-8BEN-E generally stays valid until the last day of the third calendar year after the year it is signed, but a change that makes it wrong, such as a move to another country, ends it, and the partner must give a new form within 30 days (Reg. 1.1441-1(e)(4)(ii)(A) and (D)). When to use a corporate blocker or an offshore feeder is covered in Blocker corporations for fund investors.

A CPA firm can collect and review the forms, run each partner's tests and file Forms 1042 and 1042-S: see tax services for hedge funds and private funds.

What treaty rates apply to Canadian and Chinese investors?

The IRS treaty table gives these rates for the beneficial owner (Tax Treaty Table 1):

• Canada. The Canadian rate for contingent interest that is not portfolio interest is 15%, not zero. The lower dividend rate is for a company that owns at least 10% of the voting stock of the US corporation paying the dividend. The IRS says this kind of rate usually requires direct ownership, though some treaties also count indirect ownership (Publication 515). Whether a company partner meets the test through its share of the fund's holding turns on the treaty text and needs checking; otherwise the general rate applies.
• Mainland China. The table shows the same dividend rate for individuals and companies.
• Hong Kong and Taiwan. Neither appears on the IRS list of US income tax treaties, so no treaty rate is available (IRS: treaties A to Z).

The partner must be resident in the treaty country, be the beneficial owner and meet the treaty's other conditions, such as limitation on benefits. The claim goes on the partner's Form W-8. The table itself warns that it is not a complete guide to eligibility. A Canadian partner's own US and Canadian filings are covered in Canadian partner in a US LLC.

When are Forms 1042 and 1042-S and the deposits due?

For tax the fund withholds, or must withhold, in the tax year this page covers. For an undistributed share, that is usually the year after the income is earned, unless the fund designates it to the earlier year as described above.

A quarter-monthly period ends on the 7th, 15th, 22nd and last day of the month. A partnership with more than 100 partners, or one that files 10 or more information returns in the year, must file Forms 1042 and 1042-S electronically (Form 1042 instructions; Form 1042-S instructions).

What happens if the fund did not withhold or file?

The fund owes the tax itself. Every person required to withhold is liable for the tax (26 USC 1461), and the IRS says a withholding agent is personally liable for the tax, interest and penalties (Form 1042 instructions). If the partner later pays the tax on its own return, the IRS does not collect the same tax from the fund, but interest and penalties still apply (26 USC 1463). A partner or employee whose job is to withhold and pay over the tax, and who willfully fails to, can be personally charged a penalty equal to the unpaid tax (26 USC 6671(b) and 6672). The IRS generally has 3 years from the filing of Form 1042 to assess, and a Form 1042 filed before April 15 counts as filed on April 15. If no Form 1042 was filed, there is no time limit (26 USC 6501(a), (b)(2) and (c)(3)).

The late filing, payment and deposit penalties do not apply if the fund shows reasonable cause and not willful neglect (Form 1042 instructions). These Form 1042-S amounts apply to forms for this page's tax year, filed the next year, and a similar penalty applies separately to each partner's copy (Rev. Proc. 2025-32). Before the Form 1042 due date, the fund may withhold an under-withheld amount from later payments to the partner, or from the partner's property it controls, such as capital it holds (Form 1042 instructions). Missed years need a plan for which forms to file first and which partners can show they paid; that is a case for professional help.

What do investors and states need from the fund?

Each foreign partner needs a Form 1042-S that shows the income, the exemption or treaty rate used and the tax withheld. The partner uses it to claim credit for the tax on Form 1040-NR or Form 1120-F. How an investor gets tax back is covered in Foreign investor in a US fund.

Many states have their own withholding or composite rules for nonresident partners: see Fund state returns and nonresident withholding.

What to gather before year-end:

• Each foreign partner's Form W-8, and for feeders, Form W-8IMY with the partners' forms and the withholding statement.
• Each partner's Schedule K-1 and the date it was sent.
• Income by type and payer: dividends, cash interest, PIK and OID, fees, and gains.
• For each loan: the note, its registration terms, how interest is set, and any warrants or equity the fund holds in the borrower.
• Each partner's direct and related holdings in borrowers, where the partner's share could approach the ownership threshold.
• Deposit records and prior Forms 1042 and 1042-S.

Example

Illustrative only, in US dollars.

A US credit fund organized as a partnership earns $2,000,000 of dividends from US corporations and $1,000,000 of interest on registered loans to US companies in a calendar year. It distributes nothing. One limited partner is an individual resident in Canada who holds 10% of the fund, owns no stock in any borrower, and has given a Form W-8BEN claiming the treaty rate. The loans pay fixed interest, and the fund holds no stock or warrants in any borrower.

Dividends the fund does not distribute

The partner's share is $200,000. At the 15% treaty rate, the fund owes $30,000. The income is earned in year one. The fund sends the K-1 on March 10 of year two, before the March 15 due date, so the tax must be withheld on March 10. That date falls in the quarter-monthly period ending March 15, and $30,000 is over $2,000, so the fund deposits it within 3 business days after March 15. It shows the liability on its year-two Form 1042, on the line for that period.

Interest that qualifies as portfolio interest

The partner's share is $100,000. It meets every portfolio interest test, so the fund withholds nothing. It still reports the $100,000 on a Form 1042-S with the portfolio interest exemption code.

When one partner owns too much of a borrower

Suppose the fund had received 12% of one borrower's voting stock as an equity kicker. The Canadian partner's share would be 1.2%, still under the threshold. But a second foreign partner, resident in a country with no US income tax treaty, who holds 40% of the fund and also owns 8% of that borrower's voting stock directly would count 4.8% plus 8%, or 12.8%. Interest from that borrower would fail the test for the second partner only, and the fund would withhold 30% on that partner's share of it. If the second partner could claim a treaty rate on interest, that rate would apply instead.

Different for you?

• The fund's first foreign investor, or you are setting up withholding for the first time: see the first tax year for a new hedge fund, and get tax help for hedge funds and private funds.
• The fund missed withholding or Forms 1042-S in past years: the fund is liable for the tax, and penalties grow with time. Get tax help for hedge funds and private funds.
• The fund originates loans, or a partner's share could be effectively connected income: see Blocker corporations for fund investors and Foreign partners: what a US partnership must withhold and file.
• A partner owns, or could own, a significant stake in a borrower: the ownership test needs each partner's facts. Get tax help for hedge funds and private funds.
• The fund's PIK, OID or fee income is hard to classify: see Private credit fund tax and accounting.
• You are the foreign investor: see Foreign investor in a US fund, or, if you live in Canada, Canadian partner in a US LLC.