Note - Any federal tax advice contained in this transcript and audio recording is intended to apply to the specific situation described and should not be considered official guidance independent of the presentation. This transcript has been edited for technical accuracy and may differ slightly from the audio recording of the International Tax Issues phone forum. This information is current as of April 21, 2010. Since changes may have occurred, no guarantees are made concerning the technical accuracy after that date.
N. LeBlanc: Good day, everyone. My name is Nancy LeBlanc. I am a senior stakeholder liaison with Internal Revenue Service and I will be your moderator for today’s event. Thank you for participating on our national phone forum on international tax issues.
We have one presenter for today’s event. Tom Logan is an advisor in prefiling and technical guidance in the large and midsized business division of the IRS. Tom provides technical advice to revenue agents, international examiners, managers, directors, and practitioners on various areas of withholding on payments made to foreign persons. For 25 years Tom has been responsible for managing various programs involving withholding and reporting on payments made to foreign persons, including withholding and reporting on FDAP payments to foreign persons. Withholding and reporting on effectively connected income applicable to foreign partners, and withholding and reporting on foreign persons disposing of U.S. property interest also known as FIRPTA.
Tom has an MBA in accounting and an MS in taxation from Long Island University. And with that, I’ll turn it over to our presenter, Tom Logan.
T. Logan: Thank you, Nancy. Good day to everyone on the phone here. We certainly are grateful that you joined us here today. About two years ago the commission of our Large and Midsized Business division elevated this area of taxation to the level of tier one. What this means is that the IRS has been allocating more resources to this area of taxation. We are also giving comprehensive training to our international examiners and our revenue agents. We’re also training our service campus personnel to help them be more effective in processing these withholding documents.
In addition to that, we have expended our outreach initiatives in tax forums, such as this, as well as conferences and seminars. So there’s a lot going on in this area and the timing couldn’t be better for you to join us in this forum here today. We greatly appreciate it.
Today we are going to be talking about reporting and withholding on payments to foreign persons. Now this is an area that as I say is becoming increasingly popular in the IRS and also throughout the nation, throughout the world because the world has gotten so much smaller with so many foreigners here and so many U.S. people going abroad or starting businesses abroad. But we are primarily focusing on today on payments made to those foreign persons.
We’ll have a general overview of what withholding and reporting on payments to foreign persons involve. We want you to at the end of this feel more comfortable with this area of taxation. We’ll try to throw in a little example where we can. Of course, with the time restraints, we can’t do very much with that, but where necessary, we will. I know that there is also a time at the end of this session, about ten minutes I believe, we’ll have for questions, so we’ll take it from there.
As mentioned you have the Power Point presentation before you. And if you do not have them, of course, you can follow the instructions that the moderator gave to get a copy of them. If you look at slide two, it says types of chapter three withholding, chapter three, of course, referring to chapter three of the Internal Revenue code. And if you look at each one of these sections, Section 1441, 1442, 1443, 1445, 1446, these five sections are the main sections that cover withholding on payments to foreign persons.
Section 1441 and 1442 are spoken of together because these are the ones where you have your 1042 filings and they all include the same type of income, withholding on the same type of income. So these two are the ones where we will put most of our emphasis on today. Section 1443 withholding of tax on foreign tax exempts, this covers the foreign nontax or tax exempt entities, perhaps like Amnesty International or Red Cross International or some of the religious nonprofit organizations that are foreign and so forth. We won’t say anymore about that. But if you have questions, of course, we will be glad to entertain those. Section 1445 covers withholding of tax on disposition of U.S. real property interests. This is also known as the FIRPTA defection where we have foreign persons disposing of U.S. real property interests. And section 1446 covers withholding of tax on effectively connected income applicable to foreign partners.
All of these sections, any time you make a payment to a foreign person, one or more of these sections will be affected. So just having that knowledge and knowing where you can go to should be very helpful to you because these are the sections of the code and the related regulations that govern those particular transactions where different types of income or different types of payments are being made to foreign persons.
If you look at slide number three that says withholding agent, the person who is required to do the withholding on these payments to foreign persons is called the withholding agent. Withholding agent is any person or entity who has control, received custody disposal of payment of any item of income of a foreign person that is taxable by a foreign person and that is subject to withholding. So anyone can be a withholding agent. It can be an individual. It can be a corporation or partnership. It can be an estate or a trust, foreign or domestic, as long as they have control, receive custody of disposal or payment of any item of income of a foreign person that is subject to withholding.
It’s very important to know if you’re a withholding agent because the withholding agent can be held liable, not only for the tax itself, but also for any penalty and interest. One of the things that you don’t want to do is pay taxes and interest and penalties on income that’s not yours. The withholding agent is like an agent in between. The money is not theirs, but you can end up paying taxes and interest and penalties on monies that is not yours. The withholding agent is the one that the IRS goes after. That’s the way the laws are written primarily that way because the withholding agent is normally here in the United States, which makes it far more easier to collect the monies. We will say more about withholding agent responsibilities in a moment.
But if you look at slide four, you’ll see some examples of withholding agents. You have corporations, partnerships, single proprietorships, individuals. Individuals can also be withholding agents. Lots of times we have individuals that hire foreign persons. It could be nonresident aliens, for example, to do work and when they pay that person, they are a withholding agent. In fact, any time you make a payment to a foreign person, you are automatically a withholding agent. Sometimes you are a withholding agent even if you don’t make a payment directly to a foreign person.
This happens, of course, if you are paying a foreign person for work that that foreign person has done and that foreign person tells you to pay the money to the Bank of America because they owe the Bank of America money. Even though you’re paying the Bank of America, you know that the money is for the foreign person, so you still have to withhold for that payment being there to Bank of America even though Bank of America is U.S. So you can be a withholding agent and not even know it.
Sometimes you can be a withholding agent when no withholding is required because there are various types of income that require reporting, even when no withholding is required. Portfolio interest is an example of this. So withholding agent has very great responsibilities. A withholding agent can be trust or estate, association, government agencies. You probably won’t be involved with government agencies, but we do have many government agencies who are not compliant in this as they should be. They bring over people. For example, the Department of Agriculture may bring over some Russian farmers, for example, and they pay the expenses for these people and give them a grant or a dividend or a stipend or some such compensation. But that compensation is subject to withholding by that government agency.
The same is true with colleges and universities who bring in foreign scholars to teach or to research and give them research grants or to give them other type stipend or compensation. Then there should be withholding. Nonprofit organizations as well, you have religious organizations, such as churches that bring in foreign missionaries or foreign ministers to speak or to do a conference or to do revival or something of that nature. Many times they are paid not only for their expenses, but other payments as well.
So all of these are withholding agents. Once they are making those payments to a foreign person, and a “foreign person” and we’re not just talking about a nonresident alien individual. A foreign person can be any foreign entity, a corporation, a trust, whatever. We have a slide here on that as well.
But if you look at slide number five, we talk about the responsibilities of the withholding agent. A withholding agent is responsible for verifying the identity and status of the foreign person and they do this by looking at certain documentation. The withholding agent has to determine is this person foreign or is this person U.S. They must make that determination. The onus is on them to do that.
The withholding agent must withhold at the proper rate and the withholding agent is also required to deposit the withholding or submit the withholding. Under some sections, like the first two sections we mentioned, 1441 and 1442, the withholding must be deposited following the deposit rules that are found in our publications and various other public writings of the IRS. Also, on the 1445 and 1446 the withholding must be submitted to the IRS rather than deposited. So it depends on the transaction and where, what type of section governs that transaction.
The withholding agent is also responsible for filing accurate and timely withholding tax returns, as well as providing a statement of the withholding to the foreign person that is paid. So these are the responsibilities of the withholding agent and the withholding agent can be held liable if it does not adhere or follow all of these responsibilities.
We said that the withholding agent must verify the foreign person’s identity of status by looking at certain documentation. The documentation is shown here in slide number six. This is not documentation like we use the term documentation in everyday life, but this is standard documentation issued by the IRS and require to be obtained from the foreign person by the withholding agent before the payment is made to that foreign person. This documentation is very important because if you don’t have the documentation, then how do you know or how does the IRS know who the payment was made to. So it’s very important and this is one of the first things that an auditor will ask for during a withholding type audit --where is the documentation or let me see your documentation. This is what they’re talking about here.
We have different types of documentation for each type of transaction. We have W-8BEN for the beneficial owner. The beneficial owner is the person that is required to report the income on his or her tax return. The beneficial owner or W-8BEN verifies the beneficial owner’s status, as well as the beneficial owner’s identity. And in part two of that W-8BEN, it verifies if the foreign person is subject to treaty exemptions or treaty rates.
The W-8ECI, ECI is for effectively connected income. And that also identifies the beneficial owner’s status and identity and it tells the withholding agent that they do not need to withhold because the income is effectively connected with a U.S. trade of business. In other words, it is business income, so you don’t have to do withholding on it.
We have a W-8EXP for exempt. EXP, the beneficial owner of that is usually an exempt organization. It could be a foreign government or foreign governor. It could be a foreign, let’s say, International Red Cross or some foreign religious organization or Amnesty International, one of those that met 501(c) status and are exempt. That entity will give the withholding agent, will give them the W-8EXP to show that they are exempt.
Then we have the W-8IMY. “IMY” we call it. This for your flow-through entities, like a partnership, a foreign partnership or trust or estate that is not the beneficial owner, but it is receiving the payment on behalf of its foreign partner or it’s foreign beneficiary. So they would give the withholding agent a W-8IMY in that particular situation.
If the withholding agent does not have this documentation, the withholding agent must rely on what is called presumption rules, which are found in the regulations, the 1441 regulations, but that’s beyond the scope of this presentation here today. But they will rely on a presumption rules and the presumption rules will give them guidance as to how to withhold and how to report the payment when they don’t have valid documentation or even if they got documentation and cannot rely on it for whatever reason. If the withholding agent do not rely on the presumption rules, then that withholding agent can and most likely will be held liable for the taxes, the interest and the penalties.
This documentation again is very important for the withholding agent to get and they should get this before the payment is made to the foreign person. This is how the IRS will know who you’re paying.
If you look at slide number seven, it tells what the withholding is, these are all under 1441 and 1442. We are still talking about those first two sections that we mentioned on slide number two, 1441 and 1142. This is where the vast amount of transactions will fall. So we are under those sections still.
The withholding rate on the 1141 and 1442 will be 30% on the gross amount paid to the foreign person, 30%. That 30% can and frequently is reduced. That rate itself is reduced if the foreign person is from a treaty country and that person provides documentation claiming treaty benefits. That would be a W-8BEN in most cases. That foreign person provides the withholding agent with that W8BEN, then the withholding agent will know that they don’t have to withhold.
And the tax return that is required to be filed by the withholding agent is the form 1042. Form 1042 is due March 15th of the subsequent year. And attached to the 1042 should be form 1042S; 1042S is equivalent to a W2 form. It’s called an information return and that 1042 is issued to the foreign person. The foreign person uses that form to file his or her tax return if a tax return is indeed due. And there is a penalty for not issuing that 1042S to the foreign person. I believe it’s $50 for each return that has not been issued.
A 1042S should also be attached to the form 1042 for every person, every foreign person that was paid during the year. So you may have 100, you may have 200. Some large entities have thousands of them when you get to some of the large brokerage houses and banks and investment firms and that kind of thing. They have many of these. Of course, they’re required to file them electronically when they get over 250.
If you look at slide eight, you’ll see the withholding penalties and also the interest. As you can see here, there are a variety of penalties that are applicable to the withholding agent failed to pay, failed to file, failed to deposit, failed to issue statement, failed to file information returns. And then you have your fraud and accuracy related penalties and also you have interest itself, interest on underpayments or interest on payments that were not made timely. All of these penalties and the interest itself is directed toward the withholding agent.
The withholding agent as you see is in a very responsible position here and it could be pretty risky for that withholding agent if it does not do its job. So it’s very important to keep this in mind to know whether you are indeed a withholding agent or whether you’re not a withholding agent. Many times people are withholding agents and do not know it. So you really want to be careful and you want to know if you’re a withholding agent or not.
Now in slide nine we answered the question how do you know that withholding should be done under these two sections, 1441 and 1142; 1441 and 1442 are basically the same. One covers nonresident alien individuals. That’s 1441. And 1442 covers corporations and all other entities. But 1442 refers back to 1441 in most cases. So like sometimes we just say 1441.
But how do we know when taxes is done under this? These are the sections where you have your 1042 and 1042S filings. Here’s how you know that the transaction falls under 1141 and 1442. Is the income U.S. sourced? This is the first step and this is very important because only U.S. source income requires withholding. Very seldom is foreign source income subject to withholding, only in very rare conditions. But you want to know if it’s U.S. source income. You don’t use common sense with this at all. You have to go through the sourcing rules which you’ll find in code section 8613 and 65. But we also have them enumerated in our publications, specifically publication 515. You can tell whether the income is source or not. We have one column for listing the type of income and another column listing how you determine the source of that income. So you want to know if the income is U.S. source.
Second you want to know whether the income is fixed or determinable, annual or periodic income what we call FDAP income. Of course, we’ll have much more to say about that in a minute. But you want to know if it’s FDAP income. By the way, when you go right back to the sourcing rules again, and the reason I mention that that was one you should do first is because you don’t want to waste a lot of time trying to determine whether the income is taxable or not or whether it’s treaty rates and all of that if it’s not necessary. We’ve had people that spent lots of time trying to determine how to tax withhold on foreign income and they find out the income was foreign source income, didn’t even need withholding on it or didn’t require withholding. So you want to make sure that you do that first and get it out of the way to determine the source of it. If it’s U.S source, again, there would be withholding. If it’s not U.S. source, it’s foreign source and foreign source would not require the withholding.
But back to the FDAP: if the FDAP income is fixed, determinable and periodic and as I said, we will have much more to say about that in just a moment. But that is the second requirement, U.S. source then FDAP.
The third one is that the income should not be effectively connected with the U.S. trade or business. In other words, it should not be business income. So if we determine then whether the income is subject to withholding under section 1441 and 1142, we want to know if it’s U.S. sourced. We want to know if it’s FDAP. We want to know if it’s effectively connected with an U.S. trade or business. Now let’s look at each of these in order in a little more detail.
If you look at slide ten, let’s just take the U.S. sourcing, let’s take the sourcing rules and see what that encompasses. Here we have a list of different types of FDAP income and also to the right, it tells us how to determine the source.
Personal services-- this is determined by where the services were performed, not where the contract was made, not where the payment was made to or from but where the services are performed. If you have someone in India who’s making software for a U.S. company and that U.S. company pays that foreign person in India, that is foreign source income because that foreign person is doing the services in India. So that’s foreign source income since India is a foreign country. So personal services are determined by where the services were performed.
I can’t tell you how often we get this question because the sourcing rules are somewhat complicated in some ways. And we don’t seem to follow a certain line of reasoning in many cases, but this is one. If dividends are paid to a foreign person, we look at the location; we look at whether the corporation that’s paying those dividends is an U.S. corporation or is it a foreign corporation. If it’s a U.S. corporation, then the dividends are U.S. source. If it’s a foreign corporation, then it’s foreign source.
With interest we look at the resident of the payor, the financial institution that’s paying the interest. If it’s rent, we look at the location of the property. Where is the rental property located, in the U.S. or outside of the U.S.? If it’s U.S. located in the U.S., then it’s U.S. source.
Royalties, we look at where the property is used. We have different types of royalties. We have natural royalties and we have royalties on certain intangibles, like patents and copyrights and so forth. If patents and copyrights royalties are being paid, we look at where the property is being used. An example of this would be, let’s say, you have an Italian actor who makes a movie in Rome. Next year that movie is shown here in the United States. Well, any royalties generated from that movie being shown in the United States would be U.S. source royalties and there would be a withholding requirement even though that Italian actor never stepped foot in the United States.
We also have natural royalties. These would be from your mines and wells and forestry, timberlands and so forth. We look at where the property is located. Then we have pensions. This is determined by where the nonresident alien worked, performed the service while he was a non-resident alien. So you can see how the sourcing rules work and that’s very important because you want to make sure it’s U.S. source.
Now let’s look at the second one we talked about in slide nine is the income fixed or determinable, annual or periodic, what we call FDAP income. FDAP income if you look at slide 11, this is usually looked at as investment type income or passive type income. There are several examples shown here, dividends, rents or royalties, interest and so forth. These are all FDAP type income. But you want to be aware of the fact that any income can be FDAP income, except income that is specifically exempt by statute, like tax free municipal bonds or gains from the sale of real or personal property.
Then you want to know the third one on slide nine if you look at slide 12, the third one is the income effectively connected with a U.S. trade or business. We know that there are two tests for this. We asked ourselves two questions. Were the business activities a material factor and generating the income and were the assets in the business used to generate the income? If the answer to both of those questions is yes, then that income is effectively connected. In order for it to be withheld upon under 1441 and 1442, it cannot be effectively connected. So this is how you make that determination. Is it U.S. sourced? Is it fixed or determinable, annual or periodic for FDAP income and is it not effectively connected? Then you know you withhold under section 1441.
If you look at slide 13, here we have the definition of a foreign person. This is important because if you read any of our publications or any of the regulations or the code itself or notices or rev procs, and you see the term foreign person, note that it is not just talking about a nonresident alien individual. But it is talking about any foreign entity, corporation, partnership, trust or association, any entity that’s not U.S. This is important.
Now when we talk about non-resident alien individuals, there’s two types of aliens. You need to know the difference between the two as shown here in slide 14. You have a resident alien and nonresident alien and in order to determine the difference, it’s important to determine the difference because they are taxed completely different. The resident alien is anyone who has a green card or who has passed what is called a substantial presence test, which is a simple mathematical test to see if the foreign person was in the United States 183 days during the past two years. If the person meets any one of those tests, then that person is a resident alien and he is to be taxed exactly the same as a U.S. person, no withholding, except the same that you would do for a U.S. person. If he does not fall into that situation and is a nonresident alien and you have to apply the withholding that we just talked about with the U.S. sourcing for FDAP and it’s effectively connected and so forth.
Now let’s say the person is a nonresident alien. He comes to you. He has to fill out a W-8BEN verifying his identity and status. You also give him a copy, a form W-4 to fill out. There are special rules for him to fill out the W-4 form. For example, he cannot write exempt on a W-4 form as U.S. person. He must claim only one exemption, single, even if he’s married because there’s no such thing as a joint 1040NR and this is the tax return that he must file. He cannot claim more than one personal exemption on the W-4 unless he’s from Canada, Mexico or Korea.
The are certain exceptions to the withholding. If the foreign person or nonresident alien was in the United States not over 90 days and we’re looking at slide 16, and if the income is not over $3,000 and that nonresident alien worked for a foreign entity, then you don’t have to do withholding. Also on slide 17, there are more exceptions. If the nonresident alien is on a F, J, M, or Q visa and worked for a foreign person, there’s no withholding. So that F, J, M, or Q visa is the type of visa that is usually for foreign scholars and students and so forth. So that’s how 1441 and 1442 works.
1445 covers withholding and disposition of U.S. real property interest by a foreign person. If the foreign person disposes of a U.S. real property interest, that foreign person is entitled to 10% withholding on the amount realized. And that 10% can be reduced if certain circumstances exist and that foreign person submits a form 8288-B, which is an application for reduced withholding. And whether it’s reduced or not, the withholding agent must submit the withholding by the 20th day by filing a withholding return on form 8288 and 8288-A. The 8288-A is similar to the 1042S and must be issued to the foreign person and one attached to the 8288. The foreign person ,of course, is required to file a tax return 1040NR or 1120F.
If you look at slide 19, now we are talking about 1446. This is the partnership withholding. Any time you have a partnership foreign or domestic that has effectively connected income and that income is allocable to a foreign partner, there is a withholding requirement. In other words if the effectively connected income is nothing but business income that flowed through the partnership and that income if it’s allocable to a foreign partner, there must be withholding. The income does not have to be distributed to the foreign partner at all. In other words if you have a partnership and two partners, one foreign, one domestic, that partnership has income, net income of $100,000 and the partnership agreement says they are to get 50/50, then the income that is allocable to the foreign partner is $50,000. There should be a withholding on that foreign partner at the highest rate, of course. Even though that partnership didn’t pay the money out, there’s still a withholding. That withholding must be submitted to the IRS on form 8813 on the 15th of the fourth, sixth, ninth and 12th month of the year. So it’s a quarterly estimated type tax.
At the end of the year then the partnership files the withholding return 8804, attach 8805 to it. The 8805 is the statement that is required to be given to the foreign partner and there’s one attached to the tax return 8804 for each foreign person that was paid or who was withheld upon during the year. The work that partnership can reduce some of this income if that foreign partner submits a 8804C showing that he has certain deductions and net operating losses and so forth that he wants to be included. But the documentation has to be submitted to the partnership for that to happen.
Now if you look at slide 21, it tells you where to get more information. The sections that we mentioned, 1441, 1442, 1445, 1446 and also the regulations that are related to those sections. We also have some excellent publications, 54, 515, they’re the better ones for this particular topic and also 519 and 901 will give you some information. All of the forms that we’ve mentioned here today, the related instructions are very helpful. There’s a wealth of information on those instructions. Also you can go to our Web site, which is listed here in slide 21. That will be helpful to you as well.
We have two withholding technical advisors on slide 22, Bob Driscoll and myself. We have one senior program analyst who is also an expert withholding analyst. If you cannot get the answer, if you have exhausted all resources, then you may contact one of us. Please do so by email if you do have to contact one of us, but again, make sure that you have done your homework, done your research before you contact us because we want to be helpful. We want to be available to you. But all of us are extremely busy, so it may take us a little while to get back to you. We prefer you do this by email because emails force you to list the tax situation in a more definitive way. That’s what we’re looking for. We’re looking for points. So we’re looking for emails rather than phone calls. Bob Driscoll, myself, and Lowell Hancock.
Thank you very much for listening in. I would now like to turn this over to our moderator, Nancy.
N. LeBlanc: Thank you, Tom.
Teddy: Could you even hazard a guess as to how many folks still have the offshore, the legal type of accounts there? Do you think that will be a major issue in the future?
T. Logan: Are you talking about offshore bank accounts, Teddy?
Teddy: Yes.
T. Logan: Yes, there are a lot. I don’t know the number. I’m sure you’re aware of the UBS case. That has opened up a whole keg of worms. We are looking at that very, very carefully and a lot of focus is being done on that with our qualified intermediary team in Manhattan, as well as the withholding technical advisors. We’re looking at that very carefully. We don’t know the number. I’m sure that there is a guesstimate out there somewhere, but I don’t know what the statistic is on that, but we’re trying to rein them in.
Teddy: Thank you and just quickly, are you from Charleston, South Carolina?
T. Logan: I’m from South Carolina, you bet. As a matter of fact, I’m from Summerville, South Carolina.
Teddy: Okay, I love that accent.
T. Logan: Are you from there?
Teddy: My family is from South Carolina.
McGee: I have a quick question. One of my clients is a U.S. corporation and they have an agent stationed in Mexico, a sales agent stationed in Mexico and they’ve been paying commissions to this agent in Mexico. If I’m understanding correctly, the fee or the commission paid to this agent in Mexico should be considered foreign source income because the services are performed in Mexico. Therefore, my client doesn’t need to withhold tax on the commission paid to this agent. Also my client does not need to file a form 1042. Is that correct?
T. Logan: If the services are performed in Mexico by this Mexico agent and then it’s foreign source income and it’s not required to be withheld upon or reported. However, you have to be careful. In lots of these situations we’ve seen where some of the people from the agent, especially in Mexico from the agency come over to the United States and do some work, even though it’s for part time. So you have to watch that, because if they’re here in the United States and they perform some services, now you’re making a payment to a foreign person. And you may have to do some allocation there, but you certainly have to do withholding for the time that person did work in the United States.
McGee: I see. Do we need to ask them to give us W8?
T. Logan: I always recommend that they receive, get a copy of W-8BEN or either have some documentation that the W-8BEN covers. In fact, what you want to do is verify the identity and the status of that foreign person. And the reason for that is if an order comes around for the withholding agent, then who’s this payment made to? You don’t want to say it’s made to so and so. Then you don’t have anything at all to show. So you want to have some kind of record there to show that the payment was indeed made to the foreign person.
McGee: How do we know whether he had traveled to the United States to perform the service?
T. Logan: Well, you’re supposed to have that information. You’ll definitely have to know. The person who’s making the payment would know. They know whether the person did work—in other words, you don’t want to make payments to somebody if you don’t know where they did the work at or whether they did the work, so you want to make sure. “Coming to the United States” is only to do the work in the United States, I don’t mean that the person can’t come the United States to visit. I mean if the person does work in the United States, then, of course, the payment would be made to a foreign person.
McGee: I guess my client needs to ask them, “have you traveled to the United States to perform service work?”
T. Logan: Exactly. That’s what you do. And you may have to allocate the time.
McGee: But that $3,000 extension doesn’t apply here, right?
T. Logan: What does apply there is the business profit article of the treaty, the Mexico/U.S. treaty. So before you start withholding, take a look at that treaty because the business profit article will most likely apply there and that will get him out of withholding if there is any withholding at all when he does come to the United States. You don’t need the treaty for the foreign source income for the time he worked outside of the United States down in Mexico. You don’t have to worry about the treaty for that. That’s not reportable or taxable. But if he comes to the United States and does work, then you want to look at the business profit article.
Suzanna: I almost got an answer with the previous person. So if a U.S. corporation hires foreign corporation to do research there, so it’s basically what you answered, it’s not reportable and not subject to withholding. Is that correct?
T. Logan: That is correct, but again, make sure that the people doing the work in that foreign corporation are in that foreign corporation. Lots of times we see these people that come to the United States a couple times a year to do work or for training or something like that. But if they’re performing any services at all for any length of time, you want to watch very carefully. Now there are exceptions. If they come to the United States and they don’t stay over 90 days and they don’t make over $3,000, the exceptions that are shown under our slide 16, those are exceptions for that. So usually they could get out of it pretty easily, but you want to be careful there because let’s say he comes and stays six months and doing work, which does happen. Now you’re making payments to a person who is a nonresident alien performing work in the U.S. and that’s U.S. source income, which is subject to withholding on the 1441.
Robert: If I pay an individual person in India to do data entry for a Web site, is there anything special I have to do about the withholding or reporting, in other words, I report the expense on my Schedule C?
T. Logan: Yes, you can take the expense as long as that individual is doing the work in India.
Robert: Yes, it’s remotely. He does it remotely. He’s in India.
T. Logan: Right, as long as he is not coming to the United States to do the work, he’s performing the services in India, so that is foreign source income, which is neither reportable or required to be withheld upon. You can take the expense, yes. You don’t have to do anything. One thing that I do advise is to make sure that you have some kind of record as to whom the payment is being made.
Robert: I pay him by Western Union.
T. Logan: That’s fine, but make sure you have an identity for him or a status on identity. The status being he’s a nonresident alien and the identity is who it is. So you want to make sure you have some record of that, so that if you’re audited, then the auditor will ask “who are you paying,” “who are you making these payments to?” I see the deductions here, but I don’t see who you’re making the payments to. Then you can say this guy here is a nonresident alien. I’m making payments to him and he does the work in India.
Loren: I have had clients who were trustees of U.S trusts or executors of U.S. estates paying money to beneficiaries of the trust or estate located in a foreign country. Often the beneficiaries are unsophisticated in the ways of taxation and legal matters, sometimes even quite elderly. I find that some of the questions that have to be answered on the W-8BEN are quite technical and quite challenging for the beneficiaries to deal with without obtaining legal counsel. Sometimes then there are also language issues for people trying to understand U.S tax forms that are written in highly technical, using highly technical terminology. I’m wondering if other people are finding the same challenge of getting the W-8BEN back with credible information from such payees and whether the IRS is doing anything to address these situations.
T. Logan: Yes, this is a very, very common problem. In fact when we said the withholding agents should be getting this documentation, the foreign person don’t have the slightest idea what you’re talking about when you come to them with talking about a W-8BEN or W-8ECI and you give them the form. They don’t know what you’re talking about. So most of the time the withholding agent will fill it out for them. We have no problem with that as long as they, the withholding agent explains it to them and they sign it, showing that they understood what was explained to them. You must let them know why you are getting it, why you are acquiring it from them and why it’s necessary for them to have it.
So a lot of withholding agents take this upon themselves to complete and have the foreign person sign it, but they’re certainly not going to know. You’re absolutely right there. But the way out of it is to have someone do it. You don’t want the person to have to go through a whole lot of problems with it. This could be done even if you have to do it and mail it to them. As long as you can explain to them what it’s about, mail it to them for signature and then have them mail it back to the withholding agent. And the withholding agent is just to keep these on file. They don’t submit these to the IRS. These are primarily for the auditors and for the withholding agents’ record, of course.
Debra: Just to follow up on that last question, we’ve pretty much beat to death that you don’t need the 1042 when you have foreign source income. But is there any problem with issuing them anyway just as for as like you said, you having a record for the client and the person in the other country and it’s setting up that there is a code on the 1042S that say, exempt, I think it says not U.S. source income.
T. Logan: Yes, but you don’t have to file a 1042S, if that’s what you’re asking.
Debra: I know it’s not required, but if they just want to go ahead and file it anyway as a record or just to show that the income was paid to a non-U.S. person.
T. Logan: You can if you want to. Nothing will happen there. It’s just a little bit more work for the processing and little bit more work for you, of course, but it’s not required at all. But as I said earlier, you definitely want to keep some kind of record as to whom the payment is made.
Debra: Like you said, just get going and get the W-8BEN probably would just be better way to document it.
T. Logan: That’s why most people prefer doing the BEN and just keeping the record for themselves because the BEN is already standardized and they have the questions already there and that kind of thing. So it’s better just to do that than try to keep some kind of diary type load or that kind of thing, whatever is best.
Debra: Whatever works because I think it’s a good point because sometimes you’ll say “is this person working in a foreign country?” and they say “yes.” And then a couple years later, “well, maybe I was there for a couple weeks.”
T. Logan: Right, exactly, and those kind of things do happen and somehow they will surface during an audit.
Debra: So I think at the time when you’re doing it if you’re saying to the other person “I understood you were out of the country doing it and here’s the form for you” stating that.
T. Logan: Yes, whatever is convenient.
Larry: With respect to missionaries and coming to America and preaching and their honorarium, how do we treat that and also with American missionaries going to a foreign country?
T. Logan: Let’s take the last part of that question first. If you are a U.S. citizen, if you’re American and you go to a foreign country and you get paid, then that income is reportable on a 1040. As you know U.S. citizens are required to report worldwide income. Depending on their situation, they may be able to take a foreign tax credit or either a foreign housing exclusion or deduction, depending on how long they stayed over there and that kind of thing. But they are required to report that income on the 1040 subject to report worldwide income.
If a foreign missionary comes to the United States, that foreign missionary is usually paid some type of compensation. Usually it’s called an honorarium or a gift. Lots of times they just call it a gift for churches. Sometimes they call it stipend or something to that effect, but it’s some type compensation. The IRS looks at it as compensation. That foreign minister may also receive payments for his or her expenses. There may be lodging expenses, or meals and incidentals and so forth.
You have to separate the two. The money that’s paid for compensation, whether it’s called a stipend or a grant or whatever, that money is supposed to be withheld upon at 30%. Or if that person is from a treaty country, they give you a W-8BEN in clearing the treaty …, it may bring it down to 5% or 10% or 15% or maybe zero, depending on the country and what’s in the treaty. The part that is paid for the expenses, the church has to have what is called an accountable plan, whoever is paying for these. And accountable plan, this is some kind of plan to verify expenses that are paid, payments that are made for expenses of someone. If they have an accountable plan showing what the expense are, then, of course, they don’t have to withhold on that at all, but they must separate the two. Income is paid for the actual work or compensation, and also income that is paid for the expenses. Because the church is 501(c) doesn’t mean that that minister is 501(c), he’s not.
Larry: If the minister is under a professional corporation or a 501(c)3, you’d still have the same requirements.
T. Logan: That is correct because the payment is being made to him. If the payment was made to the entity, let’s say the payment was made to a foreign church and the foreign church is a 501(c), now you have a different situation. There’s no withholding requirement. But the church would have to give the, the foreign church would have to give the U.S. payer a W-8EXP.
Larry: EXP, it being exempt.
T. Logan: EXE. Exempt, right, EXP, yes, would mean that he’s exempt.
Larry: What if that same foreign minister detained to maybe that a domestic church paid for that foreign minister in another foreign country and the work was not done, the service was not performed in America, how would that domestic church, American church, account for the services in another foreign country for another - ?
T. Logan: Same thing. You have the same church, that church is still paying that minister in a foreign country. Whatever foreign country that is, it’s foreign if it’s not the United States. What you are saying is that he’s doing work in the foreign country. In other words, then that’s a different story, because he didn’t come to the United States. I’m sorry.
Larry: He didn’t come to the United States. Say, for instance -
T. Logan: Yes, that would be foreign source.
Larry: You engage someone in a foreign country to go to Haiti and you paid the expenses for him and you paid it through Haiti or something.
T. Logan: Yes, no withholding, no reporting.
Larry: No withholding, no reporting.
T. Logan: That’s correct. That’s foreign source income.
Larry: And the tax treaties, is that information available on the IRS Web site?
T. Logan: Yes, it’s in publication 901, but if you get publication 515, we have a summary of it. The pub 515 is good because it pretty much has a summary of all of the accounts. But if you want more detail, you’ll get publication 901.
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