1099 Tax Software Blog

This is a common question.  You received Copy B of IRS Form 1042-S in the mail or by e-mail.  The form says that a US company withheld some amount of money from you and sent that withheld money to the IRS.  How can you, the recipient of this 1042-S form, get that withheld money?  Its your money.

Form 1042-S, Chapter 3, Non-Resident Withholding

The withheld amounts are known as Chapter 3 payments, and the IRS actually makes it easier for non-residents than US citizens to apply for a refund using Form 1040NR, the current non-resident alien income tax return.  This has wide application to foreign students who are on scholarship or otherwise earn taxable US income.  In many cases, a tax treaty may exist between the US and the non-resident’s home country that would supersede the withholding requirement, or reduce the taxable amount.

On Form 1040NR, Line 12 the filer can list 1042-S scholarship payments as an income amount, and Line 22 is available to list the amount of income exempt under a tax treaty.  Any remaining amounts are subject to US taxation after deductions. Presumably, other types of income would be listed as wages or other type of investment gain that would be listed in the appropriate spaces.

More importantly, amounts withheld for any reason and reported on 1042-S would be listed under Payments, Line 61 (d) on 1040NR.  This would be a credit against any tax owed on any type of income, and in case no tax is owed, then a refund would be available even to an address or account outside the US.

This process is identical to where anyone filing taxes may have had amounts withheld that exceed their tax, and have to wait for a refund.  There is no form or method to simply request a return of over-withheld amounts, and the non-resident is limited to the standard filing and refund process.  This may be frustrating for those non-residents who will not owe any tax in the end, but nonetheless have had amounts withheld.

Form 1042-S, Chapter 4, Non-Resident Withholding

Withholding agents who make payments from a US source to non-US financial institutions are required to file informational Form 1042-S as a part of FATCA, designed to identify US account holders who have assets outside the US borders.  1042-S can also include payments to non-US citizens receiving payments from a US source.  Each type of payee is designated differently, as either Chapter 3 (non-US citizens) or Chapter 4 (FFIs with US account holders).

Typically, the withholding agents are banks or other payers in the US that are making the payments to foreign financial institutions (FFI), who have a US account holder.   These withholding agents are the ones who file the form with the IRS, and if the FFI is not registered with the IRS and does not have a Global Intermediary Identification Number, then the US source must withhold 30% of the payment, and deposit that money with the IRS.

The withholding amount of 30% would be deposited with the IRS, similar to the way that tax is withheld on employee wages.  This information would be supplied to the payee in Copy B of Form 1042-S that would detail the amount withheld from the payment, similar to a W-4.  The question for many recipients of these forms is how to obtain the withheld amount, assuming the transfer was legitimate and not an effort to avoid payment of tax or a taxable inclusion in gross income.

The amounts withheld would be presumably treated like any amounts withheld and deposited with the IRS, and would be available for refund with the filing of the US taxpayer’s annual return.  On Form 1042-S, Box 1 requires an income code for the US sourced payments (i.e. dividends, independent contractor services, capital gains, etc.).  It would depend upon the type of payment and whether it would be included on the 1040 annual return as taxable income for possible refund amounts.

Form 1040: No Place to List 1042-S Payments

The real issue is that there is no place on Form 1040 to list the 1042-S withheld amounts, since the recipient was technically the FFI.   The US citizen as the ultimate beneficiary simply receives the 1042-S copy B to list the amounts withheld, similar to a W-2 for employees.  Assuming that the payment was not taxable, then the only place to list the withheld amounts is Line 67 on the 1040, which is “Reserved”.  An alternative is to list it on Line 62 with amounts withheld in Forms W-2 and 1099.   Then one could attach Copy C of 1042-S to the return to document the amount.  This differs dramatically from the other instance where 1042-S Chapter 3a mounts are listed for non-residents.  The 1040-NR has two places to list amounts withheld under 1042-S, making the process easier.

The fact that the IRS has implemented an international network of FFIs to monitor US account holders is not a surprise.  However, the fact that there is no specific instruction or form to request withheld amounts makes the 30% almost appear to be a tax penalty for holding assets offshore.  In other words, a US taxpayer should make sure that an FFI is registered with the IRS and has a GIIN prior to making any US sourced transfers.  Failure to do so could result in a long delay in receiving withheld amounts under 1042-S.

Background

FATCA (Foreign Account Tax Compliance Act) is a measure passed in 2010 to ensure accurate tax reporting by foreign financial institutions (FFI) having US taxpayers as customers.  The law is designed to address the use of foreign or ‘off-shore’ accounts to avoid payment of US taxes, but its effect will be far broader than originally thought.  It has evolved into a global tax reporting network that will now include cooperation with foreign institutions and their governmental tax authorities.

FFI Reporting

The Act requires FFIs to report on the holdings, earnings and gains of US customers with accounts over $50,000, or face fines and sanctions from the US government.  This requirement had the immediate effect of FFIs choosing to ‘lock-out’ US customers to avoid the onerous reporting requirements.  The choice for FFIs was simple, become a reporting agent for the Internal Revenue Service, or face penalties and possible exclusion from the US controlled financial network.  To enforce the rule of identifying US account holders and account proceeds, FFIs who fail to make a good faith effort to comply will face a 30% withholding on US-sourced payments.   Not surprisingly, many FFIs simply opted to close the accounts of US citizens and avoid the reporting requirement altogether.

US Taxpayer Reporting

The US foreign account holder also has a reporting duty under FATCA for accounts valued over $50,000.  Foreign investments over that threshold must be reported on the annual tax return or risk a penalty of at least $10,000.  Failure to list the asset will result in a 40% tax surcharge if US taxes were avoided at any point.  Since FFIs are mandated to report US taxpayer identities, there will be a cross-checking system in place to enforce these rules.

The Impact of Intergovernmental Agreements

The administrative burden placed on FFIs has brought a few delays to implementing the FATCA rules, and in the meantime governments have been at work trying to find a means to work together directly.  Intergovernmental Agreements (IGA) have been established between the United States and a growing list of countries that will allow FFIs to report the information directly to their own government agency, who will in turn hand it over to the IRS.

Although many countries have been reluctant to sign these agreements, the role and influence of the US financial system has been difficult to resist.  In essence, this is the founding of a global tax reporting network that could eventually affect any account holder in the world, as all governments begin to see the opportunity to crack down on tax evasion.  The list of governments participating in an IGA can be found here: http://www.treasury.gov/resource-center/tax-policy/treaties/Pages/FATCA-Archive.aspx

FATCA Rules for Foreign Account Holders in the United States

Reflecting some of these tax information sharing agreements are changes to IRS Form 1042-S, which requires non-US citizens to report US sourced income subject to withholding.  Therefore, non-US banks must report gains by any account held in the US, even if the account holder is a foreign citizen.  In essence, this expansion of FATCA’s reach ensures that the IRS will eventually have access to any account information with ties to the US financial system, whether at home or abroad.

Recently, the IRS declared 2014 and 2015 as a transition period for FATCA, delaying some of the enforcement requirements and penalties, but this is a measure that continues to expand in its reach and application in global banking.

Internal Revenue Service Form 1042-S, titled “Foreign Person’s U.S. Source Income Subject to Withholding,” must be filed for non-residents and foreign entities that have derived income or gains from investments in the US in the past year. These gains can include ordinary income dividends, long-term capital gains, or return of capital distributions. Gains from interests in US real estate also require reporting. Foreign corporations, foreign partnerships, foreign estates and foreign governments and foreign individuals should all list gains from US-based investments on the 1042-S form.

Other types of income that should be reported on Form 1042-S are: wages of employees who have claimed tax treaty benefits, fellowship/scholarship income, payments made to foreign independent contractors, royalty payments, and prizes or awards.

Form 1042-S includes a space to report withholding on investment distribution. Short-term capital gain and qualified interest income can be exempt from withholding (this exemption requires verification of the investor’s foreign status), as are long-term capital gains. Foreign persons or entities are not required to file a return if the withholding amount is equivalent to their tax obligation, or if they have not participated in income-generating trade or business inside the United States in the past year.

A 1042-S form should be filed by every withholding agent. This means an individual, a corporation, partnership or trust responsible for payment towards the foreign person’s income or investment gains. The withholding agent is defined this way regardless of whether actual withholding is required. Records of the form should be kept for three years after the original reporting date.

Every entity that engages in business with a foreign person, corporation or partnership is required to file a return for the income or capital gains they pay out. The benefit of this is that it allows non-resident alien individuals and foreign businesses to easily keep track of their investments, trading interests, and income sources within the United States.