Greetings from Haoshen Zhong.
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Today’s newsletter came by way of an email question:
I hired a web designer in Nicaragua to work on my website. He put together something from his home office. He is a nonresident alien. What are my withholding and reporting obligations now that I am about to pay him?
In today’s post, I will talk about the withholding responsibilities of a US person who is paying a nonresident alien for services performed outside the US. I will also discuss the documentation that the US person should obtain to show that he met his withholding responsibilities.
The US enforces its tax system partly by requiring withholding when certain types of payments are made to a recipient. Then, the recipient files a tax return for the year to claim refunds or pay taxes due.
Foreign persons are subject to 2 types of withholding requirements:
Chapter 3 requires you to withhold tax against certain items of income “to the extent that any of such items constitute gross income from sources within the United States”. IRC §1441(a).
Similarly, FATCA requires you to withhold tax against certain payments “if such payment is from sources within the United States”. IRC §1473(1)(A).
Income from personal services performed in the US is US source income. IRC §861(a)(3). Income from personal services performed outside the US is foreign source income. IRC §862(a)(3).
You are paying the web designer for personal services. He is a nonresident alien. He did the work outside the US. The income is foreign source income. There is no chapter 3 withholding or FATCA withholding, because the payment is not from a US source.
But the Treasury Regulations contain a plethora of rules about what you need to document, what your default assumptions are, and what your reporting obligations are. The trick is to have enough documentation in your files to prove that you satisfied your withholding obligations.
Unlike US recipients, foreign recipients use several different withholding certificates to document their status: W-8BEN, W-8BEN-E, W-8ECI, W-8IMY, etc. For example, W-8BEN is for nonresident aliens. W-8BEN-E is for foreign entities. W-8IMY is for foreign passthrough entities such as partnerships.
In the absence of documentation, you are instructed to assume whether the recipient is an individual or a type of entity matches its appearance. Reg. §1441-1T(b)(3). In our scenario, it looks like you are paying a nonresident alien individual. Consistent with his apparent status, you would first ask him to complete Form W-8BEN, withholding certificate for nonresident alien individuals.
Let us assume that the recipient has completed a Form W-8BEN and returned it to you. Can you rely on the information in the certificate?
Generally, you are entitled to rely on a person’s representations in the withholding certificate. Reg. §§1.1441-1T(b)(2)(i), 1.1471-3(d). The exception is if you have “reason to know otherwise”. Reg. §§1.1441-1(b)(2)(vii), 1.1471-3(d).
Reason to know otherwise can relate to 2 things:
One thing to note is that you are only required to use knowledge that a reasonably prudent person would have or would obtain. Reg. §.1441-7T(b)(2). The withholding rules do not conscript you into being an IRS auditor. You are not required to exhaustively challenge and investigate every claim the recipient makes.
This one is quite simple: Get the name of the person that you are paying. Get a copy of his passport. If the recipient’s name matches the name on the passport, you know you are paying an individual rather an entity.
Regulation section 1.1441-7T(b)(5)(i) gives us a list of reasons for knowing that the withholding certificate may contain false representations. This information can appear on the withholding certificate itself or from other communications. For an individual, the information can be grouped into 2 categories.
The 1st category of information indicates that the recipient may be a US resident alien. This category includes the following:
If any of these is true, do the following to verify that the claim of foreign status is true.
First, obtain in writing a foreign address or foreign phone number (whichever is lacking).
Second, obtain in writing a reasonable explanation of the claim of foreign status. For example, the recipient may have a US mailing address purely for the convenience of receiving mail from the US.
The 2nd category of information indicates that the recipient may be a US citizen. This can be a US birth certificate, a US passport, or a foreign passport indicating birth in the US. Reg. §1.1441-7T(b)(5)(ii). If you have information indicating that the recipient may be a US citizen, you must obtain a copy of a foreign passport and a copy of the recipient’s certificate of loss of nationality.
First, you make an assumption on whether you are paying an individual or entity based on what the recipient seems to be. Reg. §1.1441-1T(b)(3)(ii)(A), 1.1473T(f)(2).
In our scenario, the web designer appears to be an individual, so we assume you are paying an individual. This means there is potentially chapter 3 withholding. But there is no FATCA withholding, because FATCA withholding applies only to payments to entities, and an individual is not an entity. Reg. §§1.1471-1(a), (b)(39), -5(d).
Second, you assume you are paying a US person. Reg. §1.1441-1T(b)(3)(iii). The normal rules for withholding against a US person who fails to provide a withholding certificate and his TIN applies to the payment. I will not discuss how this works.
Form 1042-S and Form 1042 are used to report payments to foreign persons. They are analogous to the 1099 series. You may be required to file these forms if you make payments to a nonresident alien.
From this point, let us assume that you received a valid W-8BEN, and you found that you can rely on it to determine that the web designer you paid is a nonresident alien individual.
If you paid “amounts subject to reporting on Form 1042-S” to a foreign person during a year, then you must file Form 1042-S to report those amounts for the foreign person you paid. Reg. §1.1461-1(c)(2)(i). You file 1 Form 1042-S per foreign person you paid.
But “amounts subject to reporting on Form 1042-S” includes only “amounts subject to withholding”. Reg. §1.1461-1(c)(2)(i). And “amounts subject to withholding” includes only certain amounts from US sources. Reg. §1.1441-2(a).
In our scenario, the payment for the web designer are foreign source, because the web designer performed the services outside the US. Therefore, none of the payments is reportable on Form 1042-S.
You file a single Form 1042 for the year to report all payments that you were required to report on Form 1042-S. Reg. §1.1461-1T(b)(1). If you were never required to file Form 1042-S, then you are not required to file Form 1042.
In our scenario, the payments for the web designer are foreign source income, because the web designer performed the services outside the US. If the only payments to foreign persons made during the year were made to the web designer, then there is no Form 1042 filing requirement either.
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