Foreigners, like U.S. citizens, are subject to taxes on their U.S. source income. U.S. source income includes all income received from U.S. individuals or organizations for work performed in the U.S. The income sourcing rules are set forth by the IRS – the source of the income depends on the type of income. For example, the source of business income from personal services is where the service is performed; the source of interest income is the residence of the interest payer; and the source of dividend income depends on whether the payer is a U.S. or foreign corporation (subject to a 25% or more ECI exception).
How Do I Know Whether to Withhold U.S. Source Income?
Generally, U.S. source income received by a foreign person is subject to a 30% U.S. tax. A reduced rate or exemption may apply if the tax code provides for a lower rate, or if there is a tax treaty b/w the foreign person’s country of residence and the U.S. The payer of the income must generally withhold the tax from the payment made to the foreign person (“NRA withholding” = Nonresident Alien withholding).
What Form Should the Foreign Person Use?
- Form W-8 BEN is for foreign individuals who are the beneficial owner of an amount potentially subject to withholding
- Form W-8 BEN-E is for foreign entities who are the beneficial owner of an amount potentially subject to withholding
- Form W-8 ECI is for foreigners with income that is effectively connected with a U.S. trade or business
- Form W-8 EXP is for foreign governments, international organizations, central banks of issue, tax-exempt organizations, private foundations, or governments of a U.S. possession
- Form W-8 IMY is for foreign intermediaries, flow-through entities, or certain U.S. branches
What About Forms W-9 and 1099?
Form W-9 is sent by a company to a U.S. contractor to certify the contractor’s contact information and tax number. A company uses a contractor’s completed W-9 to fill out a Form 1099 to report income earned to the IRS. Each company which pays a contractor more than $600 annually is required to send the contractor and the IRS a Form 1099.
To Withhold or Not to Withhold – Example 1
A Miami-based company wants to hire a Colombian independent contractor for a $100 project which will be performed inside the U.S…
Because the personal service will be performed inside the U.S., the income that the contactor earns is U.S. source income that must be withheld for tax purposes. U.S. and Colombia do not have a tax treaty that allows for a reduction in NRA withholding. Thus, the company should withhold $30 (30% of the $100) after confirming the contractor’s foreign tax status through receipt of a valid W-8 BEN.
To Withhold or Not to Withhold – Example 2
A Miami-based company wants to hire a Colombian independent contractor for a $100 project which will be performed outside of the U.S….
Because the personal service will be performed outside the U.S., the income that the contactor earns is foreign source income. The income is earned by a foreigner and foreign sourced; thus, it’s not subject to U.S. tax withholding. The company should withhold $0 after confirming the contractor’s foreign tax status through receipt of a valid W-8 BEN.
To Withhold or Not to Withhold – Example 3
Victoria is a foreign person who owns a U.S. LLC which is disregarded as an entity. Her client, a U.S. company, wants to hire her for work that will be completed outside of the U.S…
This situation brings up a few interesting concerns. First, because the U.S. LLC is a disregarded entity, all income passes through to Victoria and she is taxed as if she, as an individual, directly earned the income. It is inappropriate for the LLC to file a W-9 because it is a disregarded entity. Second, this arrangement exposes the U.S. company to the threat of a future tax liability: The U.S. company is essentially responsible for continually determining where Victoria is providing services. If Victoria decides to relocate to the U.S., her personal services will generate U.S. source income. The U.S. company will have to withhold 30% of its payments to Victoria.
What is a Withholding Agent?
A U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding is called a withholding agent. Generally, the U.S. person who pays an amount subject to NRA withholding is the person responsible for withholding. However, other persons may be required to withhold. For example, a payment made by a flow-through entity or nonqualified intermediary that knows, or has reason to know, that the full amount of NRA withholding was not done by the person from which it receives a payment is required to do the appropriate withholding since it also falls within the definition of a withholding agent. In addition, withholding must be done by any qualified intermediary in accordance with the terms of its qualified intermediary withholding agreement.
What If a Withholding Agent Fails to Withhold?
Withholding agents must file Forms 1042 and 1042-S annually to report the income paid and amount withheld. Withheld taxes must be deposited weekly, monthly, or annually (with a Form 1042), depending on the amount of taxes withheld. A withholding agent who does not withhold when required may be liable for the tax that should have been withheld, in addition to delinquency, accuracy, and fraud penalties.
A withholding agent can cure its noncompliance by obtaining the proper Form W-8 (above) from the payee, but the withholding agent may still be subject to penalties and interest. If no return is filed, the statute of limitations for assessing a withholding tax liability against the withholding agent never begins to run. If your business has made payments to nonresident aliens, even if you have determined that withholding was not required (e.g., payment is for services rendered abroad), you may want to file a protective “zero” Form 1042 for the year so that the statute of limitations begins to run.