Dealing with your own taxes may seem daunting enough. But in today’s global society, where we—as U.S. taxpayers—are increasingly engaging in transactions with foreigners, it is important to understand that these interactions may impose certain tax obligations on us, specifically as it relates to withholding taxes.
In general, a withholding tax is a form of income tax that is paid directly to the government by the payer of the income—as opposed to the recipient of the income. It is generally reflected as the amount withheld from the employee’s wages.
For non-resident aliens (“NRAs”), there are special withholding rules. Recall that a NRA is a foreign person who is not a U.S. citizen or U.S. resident; their “foreign” status, will be identified by completing Form W-8. The U.S. tax code bifurcates the income of NRAs into either effectively connected income (ECI) or fixed/determinable annual/period income (FDAP). Each of these types of income are taxed differently.
Withholding on ECI is based on whether the NRA is “engaged in a United States trade or business.” (Note that providing personal services with the U.S. falls within this standard.) Whether the NRA is engaged in a U.S. trade or business will depend on the nature of the activity. For the most part, however, whether a “fixed place of business” is available in the U.S. and the number of days spent in the U.S. will be determinative, although income tax treaties can modify it. As such, ECI is taxable to NRA-recipients on a net basis at graduated rates with the ability to take applicable credits and deductions. This is similar to how U.S taxpayers are taxed. And so it goes that the withholding requirements of NRA employees and partners are similar as well. For NRA-employees, it matters not that wages are paid by a foreign or domestic employer; the NRA-employee will be subject to similar withholding rules as that of U.S. taxpayers. Likewise, the partnership shares distributed to a NRA-partner will be subject to the same applicable tax rate as those of a U.S. partner.
In contrast, withholding on FDAP income is based on whether the income is sourced in the United States. If it is, then the income will be subject to a statutorily-mandated 30% withholding tax. (Not to worry too much though; this rate can be modified downward based on applicable income tax treaties.) Unlike ECI, credits and deductions are not available to offset the income. This is because FDAP income is taxed on a gross basis. Under FDAP income rules, it is the responsibility of the withholding agent to satisfy withholding requirements; otherwise, the agent can be personally liable. The only exception to this is if the agent can correlate the payment with documentation that the NRA is either a U.S. taxpayer or a foreign payer entitled to a reduced or zero rate of withholding.
A U.S. taxpayers failure to withhold—or even incorrectly withhold—NRA taxes can result in unwanted consequences. The most serious of these has already been mentioned: personal responsibility for the NRA’s outstanding tax liability. Additionally, the IRS can assess penalties and interest not only for failing to withhold, but also failing to deposit funds, file returns, and/or file information returns.
Here are some keys steps to meet withholding compliance: 1) ensure actual withholding occurs; 2) ensure compliance with all reporting and tax deposit requirements; and 3) remit withheld taxes in a timely manner. Most importantly, however, contact a tax professional.