The US Tax Obligations Of Foreign-Born Persons: Debunking The Myths
With the expansion of the global business community, a growing number of corporations—both big and small—now employ foreign-born workers, make payments to foreign directors and other self-employed foreign workers, and provide education or training to foreign-born students and trainees. Although corporations have been employing foreign-born workers for years, many of these employers are unaware of the special rules that apply to payments to these foreign-born persons.
Myth #5 - Payments to foreign-born workers for self-employment services, such as directors’ fees and honoraria, are not subject to U.S. reporting.
Reality - Payments for self-employment services made to foreign-born workers who are resident aliens are subject to U.S. reporting on Form 1099MISC as Non-employee Compensation. If the foreign-born worker does not provide a Social Security number or an individual taxpayer identification number (TIN), the amounts are subject to backup withholding. The $600 de minimus rule applies to payments to resident aliens as well as payments to U.S. citizens.
Payments for self-employment services made to foreign-born workers who are nonresident aliens are not subject to U.S. reporting on Form 1099MISC. These amounts must be reported on Forms 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding—which are due March 15, not April 15.
In addition, these amounts are subject to a withholding tax at a 30 percent rate unless a tax treaty exemption applies. There is no de minimus rule for such payments made to nonresident aliens. Reporting on Forms 1042 and 1042-S is required even if the income is exempt under an income tax treaty.
Myth #6 - If a foreign-born person is a nonresident for federal income tax purposes, the individual is a nonresident for state income taxes as well.
Reality - Each state has its own rules for determining when an individual is a resident or a nonresident for state income tax purposes. These definitions are not the same as the federal definitions of a resident alien and nonresident alien.
Therefore, under these rules:
For example, Massachusetts defines income with reference to the Code. As a result of this definition, a foreign-born individual, who is a resident for Massachusetts purposes but a nonresident alien for federal income tax purposes, is subject to income tax only on U.S. source income, not worldwide income.
Myth #7 - A U.S. citizen, who is also the citizen of a foreign country, can determine under which income tax rules he or she will be subject to tax, depending on the passport used for entering the United States.
Reality - A U.S. citizen is taxed as a U.S. citizen, period. How a citizen enters the United States, or the fact that a U.S. citizen may also be a citizen of another country, has no impact on a U.S. citizen’s U.S. income tax obligations.
Myth #8 - If a foreign-born person is a citizen of a tax treaty country, U.S. income paid to the individual is exempt from U.S. income taxes.
Reality - The United States has income tax treaties currently in effect with over 60 countries. An income tax treaty may provide an exemption from tax for an individual who is a resident for income tax purposes in a treaty country. Such an individual may, or may not, be a citizen of the treaty country as well.
In order to be exempt from U.S. income tax under an income tax treaty, a number of conditions must be met:
Reality - All income tax treaties provide an exemption from tax for employment compensation for U.S. services if the conditions of the treaty article are met. One of the typical conditions is that the individual’s period of stay in the United States not exceed 183 days in the fiscal (i.e., calendar) year. Some newer treaties use a 12-month period beginning or ending in the calendar year as the testing period. Many of the employment income articles have testing periods much shorter than six months.
However, all but two treaties, the treaties with Canada and Trinidad and Tobago, require that the compensation be paid either by a foreign employer or by an employer that is not resident in the United States. Also, the employment income articles typically state that the compensation not be “borne by” (i.e., taken as a tax deduction) a U.S. permanent establishment. Under the IRS interpretation of these provisions, neither the foreign employer nor the “borne by” provision is met if a U.S. company reimburses the foreign employer for the salaries.
The employment income article of the treaty with Canada allows an exemption from U.S. tax on $10,000 regardless of the period of time that the Canadian resident is in the United States—as long as he or she does not become a U.S. resident. This treaty exemption is lost to the first penny if the individual is paid more than $10,000 in the calendar year.
IRS Publication 901, U.S. Tax Treaties, provides an overview table of the articles that allow an exemption from U.S. tax on compensation for services.
With the expansion of the global business community, a growing number of corporations, both big and small, now employ foreign-born workers, make payments to foreign directors and other self-employed foreign workers, and provide education or training to foreign-born students and trainees. Although corporations have been employing foreign-born workers for years, many of these employers are unaware of the special rules that apply to payments to these foreign-born persons.
Educational institutions, research institutions, teaching hospitals, and other nonprofit entities that make payments to foreign-born students, professors, research scholars, and other international visitors have been coaxed by IRS audits—some resulting in assessments in the millions of dollars—and educational initiatives to learn and apply these special tax rules. IRS personnel who learned these rules by auditing nonprofit institutions have been teaching these rules to employment tax auditors and other IRS personnel.
With the decrease in tax revenues caused by lower tax rates and the slow-down in the economy, the IRS—in order to increase revenues—will be focusing its efforts on areas where there has been a history of substantial noncompliance. As a result, corporations that continue to ignore the special tax rules that apply to payments to foreign-born persons may pay dearly for their continued ignorance.
The first installment of this article shed light on nine myths regarding general reporting of taxes for foreign-born persons. The purpose of the second installment of this article is to pick up where the first installment left off with a more in-depth look at specific tax rules.
Myth #10 - J-1 Exchange Visitors are exempt from U.S. Social Security and Medicare taxes.
Reality - All compensation for employment services performed within the United States is subject to U.S. Social Security and Medicare taxes unless an exception applies. The Internal Revenue Code includes two exceptions that may provide exemptions from Social Security and Medicare taxes for compensation paid to a J-1 Exchange Visitor.
Section 3121(b)(10) of the Code allows an exemption from Social Security and Medicare taxes on wages for services performed in the employ of a school, college, or university by “a student who is enrolled and regularly attending classes at the institution.” In 1998, the IRS issued Rev. Proc. 98-16, 1998-1 C.B. 403, setting forth guidelines for applying this rule. Referred to as the “Student FICA Rule,” this rule applies to U.S. citizen and foreign-born students alike. This rule may apply to exempt qualified J-1 students from Social Security and Medicare taxes since the U.S. tax residency status of a foreign-born student is not relevant for purposes of this exemption.
Section 3121(b)(19) of the Code allows an exemption from Social Security and Medicare taxes for compensation for services performed by a nonresident alien individual temporarily in the United States in F, J, M, or Q status, so long as the services performed are in connection with the purpose for which the individual entered the country. (An individual in J-2 derivative status is not eligible for this exemption because his or her purpose in coming to the United States is to accompany the primary visa holder.) This special exemption does not apply to compensation paid to an individual in F, M, J, or Q status who has become a resident alien.
Under current IRS audit guidelines, an employer must begin to withhold Social Security and Medicare taxes from the compensation of such an individual from the latter of January 1 or the individual’s first day of physical presence in the United States in the particular calendar year. On an IRS audit, a U.S. employer that cannot produce evidence of an exemption for Social Security and Medicare taxes will be required to pay the tax, plus penalties and interest.
Myth #11 - The compensation of a foreign-born worker, who is from a country with which the United States has a Social Security (“totalization”) agreement, is not subject to U.S. Social Security or Medicare taxes.
Reality - The United States currently has Social Security agreements in force with 18 countries. The agreements and booklets explaining how the agreements work are available on the Social Security Administration Web site at www.ssa.gov. These agreements also are called “totalization” agreements, since one of the purposes of the agreement is to provide benefits by combining total work periods in each applicable country for vesting purposes under each country’s applicable vesting rules.
In order for compensation of a foreign-born worker to be exempt under a Social Security agreement, the worker must meet the conditions of the “detached worker rule” as explained in the SSA booklet—and the worker’s U.S. compensation must be subject to mandatory Social Security taxes in the home country. The payment of voluntary contributions to maintain home country coverage is not sufficient to support an exemption from U.S. Social Security and Medicare taxes.
A certificate of coverage from the foreign Social Security Administration will evidence the mandatory payments into the foreign system. The procedures for requesting such a certificate are explained in the Social Security Administration booklets. On an IRS audit, a U.S. employer must produce evidence to support an exemption from Social Security and Medicare taxes. An employer that cannot produce a certificate of coverage to support the exemption will be required to pay the tax, plus penalties and interest.
Myth #12 - Benefits paid by a U.S. or foreign employer to a third party, such as company- provided housing, are not subject to U.S. income taxes.
Reality - All compensation for employment services, including the value of benefits in kind such as company-provided housing, are wages subject to wage withholding and income reporting unless an exception applies. As a general rule, payments for travel, food, and lodging provided by the employer that meet the accountable plan rules of §274 of the Code are excludable from income. The accountable plan rules are explained in detail in IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses.
In order to adhere to the accountable plan rules, the following two conditions must be met:
If an employee’s assignment is originally anticipated to last longer than a year, but facts and circumstances change so that the assignment lasts a year or less, the worker’s tax home nevertheless will have changed to the new work location even during the shorter period. If an employee’s tax home has changed to the assignment location, the cost of travel, food, and lodging related to the assignment location are wages subject to wage withholding. These rules are explained with examples in Rev. Rul. 93-89, 1993-2 C.B. 71.
As a general rule, payments, reimbursements, and benefits in kind made on behalf of family members of an employee are personal in nature. As such, they are wages subject to wage withholding. Also, if an individual is not providing services, but rather is receiving a non-service grant for travel, food, and lodging related to study or research that primarily benefits the individual, the accountable plan rules do not apply because the business purpose requirement has not been met.
Myth #13 - Scholarship and fellowship grants are not subject to U.S. income taxes.
Reality - A scholarship or fellowship grant is any amount paid to or on behalf of an individual for the purpose of aiding the individual’s study, training, or research, and which does not represent compensation for services. A non-service grant is excludable from income if it is for tuition, or required fees, books, supplies, or equipment. Such a non-service grant is referred to as a “qualified scholarship or fellowship.” All other non-service grants (called “non-qualified” grants) are subject to U.S. income taxes if the recipient is a U.S. citizen or resident alien—regardless of where the study, training, or research takes place. Although there is no required income tax withholding or reporting of non-qualified grants, the amounts must be included in the recipient’s Form 1040 tax return.
If the recipient is a nonresident alien studying, training, or engaged in research in the United States, and the grantor is a U.S. resident or domestic entity, the nonqualified non-service grant is subject to income tax withholding and reporting on Forms 1042 and 1042-S.
The rate of tax withheld depends on the immigration status of the recipient. A non-service grant paid to or on behalf of a nonresident in F, M, J, or Q status is subject to withholding tax at a 14 percent rate, or alternatively at the option of the payer, at wage withholding rates. All other nonqualified non-service grants are subject to withholding tax at a 30 percent rate.
The gross income and withheld taxes must be reported on Forms 1042 and 1042-S, which are due March 15. Non-service grants paid to a nonresident recipient for study or training abroad are not subject to U.S. income taxes, and are, therefore, not subject to U.S. income tax withholding or reporting.
A recipient of a non-service grant who is in F, M, J, or Q status—and whose tax home has not changed to the United States under the one-year rule as defined in Rev. Rul. 93-89—may be able to claim a withholding allowance for travel, food, and lodging expenses, in order to reduce the taxable gross income. Rules for determining such a withholding allowance are set forth in Rev. Proc. 88-24, 1988-1 C.B. 800. Note that this revenue procedure has not been updated for the one-year temporarily away from home rule that became effective in 1993.
Grants that are for past, present, or future services are subject to wage withholding and Form W-2 reporting. The rules for determining the tax treatment of scholarship and fellowship grants are defined by §117 of the Code and the regulations under that section. These rules are described in detail in IRS Publication 520, Scholarships and Fellowships.
Myth #14 - A foreign-born person who meets the conditions for an income tax treaty exemption is exempt from U.S. withholding taxes as well.
Reality - An individual who meets the conditions of an income tax treaty for exemption from U.S. income tax may also be exempt from wage withholding on compensation or withholding at source on self-employment income or non-service grants. However, to be exempt from withholding, the individual must provide the payer with a properly completed withholding certificate prior to payment. The proper withholding certificate is Form 8233 with an attached certification or W-8BEN for a nonresident alien. The proper withholding certificate for a resident alien is a Form W-9 with an attached statement explaining the saving clause exception and article under which the exemption from U.S. tax is being claimed. These withholding certificates are explained in more detail in IRS Publications 519 and 901.
In order for a withholding certificate to be valid, it must include a U.S. taxpayer identification number (TIN)—either a Social Security number (SSN) or an individual taxpayer identification number (ITIN). An nonresident alien claiming an exemption from U.S. tax on Form 8233, who has applied for but not yet received the TIN, may be able to submit proof of application for an SSN or ITIN with the Form 8233. No such exception applies for Form W-8BEN.
An individual who fails to submit the proper withholding certificate must claim the treaty exemption from tax on a tax return. An individual, who is properly exempt from withholding tax because of a treaty exemption for compensation for services or for a scholarship or fellowship grant, must nevertheless submit a U.S. tax return with the treaty claim.
Myth #15 - Compensation that is exempt from tax under an income tax treaty is also exempt from Social Security and Medicare taxes.
Reality - The articles of the treaties that became effective since the mid-80s that cover taxes all include a statement that Social Security taxes, sometimes referred to as employment taxes, are not covered by the treaty. (The treaty with China has this exclusion in a protocol, which is an amendment to the original treaty.)
The IRS ruled in Rev. Rul. 56-609, 1956-2 C.B. 1066, and Rev. Rul. 66-77, 1966-1 C.B. 242, that income tax treaties do not cover Social Security taxes. (Although some IRS private rulings state otherwise, those rulings do not take precedence over a revenue ruling.) However, one treaty, the treaty with the former U.S.S.R.—which has a broader definition of taxes covered—covers the employee’s share of Social Security and Medicare taxes.
Myth #16 - A U.S. employer can give a treaty exemption from withholding on employment compensation and report the treaty exempt income on a Form W-2.
Reality - Form W-2 is for reporting federal gross income for compensation for employment services to the extent that the compensation is not exempt from U.S. income tax under an income tax treaty. Employment compensation that is exempt from U.S. tax under an income tax treaty must be reported on Forms 1042 and 1042-S.
Form 1042-S is shared with the U.S. treaty partner through the electronic exchange of information. If the treaty exempt compensation is not exempt from U.S. Social Security and Medicare taxes, the Social Security and Medicare wages and taxes must be reported on Form W-2. (GAVEL)