The Ten Rules Of U.S. Taxation
The general principle of taxation is that income is taxable where the economic activity occurs. A country, for policy reasons, may legislate specific exceptions to this general principle. For example, the United States allows an exemption from tax for certain types of interest income in order to attract capital investment to the United States. The general principles of taxation are incorporated into a country’s tax legislation. In the United States, the rules of federal taxation are in Title 26 of the U.S. Code, hereafter referred to as the Internal Revenue Code or the “Code.” Under the Code and the regulations issued by the Internal Revenue Service (IRS) to define the Code, the general tax rules are stated. However, after first stating the general tax rule, the Code typically enumerates exceptions to the general tax rule. An exception to the general tax rule may be followed by exceptions to the exception to the general tax rule. In order for an exception to apply, all of the conditions for the exception must be met.
The Exception is Not the Rule
Many taxpayers and payers either assume that the exception is the rule, or apply the exception even though all of the conditions for the exception are not met. For example, most J-1 Exchange Visitors and those who employ them think that all J-1 Exchange Visitors are exempt from U.S. Social Security and Medicare taxes on their compensation for U.S. services. However, this is an exception, not the general rule. The general rule is that compensation for U.S. employment services is subject to U.S. Social Security and Medicare taxes. There is an exception for J-1 Exchange Visitors, but in order for the exception to apply, three conditions must be met as explained under Rule #7 below. One of these conditions is that the J-1 Exchange Visitor be a nonresident alien. Therefore, a J-1 Exchange Visitor who is a resident alien is not exempt from U.S. Social Security and Medicare taxes.
The Substance Over Form Doctrine May Apply
In addition to this structure, the courts have supported the Internal Revenue Service’s application of the “substance over form” doctrine. Under this doctrine, the economic substance of a transaction may take precedence over its form to deny a tax benefit. For example, Article 21, Professors and Teachers, of the income tax treaty between the United States and The Netherlands allows an exemption from U.S. tax on compensation for teaching or engaging in research for a two-year period, if the individual claiming the benefit meets the conditions of the Article. If the individual physically overstays the two-year benefit period, the exemption is lost retroactively to the first day in the United States. If the individual claiming a benefit under this Article leaves the United States before the end of the two-year benefit period the tax exemption is preserved. However, if the individual reenters the United States to teach or engage in research for the same or an affiliated employer, even without claiming a treaty benefit, the IRS can disallow the treaty exemption under the substance over form doctrine because the substance of the employment is for longer than the two-year period allowed by the treaty article.
The purpose of this article is to explain the general rules of U.S. taxation that apply to compensation income of foreign-born workers, and exceptions that may apply if the conditions for the exception are met.
RULE #1: ALL COMPENSATION FOR SERVICES PERFORMED IN THE UNITED STATES IS SUBJECT TO U.S. TAXES UNLESS AN EXCEPTION APPLIES
The General Rule
Under Section 864(b) of the Code and the regulations under that section, compensation for the performance of services is U.S. source income to the extent that the income is paid for services performed while the worker is physically present in the United States. Under the general rule, the location of the payer is not relevant, nor is the currency of the payment.
The Exceptions to the General Rule
The following are the primary exceptions to this general rule:
The Commercial Traveler Rule
Under the commercial traveler rule of Sections 861(a)(3) and 864(b)(1) and the regulations under those sections, compensation is considered foreign source if the following three conditions are met:
If the total pay is more than $3,000, the entire amount is U.S. source income and is subject to U.S. tax.
When the recipient of the compensation is a non-resident alien, the compensation is not subject to U.S. income taxation.
Temporarily-Away-From-Home Business Expenses
Under Section 162 of the Code and the regulations under that section, travel, food, and lodging reimbursed or paid on behalf or an employee who is temporarily away from his or her tax home, are deductible business expenses. To be temporarily away from home, the employee must be on a work assignment anticipated to last a year or less.1
When the requirements of the accountable plan rules of Section 274 of the Code are met, the amounts are excludable from the employee’s income.2 To meet the accountable plan rules the payee must:
Reimbursed business expenses, which do not meet these requirements cannot be excluded from income.
Expenses reimbursed for travel, food, and lodging paid to or on behalf of an individual by a prospective employer for expenses incurred in connection with interviews do not meet these conditions. However, the IRS has ruled that such reimbursements are not wages for employment tax purposes and, to the extent they do not exceed the expenses incurred, they are not includible in the individual’s gross income.3
Compensation Paid by a Foreign Employer to Certain Nonresident Aliens
Under section 872(b)(3) of the Code and the regulations under that section, compensation paid by a foreign employer is exempt from U.S. income tax if the following two conditions are met:
A “foreign employer” is defined as (1) a nonresident alien individual, (2) a foreign partnership or foreign corporation, or (3) a branch or place of business maintained in a foreign country by a domestic corporation, domestic partnership or U.S. citizen or resident alien. A foreign government or foreign government agency is not included in this definition.
Compensation of Employees or Foreign Governments or International Organizations
Section 893 of the Code and the regulations under that section provide an exemption from U.S. federal income taxes for wages or nonemployee compensation paid to any employee of a foreign government or of an international organization received by a foreign national as compensation for official services to the foreign government or international organization provided that certain conditions are met.
In the case of an employee of a foreign government:
The exclusion for foreign government employees does not apply to services that are primarily in connection with commercial activity or that are performed for a controlled commercial entity.
Compensation received for official services to an international organization that qualifies for this special exemption under the International Organizations Immunities Act is also exempt from federal income tax.
These exclusions do not apply to U.S. citizens unless the individual is also a citizen of the Philippines.
Compensation Exempt Under an Income Tax Treaty
Section 894(a) of the Code and the regulations under that section provide that a qualified person may elect to claim an exemption from U.S. federal income tax under the provisions of an income tax treaty between the United States and the person’s country of residency.
Compensation of Certain Residents of Canada and Mexico
The regulations under Section 1441 provide an exception for compensation paid to certain residents of Canada or Mexico who enter or leave the United States at frequent intervals to perform duties in transportation services or in connection with certain types of international projects relating to waterways.4
Neither the transportation exception nor the international projects exception applies to the compensation of a resident of Canada or Mexico who commutes to work in the United States from a residence in Canada or Mexico.
RULE #2: HOW AN INDIVIDUAL PERFORMING SERVICES IN THE UNITED STATES IS TAXED DEPENDS ON HIS OR HER U.S. TAX STATUS
A foreign national may be a resident alien or a nonresident alien for U.S. federal income tax purposes. However, there are three federal tax structures for individuals, one for U.S. citizens and resident aliens, one for nonresident aliens, and one for dual status taxpayers. Resident alien and nonresident alien are tax terms, not immigration terms. The rules for resident aliens and nonresident aliens are discussed below under Rule #5.
A foreign national may be a dual status taxpayer if any one of the following situations applies:
RULE #3: A NONIMMIGRANT’S U.S. TAX RESIDENCY STATUS DEPENDS ON HIS OR HER U.S. IMMIGRATION STATUS AND U.S. PRESENCE
The General Rule.
Under section 7701(b) and the regulations under that section, a nonimmigrant is a resident alien if he or she has been physically present in the United States for 183 days or more, for any reason, based on a formula unless an exception applies. The substantial presence test for U.S. residency status (called hereafter the 183-day residency formula) applies to all foreign nationals present in the United States. Under this rule, an individual who is present in the United States for 183 days or more in the calendar year is a resident unless an exception applies. For purposes of this formula, a U.S. day is any day or any part of a day that an individual is physically present in the United States for any reason unless an exception applies.
An individual who is not physically present in the United States for 183 days in the calendar year, but is present more than 30 days in the calendar year, is a resident if his presence over a three-year period that includes the current year equals or exceeds 183 days based on a formula. The formula adds all of the U.S. days in the current calendar year plus 1/3 of the U.S. days in the prior calendar year plus 1/6 of the U.S. days in the second preceding calendar year.
If the result of the formula equals or exceeds 183 days, the individual is a resident alien. Otherwise, the individual is a nonresident. Special rules under section 7701(b) of the Code and the regulations under that section determine when resident alien status begins and ends.5 If special procedures are followed, certain nonresidents aliens may elect to be treated as residents and certain resident aliens in the last year of residency may be able to be treated as nonresidents for the period following departure from the United States. Refer to IRS Publication 519, U.S. Tax Guide for Aliens for an explanation of the rules and procedures.
The Exceptions to the General Rule
U.S. Days That Do Not Count
For tax policy reasons, certain days have been excluded from counting for purposes of the 183-day residency formula. U.S. days that do not count include the following:
Individuals Exempt from Counting Days
The 183-day residency formula includes exceptions for counting days for “exempt” individuals. For tax policy reasons, nonimmigrants in these immigration categories do not count days of U.S. presence, and therefore, remain nonresidents for U.S. income tax purposes for a number of calendar years. Note that the “exempt” designation refers only to counting days for purposes of the 183-day residency formula. To be exempt from tax, the individual must qualify for tax exemption under an Internal Revenue Code rule or income tax treaty provision. Exempt individuals include the following nonimmigrants—foreign government related individuals, students, and “teachers and trainees”.
Unlimited Nonresidency Rule for Foreign Government-Related Individuals
A foreign government related individual is exempt from counting days for purposes of the 183-day residency formula while in the United States in such status. A foreign government related individual is an individual who is temporarily present in the United States in A or G nonimmigrant status who is:
The servants, attendants or other employees of such exempt individuals who also may enter the United States in A or G status are not included in this exempt category. The general rules that determine residency status under the 183-day residency formula apply to these individuals.
For purposes of this exception, an International Organization is any public international organization that is designated as being entitled to the privileges, exemptions, and immunities provided for in the International Organization Act.
Five-Year Nonresidency Rule for Students
A special five-calendar year rule applies to maintain nonresident status for an individual who is in the United States in student status. A student is a foreign national who is in the United States in F, J, M, or Q nonimmigrant status. To be a student in J status, the IAP-66, Application for Exchange Visitor Status, category must indicate “student”. (Note that use of the “student” category by other individuals such as by an au pair, does not include such individuals in the student category.)
A student does not count U.S. days of presence for purposes of the 183-day residency formula for any part of five calendar years as a student or “teacher or trainee” as defined below. A student who has been in the United States as an exempt student, teacher or trainee for more than five calendar years must begin counting U.S. days for purposes of the 183-day residency formula unless an exception applies. One U.S. day in the calendar year as such exempt status satisfies the one calendar year requirement. This is a once in a lifetime test. If a student has been in the United States as an exempt individual for five calendar years, beginning in 1985, the effective date of the 183-day residency formula, the individual must begin counting U.S. days for purposes of determining his or her residency status. In the typical situation, a student must begin counting days in his 6th calendar year in the United States as a student.
The Code allows a student to continue to be exempt from counting days for purposes of the 183-day residency formula if the student can prove to the IRS the intent not to reside permanently in the United States. To request such an exception, an individual must write to the Field Assistance Area Director for his region providing the facts and circumstances that support his or her intent to remain temporarily in the United States.6
Two Out of Seven-Year Rule for “Teachers and Trainees”
“Teachers and trainees” are defined by the Code to include all individuals in J and Q nonimmigrant status other than J and Q students. An individual in this category may be a trainee, teacher, professor, research scholar, specialist, international visitor, medical trainee, alien physician, short-term visitor, government visitor, camp counselor, or au pair. The J-1 category is indicated in Box 4 of the IAP-66, Certificate of Eligibility for Exchange Visitor (J-1) Status. Note that a teacher in the United States in H-1B status is not a “teacher” for purposes of this category, nor is a trainee in the United States in H-3 status a “trainee” under this category. To avoid confusion, “teachers and trainees” are referred to as J and Q Non-students. The tax rule applies to spouses and other dependents in the United States in a derivative status such as J-2, as well as to the principal visa holder. Under this exception, a J-1 or Q-1 non-student, who has not been in the United States in F, M, J, or Q status in the prior six years, is a nonresident alien for tax purposes for his or her first two calendar years in the United States. The individual will become a resident in the third calendar year if he or she is in the United States for at least 183 days in that third year. The determination of residency status for a J-1 non-student may be particularly complicated if the individual has entered the United States periodically over a period of years in F or J status, which is not unusual for many research scholars.7
Under an exception to the two out of seven year calendar year rule, an individual who is paid all of his or her compensation by a foreign employer is exempt for four calendar years instead of two calendar years as long as the foreign employer paid all compensation in those prior years. A foreign employer for purposes of this rule includes an office or place of business of an American entity in a foreign country. However, a foreign government is not included in the definition of a foreign employer.
Closer Connection Exception
An individual whose U.S. days satisfy the 183-day residency formula, but who is physically present in the United States for less than 183 days in the current calendar year may be able to claim nonresident status under the closer connection exception. In order to meet the closer connection exception, the individual must submit a completed Form 8840, Closer Connection Statement for Aliens, with facts and circumstances supporting 1) that his or her principal place of business for the full calendar year is in a foreign country or countries and 2) that he or she has a closer connection to a foreign country or countries than to the United States.
An individual who has taken steps to become a U.S. lawful permanent resident cannot use the closer connection test to avoid U.S. tax residency status. Also, a nonimmigrant on a work assignment in the United States that is anticipated to last more than one year has changed his or her tax home to the United States.8 Such a nonimmigrant is, therefore, ineligible to claim this exception.
Nonresidency Status Under an Income Tax Treaty
An individual who is a resident alien under the internal tax laws of a treaty country and under the 183-day residency formula is a dual resident. Such a dual resident may claim to be a resident of the treaty country and a nonresident of the United States if his or her facts and circumstances support a claim of U.S. nonresidency under the tie-breaker rule of the Residency Article of an income tax treaty. Such a claim of nonresidency is effective for income tax treaty purposes only. For example, nonresidency status under a tie-breaker rule does not apply to U.S. Social Security and Medicare taxes, since these taxes are generally not covered by the Taxes Covered Article of the treaty. A nonimmigrant who relocates to the United States for a substantial period of time may lose tax residency status in the treaty country and, therefore, be unable to claim nonresidency status under a treaty.
RULE #4: AN IMMIGRANT, LIKE A U.S. CITIZEN, IS SUBJECT TO U.S. TAX ON WORLDWIDE INCOME
Under Section 7701(b) of the Code and the regulations under that section, an immigrant is a resident alien for U.S. federal tax purposes from his or her first day of U.S. presence in that status. This test is referred to as the U.S. lawful permanent residency test or “green card” test. An immigrant remains a resident alien until that status has been revoked or administratively or judicially determined to have been abandoned. U.S. citizens and resident aliens are subject to U.S. federal income taxes on worldwide income regardless of where in the world they reside and work.
U.S. Citizens and Resident Aliens with Foreign Income
A U.S. citizen or resident alien residing and working in the United States, who has income from foreign sources, must include that income in his or her U.S. tax return. If the foreign source income is subject to foreign income taxes, the taxpayer can use foreign tax credits to offset U.S. taxes attributable to the foreign income to avoid double taxation.10
U.S. Citizens and Resident Aliens Abroad
A U.S. citizen or resident alien who resides and works abroad remains subject to U.S. income taxes and obligated to submit a U.S. tax return. Special rules under section 911 of the Code and the regulations under that section allow a qualifying individual to elect to exclude up to $80,000 of earned income and certain housing costs to the extent they exceed a base housing amount. The exclusions do not apply to unearned income such as interest, dividends, capital gains, and rents. An individual may claim foreign tax credits to offset U.S. taxes on foreign earnings to the extent that the foreign income is not excluded under section 911. Refer to IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, for a detailed explanation of these rules.
To qualify for the earned income exclusions, an individual must have a tax home in a foreign country and meet one of two tests—the bona fide residency test or the physical presence test. A resident alien may only qualify for the income exclusions under the physical presence test with one exception. An individual who is a national of a country with which the United States has an income tax treaty is entitled to nondiscrimination treatment may use the bona fide resident test to qualify for section 911 exclusions.11
Section 7701(b) allows a foreign national who is a resident of a treaty country to claim U.S. nonresidency status if the individual may support such a claim with facts and circumstances under the tie-breaker rule of the Residency Article of the applicable treaty.12
Whether a bona fide residency claim under section 911 or a nonresidency claim under an income tax treaty is advisable is more a matter of immigration law than tax law.
RULE #5: DIFFERENT INCOME TAX RULES APPLY TO DETERMINE THE INCOME OF RESIDENT ALIENS AND NONRESIDENT ALIENS
U.S. Income Tax Rules for Resident Aliens
A resident alien is subject to U.S. tax on worldwide income regardless of the currency or location of income payment. This rule applies whether the individual is a resident alien under the U.S. lawful permanent resident test or under the 183-day residency formula. As described in Rule #4, a resident alien may be able to minimize U.S. income taxes on foreign income by using foreign tax credits or section 911 foreign earned income exclusions, or a combination of the two.
U.S. Income Tax Rules for Nonresident Aliens
A nonresident is subject to U.S. tax at a 30 percent rate on gross U.S. source fixed or determinable annual or periodic income, unless an income tax treaty reduces the rate; and at graduated rates on net income effectively connected to a U.S. trade or business regardless of the source. Special rules apply to the deductions and exemptions that a nonresident may claim. A nonresident:
Compensation for services performed in the United States is U.S. source income regardless of the currency or location of payment unless an exception applies. Refer to Rule #1 above for the exceptions.
RULE #6: THE UNITED STATES COLLECTS TAXES ON THE INCOME OF NONRESIDENTS THROUGH WITHHOLDING TAXES
As with most governments, the United States collects income taxes from nonresidents through withholding taxes. That is, the payer is required to withhold the taxes from the payment and pay the taxes over to the government.
The General Rule
The United States imposes a withholding tax at a rate of 30 percent on gross income that is fixed or determinable annual or periodic (FDAP). Regulation section 1.14411 defines FDAP income as all income that is not excluded from income under section 62 of the Code. The regulations under section 1441 define the rules and exceptions for withholding income tax from U.S. source payments made to foreign persons. New regulations under section 1441 apply to U.S. source income payments made to foreign persons on or after January 1, 2001.
The Exceptions to the General Rule
Wages Subject to Wage Withholding
Section 1441 and the regulations under that section specifically exempt wages subject to wage withholding from the 30 percent withholding tax. However, special wage withholding rules apply to wages paid to nonresident aliens.13
Income Effectively Connected to A U.S. Trade or Business
A foreign corporation that has income effectively connected (ECI) with a U.S. trade or business may submit a Form W8ECI to the payer and avoid the 30 percent withholding tax. However, such a taxpayer must submit a Form 1120F income tax return to report U.S. ECI and pay the tax. In order to avoid underpayment penalties, the foreign entity must make estimated payments.
Unlike a foreign corporation, a nonresident alien with ECI, such as compensation for U.S. selfemployment services or fees for U.S. services of a director, is nevertheless subject to the 30 percent withholding tax. However, such a nonresident alien may submit a Form 1040NR tax return with a Schedule C, and claim allowable deductions and personal exemptions. If the tax computed on net income is less than the 30 percent withholding tax, the nonresident alien will receive a refund of the overpaid tax.
Income Exempt Under an Income Tax Treaty
An individual, who is entitled to an exemption from tax under an income tax treaty, may be able to claim an exemption from income tax withholding or a reduction in the rate of withholding, by submitting the proper withholding certificate to the withholding agent prior to payment. Even if the income is subject to the withholding tax because of the failure to timely submit the withholding certificate for the treaty claim, the individual may claim the exemption from tax on his or her U.S. income tax return. A nonresident makes the claim for the treaty exemption on a Form 1040NR or 1040NREZ. A resident alien makes the claim for the treaty exemption on a Form 1040, unless the individual is a nonresident of the United States under the tie-breaker rule of the Residency Article of an applicable income tax treaty.14
RULE #7: AN EMPLOYER IS REQUIRED TO WITHHOLD EMPLOYMENT TAXES ON COMPENSATION PAID FOR EMPLOYMENT SERVICES PERFORMED IN THE UNITED STATES.
Federal Income Tax Withholding
The General Rules
Compensation for employment services performed in the United States are wages subject to federal income tax withholding, state income tax withholding, and Social Security and Medicare tax withholding unless an exception applies. The withholding rules for payments to individuals who are resident aliens follow the same rules as for U.S. citizens. U.S. employment taxes apply even if the employee’s compensation is paid on a foreign payroll, unless a special exception applies. The foreign employer, or the U.S. employer bearing the cost of the employee through inter-company charges, is required to withhold federal and state income taxes and Social Security and Medicare taxes.15
The withholding rules for nonresidents are different from the withholding rules for U.S. citizens and residents.16 These rules are different because:
The Exceptions to the General Rules
A nonresident alien or resident alien, who is not a U.S. lawful permanent resident, may claim an exemption from federal income tax withholding if the individual satisfies the requirements of an income tax treaty provision.
Special rules apply to allow certain foreign nationals who are nonresident aliens to claim additional personal exemptions. These foreign nationals are residents of Canada and Mexico; residents of Japan and South Korea if certain conditions are met; nationals of American Samoa, the Northern Mariana Islands, and U.S. Virgin Islands, and students from India.17
Students or business apprentices, who were residents of India immediately before visiting the United States to study or train, may claim the standard deduction. Therefore, the additional withholding allowance does not apply.
See other exceptions listed in Rule #1.
State Income Tax Withholding
The General Rules
Generally, the state income tax withholding rules are the same for foreign nationals as they are for U.S. citizens. Whether an individual is a resident or nonresident for state income tax purposes depends on the state’s definition of resident and nonresident. Any variation in withholding for residents and nonresidents is generally the same for foreign nationals as for U.S. citizens, regardless of the foreign national’s U.S. tax status—resident alien or nonresident alien.
The Exceptions to the General Rules
Some states define income with reference to federal income, federal taxable income, or federal adjusted gross income. In such a case, the state income of a foreign national who is a nonresident for federal income tax purposes, but a resident for state income tax purposes, is limited to U.S. source income. Also, in this case, a foreign national who is eligible for exemption from federal income tax withholding under an income tax treaty is eligible for state income tax withholding also, unless the state has ruled otherwise. For example, Montana allows a treaty claim on an income tax return, but not for state income tax withholding purposes. Some states, such as Connecticut, that use a definition of income tied to the federal definition add treaty exempt income back into state income.
Social Security and Medicare taxes
The General Rules
All compensation for employment services performed in the United States, including services performed for a foreign employer, is subject to U.S. Social Security (FICA) and Medicare taxes unless an exception applies. In addition, compensation for services performed abroad by a U.S. citizen or resident for an American employer are subject to FICA and Medicare taxes. Lastly, special rules apply to impose FICA and Medicare taxes on compensation for services performed aboard an aircraft or ship that is documented by the United States.18
The Exceptions to the General Rules
Special Exemptions under the Code
Several Internal Revenue Code provisions provide exemptions from Social Security and Medicare taxes based on a foreign national’s immigration status. For example:
Exemption under a Social Security Agreement
The United States has Social Security (“Totalization”) Agreements with a number of countries. These agreements allow an individual who is temporarily working in the United States an exemption for U.S. Social Security and Medicare taxes under the detached worker rule of the agreement. A detached worker is an individual who is on a temporary work assignment in the United States that is anticipated to last five years or less. To be exempt under a Totalization Agreement, an individual who is temporarily working in the United States must be covered by and paying mandatory social welfare taxes to his or her home country on the U. S. compensation on which the exemption from Social Security is sought. The payment of voluntary contributions in the home country is not sufficient to support a claim of exemption from Social Security and Medicare taxes under a Totalization Agreement.
An individual seeking exemption from Social Security and Medicare taxes under a totalization agreement should obtain a Certificate of Coverage from the appropriate agency in his or her home country. This Certificate, which should be given to the U.S. payer, serves as proof of exemption from U.S. Social Security and Medicare taxes. The Totalization Agreements and booklets explaining how the agreements work are available on the Social Security Administration web site, www.ssa.gov.
RULE #8: ALL PAYMENTS MADE BY AN EMPLOYER TO OR ON BEHALF OF AN EMPLOYEE, INCLUDING CASH AND THE FAIR MARKET VALUE OF BENEFITS IN KIND, ARE WAGES SUBJECT TO WITHHOLDING TAXES UNLESS AN EXCEPTION APPLIES
The General Rules
Section 61(a) of the Code and the regulations under that section provide that “Except as otherwise provided gross income means all income from whatever source derived, including (but not limited to) compensation for services, including fees, commissions, fringe benefits, and similar items.” Section 3401(a) of the Code and the regulations under that section define “wages” for income tax withholding purposes as “all remuneration for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” Therefore, any benefit in kind provided by an employer to an employee must be presumed to be taxable unless it is specifically excluded by another Code section.
A benefit paid to a third person on behalf of an employee, is treated as compensation of the employee. Also a benefit provided to an employee’s spouse or child is considered to be a benefit provided to the employee by the employer.19 Taxable benefits may also be provided the employee by a client of the employer. In this case, the person in control of the wages may have a withholding and/or reporting obligation.20
Any medium other than cash, which means cash in U.S. dollars, includes remuneration paid in another currency. The value of the payment made in another currency must be translated to U.S. dollars as of the date of payment using the exchange rate that most clearly reflects income. Payments made periodically may be translated into U.S. dollars using an average exchange rate.
The fair market value of other benefits must be determined in order for the amounts to be reported in income and subject to employment taxes. The fair market value is the amount that an individual would have to pay for the benefit in an arm’slength transaction.21 To the extent that the benefit is in kind, rather than cash, the taxes must be withheld from other cash payments. If the employer pays the taxes on behalf of the employee, the taxes paid are also compensation.22 To keep the employee whole on such tax reimbursements, the employer must gross up the tax reimbursement for the taxes.
The Exceptions to the General Rules
Many Code provisions provide exclusions for specified fringe benefits, such as:
In order for income to be excluded under one of these special rules, it must meet the conditions of the Code section. For example, for employer-provided lodging to be excluded from income, 1) the lodging must be on the business premises of the employer and 2) the lodging must be accepted as a condition of the employment.
Under the section 132 fringe benefit rules, nondiscrimination rules apply to prevent such benefits from being used to only reward highly compensated employees. Other Section 132 fringe benefits, such as working condition fringe benefits qualified moving expenses reimbursements may be provided on a discriminatory basis and still excluded from gross income.
The most common excludable benefits are temporarily-away-from-home travel, food, and lodging that are paid under a section 274 accountable plan as explained in Rule #2. In order for allowances to be excludable, they must meet the substantiation requirements of the per diem rules of Rev. Proc. 2001-4723. To the extent that the payments exceed the allowable per diem amounts, it is taxable income subject to employment taxes. The exclusion for employee business expenses does not apply to benefits provided for the employee’s spouse or child.
In addition, in order for the amounts to be excludable, the employee must be temporarily away from his or her tax home for a period anticipated to last a year or less. An employee’s tax home is his or her principle place of business. Under the substance over form doctrine, the IRS will disallow such exclusions for multiple assignments unless a sufficient time has expired between assignments to start the clock again. A break of two to three weeks will not “restart the clock” for a new one-year limitation but a break of a seven-month continuous period will restart the clock.24
RULE #9: AN EMPLOYEE MUST FOLLOW THE DOCUMENTATION RULES IN ORDER FOR AN INCOME EXCLUSION TO APPLY
In addition to meeting the conditions for an exception, an employee must document the exception as required under the procedures set forth by the IRS for the particular exclusion.
Substantiation of Expenses Under an Accountable Plan
As noted in Rules #2 and #8, in order to exclude amounts as temporarily-away-from- home business expenses, the amounts must be substantiated under an accountable plan.25 Similar rules apply to income exclusions for qualified moving expenses.26 When the employer chooses to pay the employee an allowance rather than reimburse the expenses under the accountable plan rules, the amount is fully includable in taxable income and subject to employment taxes. The employee may be able to deduct the allowable expenses on his or her U.S. tax return. However, employee business expenses are deductible only to the extent that they exceed two percent of the employee’s adjusted gross income. Because of this limitation, the amounts may not be deductible at all.
Special Documentation Requirements for Treaty Exempt Compensation
In order to claim an exemption from income tax withholding under an income tax treaty provision, the beneficial owner of the income must submit a special form to the payer prior to the payment. The type of form depends on the type of income on which the exemption is being claimed and whether the individual claiming the benefit is a nonresident or a resident for the calendar year under the 183-day residency formula for the calendar year. (Note also that income that is exempt from withholding under an income tax treaty must be reported to the recipient and to the IRS on Form 1042-S, not Form W-2.)
Form 8233 for a Nonresident’s Treaty Claim
To claim exemption from tax under a tax treaty provision, a nonresident must submit a completed Form 8233, Exemption from Withholding on Compensation, accompanied by a certifying statement for the treaty article under which the treaty benefit is being claimed. A copy of the signed form and statement must be submitted to the IRS in accordance with the instructions for the form. 27 Payers may draft statements for the situations not included in these Revenue Procedures, such as exemptions for trainees or for provisions in treaties that have come into effect since these Revenue Procedures were issued.
A payer cannot allow an exemption from withholding for payments if the Form 8233 submitted by the individual does not have a taxpayer identification number (TIN). For an individual a TIN is a Social Security number (SSN) or an individual taxpayer identification number (ITIN). If the SSN or ITIN has been applied for but not yet received, a copy of the application, Form SS-5 or W-7 must be submitted with the Form 8233.28
Form W-9 for a Resident’s Treaty Claim
Under Regulation Section 1.1441-6(b)(5), a resident who is claiming an income tax treaty exemption from withholding tax based on a treaty article, the benefits of which are preserved by an exception to the treaty’s saving clause, must submit a Form W-9 to the withholding agent. To support the treaty claim, the resident must submit an attachment that includes the following information:
Unlike the Form 8233, which must be submitted to the IRS, the Form W-9 is for the payer’s records only and should not be sent to the IRS. There is no regulatory requirement that the Form W-9 be submitted annually. However, requesting such a submission assures the payer that the facts supporting the claim have not changed.
RULE #10: THE IRS ENFORCES COMPLIANCE BY COLLECTING THE TAX, PLUS PENALTIES AND INTEREST, FROM THE PAYER WHO FAILED TO WITHHOLD
The IRS enforces compliance of withholding and obligations by imposing taxes, penalties, and interest upon the employer or withholding agent who fails to meet these obligations, or who met the obligations but untimely. The withholding agent for purposes of these obligations is anyone who receives, controls, has custody of, disposes of, or pays an item of income to a foreign person.
Failure to Meet Withholding Obligations
Employer that makes wage payments to employees, regardless of the employee’s U.S. tax resident status, or a withholding agents that make U.S. source income payments to foreign persons, that fail to withhold and pay over required taxes, will be responsible for the taxes that should have been withheld. In addition to the tax, the IRS will also impose penalties and interest computed on the amount of the tax. The following are the penalties that may apply, depending upon the failure of the employer or payer:
Penalty for Late Deposit
The IRS prescribes when a deposit for taxes must be made depending on the amount of taxes withheld during a quarter year.29 If an employer or withholding agent fails to make a required deposit within the time prescribed, the IRS will impose a penalty on the underpayment, that is, the excess of the required deposit over any actual timely deposit for the period. A withholding agent may be able to abate the penalty by showing that the failure to deposit timely was for reasonable cause and not because of willful neglect. Also, the IRS may waive the penalty for certain first-time depositors.
The penalty rate is based on the number of days that the deposit is late, as follows:
Penalty for Late Payment
The penalty for late payment is .5 percent of any tax not paid by the original due date of a return (Form 941 for employers, and Form 1042 for withholding agents making nonemployee payments to foreign persons) for each month or part of a month that the tax remains unpaid. The penalty cannot exceed 25 percent of the tax due. The penalty may be abated if you can show reasonable cause for not paying on time.
Trust Fund Taxes
When taxes are withheld from payments made to individuals, the taxes withheld are credited to the account of the employee or payee. These withheld taxes are called “trust fund taxes” because they are considered to be a trust in favor of the United States from the time that they are withheld from the payment until the time that they are paid over to the government.
Section 6672 of the Code and the regulations under that section impose personal liability upon the agents and officers of corporations or other entities that fail to withhold and pay over the trust fund taxes. Section 6672 only applies to the taxes that were withheld on behalf of the third party. For example, the employee’s share of Social Security and Medicare taxes are a trust fund tax, while the employer’s share is an excise tax not subject to section 6672 penalties. Because of the scope of section 6672, it also applies to taxes that must be withheld and collected on payments to foreign persons under section 1441. Section 6672 is essentially a collection device. Therefore, if the employer or withholding agent can show that the employee or payee paid the tax, no penalty will be imposed.
If the failure to withhold trust fund taxes was willful, responsible individuals may be personally liable for the taxes that were not withheld and paid over plus penalties, and interest.
The IRS will charge interest on any tax not paid by the original due date until the tax is paid. The interest will accrue even if you have been granted an extension or have shown reasonable cause for not paying on time.
Failure to Report Timely
In addition to the failure to withhold, the IRS imposes penalties for the failure to report the income timely. Wages subject to wage withholding must be reported on Form W-2 and Form 941, Employer’s Tax Return. Income payments to U.S. citizens and residents must be reported on Form 1099. All U.S. source income payments paid to nonresidents that are subject to withholding, or are exempt from withholding under an income tax treaty provision, must be reported on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, and on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. These forms are due March 15 of the calendar year following the payment.30 The following penalties may be imposed for failure to comply with the Form 1042 and 1042-S requirements.
Late Forms 1042-S for the Recipient
If a withholding agent fails to provide correct Forms 1042-S to recipients when due and cannot show reasonable cause, the withholding agent may be subject to a penalty of $50 for each such failure. The IRS may also impose the penalty for failure to include all required information or for furnishing incorrect information on Form 1042-S.
The maximum penalty is $100,000 for all failures to furnish correct Forms 1042-S to recipients during a calendar year. However, if the withholding agent is determined to have intentionally disregarded the requirement to report correct information, each $50 penalty is increased to $100 or, if greater, 10 percent of the total amount of items required to be reported, with no maximum penalty.
Late IRS Forms 1042-S Submission
The amount of the penalty for submitting Forms 1042-S is based on when the forms are submitted and the number of forms submitted. The penalty is computed as follows:
A small business is defined as a business with average annual gross receipts of $5 million or less for the three most recent tax years (or the period of existence of the business if shorter) ending before the calendar year in which the Forms 1042-S are due.
If a withholding agent does not intentionally file required Forms 1042-S, the minimum penalty is $100 per form or, if greater, 10 percent of the total amount of the items that must be reported, with no maximum penalty.
Failure to File Forms 1042-S Electronically/Magnetically
If a withholding agent with 250 or more Forms 1042-S must file the IRS forms either magnetically or electronically through the IRS’ Filing Information Returns Electronically (FIRE) System. A withholding agent who is required to file magnetically/electronically and fails to do so may be subject to a $50 per return penalty unless the withholding agent has an approved waiver or establishes reasonable cause for the failure. The penalty applies separately to original returns and corrected returns. THE TEN RULES OF U.S. TAXATION 15
Failure to Submit Form 1042 Timely
1 Rev. Rul. 93-86, 1993-2, C.B. 71.
Paula Singer, Esq., CEO of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer, Newton, MA has over 25 years of experience providing advice and compliance services to employers on cross-border employment matters. For more information, visit www.windstar.com. For additional information, call 1-800-259-6398 or email: firstname.lastname@example.org
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