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Penalties For Failure To Comply With NRA Withholding And 1042-S Information Reporting

by Paula N. Singer, Esq.

On August 4, 2010 the IRS announced, “executing our international strategy is a top priority, and our work continues to intensify in this area.” Included in this strategy is a requirement for examiners to review withholding and reporting on payments to foreign individuals and entities during corporate audits. Other organizations should anticipate that the IRS will apply what they learn in corporate audits of Accounts Payable to audits of their organizations as well.

Under long-standing rules and regulations, payers making payments of U.S.-source income to foreign persons are required to collect a 30 percent withholding tax on the gross income unless an exception applies. For an exception to be valid, the payer must follow prescribed procedures, including collecting appropriate and valid withholding certificates from the recipient prior to payment. Withheld taxes must be deposited timely. The gross income and taxes withheld (if any) must be reported on a Form 1042-S information return filed with the IRS and sent to the recipient by March 15th of the calendar year following the payment.

The IRS enforces compliance with these rules by requiring the payer (called a “withholding agent” because of the obligation to withhold taxes) to make periodic payments of withheld taxes (the due date varies with the amount of the liability) and imposing penalties for the failure to comply with withholding and reporting rules. The Small Business Jobs Act included increased penalties for failure to report income timely (described below) for payments required to be reported on or after January 1, 2011. Payers making payments of U.S.-source income to foreign persons should expect the IRS to be diligent in collecting the following penalties:

A. Penalty for Late Deposit The IRS prescribes when deposits of NRA (nonresident alien) withholding are required in IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities. A payer who fails to make a required deposit of withheld taxes within the time prescribed is liable for a penalty on the underpayment (i.e., the excess of the required deposit over any actual timely deposit for the period).

The penalty rate is based on the number of days that the deposit is late:

  • 1 to 5 days late — 2 percent;
  • 6 to 15 days late — 5 percent; or
  • 16 or more days late — 10 percent.

If the late deposit is not made within 10 days after the IRS issues the first notice demanding payment, the penalty is 15 percent. A withholding agent may be able to abate the penalty by showing that the failure to timely deposit was for reasonable cause and not because of willful neglect.

The tax liabilities and deposits must be listed on Form 1042 quarterly by month. The date for tax liabilities is the date paid (or deemed paid under constructive receipt principles). The date for deposits is the date the deposit is made.

B. Failure to Report Timely
U.S.-source income payments to foreign persons that are subject to withholding or that are exempt from withholding under an Internal Revenue Code or income tax treaty provision must be reported on Form 1042-S. Unlike the rules for Form 1099, Form 1042-S is required whether or not the payer is engaged in a U.S. trade or business. There is no de minimis income rule for Form 1042-S reporting and no special exemption for corporate recipients.

1. 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 amount is computed as follows:

  • $30 per Form 1042-S if correctly filed within 30 days. The maximum penalty is $250,000 per year ($75,000 for a small business).
  • $60 per Form 1042-S if correctly filed more than 30 days after the due date but by August 1st. The maximum penalty is $500,000 per year ($200,000 for a small business).
  • $100 per Form 1042-S if correctly filed after August 1st, or if required Forms 1042-S are not filed. The maximum penalty is $1,500,000 per year ($500,000 for a small business).

A small business is defined as a business having 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 intentionally disregards the requirement to report correct information, the penalty per Form 1042-S is increased to $250 or, if greater, 10 percent of the total amount of the items that must be reported, with no maximum penalty.

2. 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 for each 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 penalty is based on when the correct Form 1042-S is submitted and the number of forms filed as described above for the IRS submission. However, if a recipient statement is provided before August 1st for which the payer provides reasonable cause, the recipient statement shall be treated as if timely filed. The number of statements to which this de minimis rule applies may not exceed 10, or .5 percent of the total number of recipient statements required to be filed by the payer, whichever is greater.

C. Failure to File Forms 1042-S Electronically
A withholding agent with 250 or more Forms 1042-S must file the forms electronically through the IRS’s Filing Information Returns Electronically (FIRE) system. A withholding agent who is required to file electronically and fails to do so may be subject to a $100-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 amended returns.

D. Failure to Timely Submit Form 1042
The penalty for the late filing of Form 1042 is 5 percent of the tax not paid by March 15th (even if an extension of time to file has been granted) for each month or part of a month that the Form 1042 is late.

The penalty cannot exceed 25 percent of the tax due. For a Form 1042 filed more than 60 days late, the penalty is $100 or the balance of the tax due on the Form 1042, whichever is smaller.

E. Trust Fund Taxes
Liability is imposed on responsible parties for the willful failure to withhold and pay over trust fund taxes. Trust fund taxes are the taxes that are withheld from an employee’s or payee’s income payments. These taxes are considered a trust from the time they are withheld from the payment until the time that they are deposited with the government. Trust fund taxes are a collection device that applies to taxes that must be withheld and collected, and as such include NRA withholding on U.S.-source income payments to foreign persons as well as payroll taxes required to be collected on an employee’s wages.

An employer or withholding agent that can show that the employee or payee paid the tax will not be liable for the tax. Currently, the only form specified for collecting a payee’s certification that their taxes have been paid is Form 4669.

About The Author

Paula Singer, Esq., Co-founder and Chair of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer LLP, Newton, MA, has over 25 years of experience providing advice and compliance services to individuals and their employers, and payers on cross-border matters.

The opinions expressed in this article do not necessarily reflect the opinion of ILW.COM.