Article written by:
Jack Grote, CPA
As many middle market businesses are forced to adapt to the increasing globalization of the marketplace, they are not always properly equipped to deal with the variety of regulatory and compliance-related issues they will face as their business crosses borders. One prevalent issue is the withholding tax requirement imposed by the U.S. on payments to foreign persons. Two common payment types are payments to foreign individuals for personal services, which include:
- Payments to foreign individuals as independent contractors
- Wages paid to nonresident aliens as employees
The company making these payments is considered the “withholding agent” and is required to withhold taxes on these amounts and remit the tax to the IRS, similar to the way that taxes are withheld on a U.S. employee’s W-2 wages.
How To Report These Payments
The reporting method for payments to foreign individuals differs based on whether the payee is treated as an independent contractor or an employee:
Payments to Foreign Individuals as Independent Contractors
- Reported on: Form 1042-S (Similar to Form 1099 for domestic independent contractors)
- Withholding rate: 30 percent (unless treaty rate or exemption applies, see below)
- Examples: payments for consulting fees, contract labor, honoraria paid to visiting speakers
Wages Paid to Nonresident Aliens as Employees
- Reported on: Form W-2 if taxable in U.S., Form 1042-S if exempt under a tax treaty (see below)
- Withholding rate: graduated withholding rate, similar to rates applied to domestic employees’ wages
Not all payments to foreign individuals are subject to the withholding tax, however. The U.S. has entered into more than 60 income tax treaties with other countries. Under many of these treaties, assuming certain criteria are met, residents of a foreign country are exempt from the withholding tax on compensation they earn for the performance of personal services in the U.S. A common feature among the treaties is a provision that allows for foreign individuals working in the U.S. as independent contractors to be exempt from U.S. tax so long as they are not working in the U.S. for more than a specified number of days in a given period of time. Other special provisions allow for foreign employees of a U.S. company to be exempt from tax if they are working in the U.S. as a full-time student, or providing certain services such as research or teaching.
In order to claim a treaty exemption on any income earned in the U.S., a foreign individual must provide the company with a completed Form 8233 and cite the treaty and article number under which they qualify for exemption.
The discussion above represents only the tip of the iceberg when it comes to the rules surrounding U.S. withholding tax. If you’ve made a payment(s) to foreign persons, or are planning to do so in the future, please contact your GBQ advisor to discuss the pitfalls and opportunities related to the withholding of U.S. tax.