For businesses handling payments to contractors, freelancers, and other persons without U.S. citizenship or residency, tax withholding is a common question mark. In this article, we’ll explore what tax withholding is, who is in scope of chapters 3 and 4 withholding, important forms in relation to non-resident alien tax withholding, and how Trolley can help you manage withholding moving forward.
Foreign individuals working in the U.S. are typically subject to the withholding of U.S. tax on income earned on any payments they receive, be it wages, salaries, or other forms of compensation.
This process often managed by the companies responsible for making these payments. These “withholding agents” ensure that the correct amount of tax, as determined by U.S. tax laws and any applicable tax treaties, is deducted from a payment before it is passed to the foreign individual.
This preemptive collection of taxes is vital in ensuring compliance with U.S. tax regulations, and simplifies the tax-paying process for foreign workers, as it partially or fully covers their tax liabilities in advance. However, these rules have many exceptions and errors in application may result in notices or even worse, penalties, from the IRS.
Keep reading to learn more about NRA tax withholding and to see how we can make tax withholding simple and efficient for your business.
What we cover
Understanding NRA tax withholding
The Internal Revenue Service (IRS) mandates that employers or payers (Tax Withholding Agents) withhold a portion of payments made to non-U.S. citizens or non-residents performing services within the U.S. Known as non-resident alien (NRA) withholding, this amount is remitted to the IRS, to be applied towards the payee’s annual income tax obligation.
The common withholding rate for payments received by a non-resident is 30 percent.
Role of a tax withholding agent
A tax withholding agent is responsible for withholding taxes on behalf of foreign individuals. This role is often filled by employers, banks, or other financial entities making payments to non-U.S. residents.
While employers are the most frequent agents, due to them making wage payments to non-resident employees in the U.S., foreign financial institutions can also serve as agents under Chapter 4 withholding.
There are two main types of tax withholding, Chapter 3 and Chapter 4, each relevant to different payment types and scenarios.
Chapter 3 tax withholding: Who is and isn’t in scope
Chapter 3 withholding applies to non-U.S. persons receiving income from U.S. sources. This includes but is not limited to wages, salaries, bonuses, pensions, annuities, rents, and royalties.
Chapter 3 withholding applies only to payments made to a payee who is a foreign person. The categories below help to define when a person may or may not count as a non-U.S. person:
- Non-resident alien – A non-resident alien is defined by IRS Publication 519 as “an individual who is not a U.S. citizen or resident alien.” Non-resident aliens are generally subject to taxation only on their U.S.-source income and may be subject to Chapter 3 tax withholding under the residence article of an income tax treaty.
- Married to U.S. citizen or resident alien – If a non-resident alien is married to a U.S. citizen or resident alien, they can choose to be treated as a resident alien for tax purposes; they must also file a joint return and meet other IRS criteria. As resident aliens for tax purposes, their worldwide income is subject to U.S. tax, but specific withholding rules, such as Chapter 3 withholding, depends on the type of income and any applicable tax treaties.
- Resident alien – A resident alien is not a citizen or national of the United States but meets the conditions of either “the green card test” or “the substantial presence test.” They can be considered a resident for tax purposes and would not be subject to withholding.
- Green card test – Someone is considered a resident alien for tax purposes if they are a lawful permanent resident of the United States at any time during the calendar year. This status is typically achieved through the possession of a Green Card.
- Note: Resident aliens under the Green Card Test are subject to U.S. tax on their worldwide income. This means they must report all income they earn, both from U.S. sources and from abroad, on their U.S. tax return.
- Substantial presence test – Someone who has been physically present in the United States for at least 31 days during the current year and 183 days over three years (including the current year) is generally considered a U.S. resident for tax purposes for that year and would not be subject to withholding.
- Green card test – Someone is considered a resident alien for tax purposes if they are a lawful permanent resident of the United States at any time during the calendar year. This status is typically achieved through the possession of a Green Card.
- Resident of a U.S. possession – Residents of these territories may be subject to U.S. federal income tax on income from sources within the United States (rules may vary). This means that if they earn income from U.S. sources, that income may be subject to U.S. tax withholding.
Chapter 3 permits 30% withholding on taxable income from U.S. sources, which is adjustable by tax treaties.
Chapter 4 tax withholding (FATCA)
Chapter 4 withholding, also known as FATCA (Foreign Account Tax Compliance Act) withholding, applies to certain types of payments made from U.S. sources to foreign financial institutions or non-financial foreign entities.
FATCA was introduced to prevent tax evasion by U.S. citizens and residents through offshore accounts. It requires foreign financial institutions to report information about financial accounts held by U.S. taxpayers to the IRS.
An FFI (foreign financial institution) that does not comply with FATCA is subject to a 30% withholding tax on certain U.S. source payments. As a result, most FFIs have entered into agreements with the IRS to report on their U.S. account holders in exchange for avoiding this penalty.
The following are entities that may be subject to Chapter 4 FATCA withholding:
- Foreign corporations – Corporations organized under the laws of a foreign country.
- Foreign private foundations – Private foundations that are organized under the laws of a foreign country.
- Other foreign organizations, associations, and charitable institutions – Organizations or associations that are not corporations but are organized under a foreign country’s laws, such as partnerships, trusts, and charities.
- Foreign partnerships – A partnership not organized under U.S. law, with at least one partner who is an unfamiliar person or entity.
- Non-financial foreign entities (NFFE) – These include all non-U.S. entities that are not financial institutions.
- Guamanian or CNMI corporations – Corporations that are organized under the laws of Guam or CNMI and are not considered to be U.S. persons.
- USVI and American Samoan corporations – Similar to Guamanian and CNMI corporations, these are organized under the laws of the U.S. Virgin Islands or American Samoa.
- Foreign trusts and estates – Trusts or estates that are created under foreign law and do not have any U.S. beneficiaries.
Understanding withholding exemptions due to tax treaties
Tax treaties play a pivotal role in international taxation, offering specific exemptions or reduced tax rates under certain conditions. These agreements are made between two countries and are designed to avoid double taxation for individuals and entities that might be subject to tax in both countries. Here’s how tax exemptions due to tax treaties work:
Eligibility for Tax Treaty Benefits: To enjoy a tax treaty, an individual or entity must be a resident of one of the countries party to the treaty. The specific definitions of residency and the scope of benefits vary from one treaty to another. Therefore, understanding the provisions of the specific tax treaty between the individual’s or entity’s country of residence and the United States is crucial.
Types of Income Covered: Tax treaties cover various types of income such as dividends, interest, royalties, pensions, and income from employment or independent personal services. Each type of income can have different treatment under a treaty.
Claiming Treaty Benefits: To claim tax treaty benefits, individuals typically must provide a Form W-8 BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting) to the U.S. payer. Entities use Form W-8 BEN-E for the same purpose.
These forms require the beneficiary to certify their status and claim any applicable treaty benefits, like a reduced rate of withholding or exemption.
Reduced Withholding Rates: Many tax treaties provide for reduced rates of withholding tax on certain types of income. For example, dividends paid by a U.S. corporation to a resident of a treaty country may be subject to a lower withholding rate than the standard 30% rate imposed under U.S. tax law.
Documentation and Compliance: Payers are required to report payments and the application of treaty benefits on Form 1042-S.
Important IRS forms for withholding purposes
What is form W-8 BEN?
The most common form in the W-8 series is Form W-8 BEN, also known as the “Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals)“.
The primary purpose of Form W-8 BEN is for individuals to certify their non-U.S. status for tax withholding and reporting purposes.
When a foreign individual is expected to receive U.S. sourced income, the tax withholding agent associated with that payment needs to collect a completed Form W-8 BEN. They can use the information provided such as the individual’s country of residence to assess the potential applicability of tax treaties, which can affect withholding rates.
What is form W-8 BEN-E?
Form W-8 BEN-E is known as the “Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities).”
This form is specifically designed for foreign entities, as opposed to individuals, to certify their status for U.S. tax withholding purposes.
The primary purpose of Form W-8 BEN-E is for a foreign entity to establish its beneficial ownership and to claim any applicable benefits under tax treaties between the United States and the foreign entity’s country of residence.
The importance of Form 1042-S in reporting withholding
Form 1042-S, or Foreign Person’s U.S. Source Income Subject to Withholding, is an IRS form used to report income received by a foreign person from U.S. sources subject to Chapter 3 and 4 withholding.
As a tax withholding agent, it is crucial to accurately fill out and file Form 1042-S for each foreign person to whom you have made payments.
Form 1042-S provides vital information for the IRS to determine if the correct tax amount has been withheld from foreign persons’ income. It also allows the IRS to track and verify income reported on foreign persons’ tax returns.
In addition, Form 1042-S is used by foreign persons to claim a refund or credit for any excess taxes withheld from their U.S. source income.
Form 1042-S deadlines and penalties
Tax withholding agents must file all Forms 1042-S with the IRS by March 15th of the year following the year in which the income was paid. For instance, for income paid during the 2023 tax year, Form 1042-S must be filed by March 15, 2024.
Additionally, the individuals or entities who received the income must also be provided with a copy of Form 1042-S by March 15th.
Failure to comply with this deadline or filing an incorrect form can result in penalties and interest. If more time is needed, an extension can be requested using Form 8809, “Application for Extension of Time to File Information Returns,” but this request must be made before the original due date.
Let Trolley handle your withholding work
Looking for a payout platform that simplifies non-resident alien tax withholding and reporting? Try Trolley, an IRS-compliant, all-in-one payout and tax solution. Our platform helps businesses comply with tax obligations and streamline global payments. Here’s how Trolley can benefit you:
- Automated Form W-8 Collection: Our self-serve tools let foreign contractors and freelancers provide necessary details for Forms W-8 and W-8 BEN, ensuring accuracy and IRS compliance.
- Automated Tax Documentation and Withholding: Trolley automatically generates tax records and manages withholding for each payout, considering tax treaties and W-8 form information.
- Income Classification and Payment Allocation: We automatically categorize income types and allocate payments, crucial for accurate tax reporting on forms like 1042-S.
- Form 1042-S Generation: Trolley efficiently generates and sends Form 1042-S for foreign recipients, including withheld tax details, ensuring U.S. tax law compliance.
- Efficient E-Filing with the IRS: Our platform enables direct e-filing of Form 1042-S with the IRS, saving time and minimizing errors.
Ready to enhance your payment processes and ensure smooth compliance with the IRS? Switch to Trolley today!
