Key Takeaways:
- U.S. businesses making payments to non-U.S. payees must report those payments and any taxes withheld using Form 1042-S, similar to Form 1099 for U.S. vendors or contractors.
- Filing requirements: As of 2024, businesses with 10 or more information return filings (e.g., W-2, 1099, 1042-S) must file Forms 1042 and 1042-S electronically, with a deadline of March 15, 2025. Extensions are available.
- Importance of compliance: Companies should document foreign payments regularly to avoid penalties, and seek assistance from a tax professional to ensure proper filing, especially with the complexities of tax treaties and cross-border work.
Reporting Applies Broadly to Foreign Employees, Contractors – Even Jackpot Winners
The IRS Form 1042 is not widely known, but it is an important form for U.S.-based businesses that make payments to non-U.S. vendors, contractors, or lenders. Forms 1042 and 1042-S (“Forms 1042”) are used to report those payments, as well as any taxes withheld, to the IRS, much like a Form 1099 is used to report payments to service providers who are not employees of a company. The default rule in the U.S. for payments to foreign persons is that they are subject to a 30% withholding tax. That withholding tax is the responsibility of the payor and if it is missed, the IRS can come after a U.S. taxpayer to collect a foreign person’s tax liability.
Forms 1042 have broad application, especially in industries that hire a large number of foreign workers, such as agriculture, technology, health care and higher education. In addition to reporting payments for work or services rendered, Forms 1042 are also used to report payments of dividends, rents and royalties to a foreign person or foreign investor in a U.S. partnership or LLC. Even at a casino, if a foreign individual wins a large jackpot, they will be issued a Form 1042-S right there on the floor!
Who Must File Forms 1042?
Any U.S. taxpayer who makes payments to non-U.S. persons who is considered a withholding agent, meaning they had custody and control of the funds before the payment, must file Forms 1042 and issue copies of the 1042-S to the recipient of the payment who should be the beneficial owner of the income. The beneficial owner may not always be the person receiving the payment.
As of the 2024 tax year, Forms 1042 are required to be electronically filed by any withholding agent that filed 10 or more information returns during the tax year. Information returns refers to the W-2, 1099, and 1042-S. Many companies are not aware of their electronic filing requirement for the 1042-S. If a company has 9 employees receiving a W-2 and one payment to a foreign party that is reportable on a 1042-S, they will have met the 10-filing threshold and would be required to electronically file both the W-2s and 1042-S electronically The filing deadline for 2024 forms is March 15, 2025, with a six-month extension available upon application for Form 1042 and a 30-day extension for electronically filing Forms 1042-S.
It is important to note that if Forms 1042 are required to be filed electronically and are not, the IRS can deny that there was any filing and assess penalties and interest. So, obtaining guidance and assistance in filing the Forms 1042 – at least the first time – is a wise move for most filers. Additionally, filers must make sure that the foreign payee’s Form W-8 – the equivalent of a W-9 that is used for foreign workers – has been received and is valid.
Certain foreign workers and businesses may have full or partial exemptions from paying taxes on their U.S. earnings, depending on whether their home countries have a tax treaty with the U.S. and what that treaty provides. Employers and foreign workers should both be aware of these exemptions.
U.S. Partnerships with Foreign Partners
Many U.S. partnerships attract foreign investors who may not be aware of all compliance and withholding requirements that come along with having a foreign person in the ownership mix. In addition to being responsible for withholding taxes on operating income or “effectively connected income”, U.S. partnerships and LLCs taxed as partnerships are responsible for withholding on passive income (interest, dividends, and royalties generally) that is allocated to a foreign partner. The U.S. partnership will be required to file Forms 1042 to report the income and withholding taxes related to their foreign partners.
Identifying foreign partners and proper withholding tax rates can be tricky, especially when the foreign partner is a partnership themselves. Foreign partners may be entitled to treaty benefits that reduce the withholding tax rate on certain types of income or the portfolio interest exemption, which provides relief from withholding on interest income in many cases.
Even if the foreign partner is not receiving cash distributions, the partnership may be required to withhold and report under something called “the lag method”. The lag method applies when the foreign partner has not received a distribution during the year but has received their K-1 showing U.S.-source income. The issuance of the K-1 is treated as a payment and the partnership is required to collect and remit withholding tax on the foreign partner’s U.S.-source income at that time, creating a tax deferral or “lag”.
Impact of Workplace Trends
The growth of the digital economy and remote work phenomena have made cross-border payments more prevalent than ever. In some cases, the question of whether to file Forms 1042 becomes a matter of judgement rather than compliance.
For instance, a U.S. company may hire a social media coordinator to manage its online marketing presence, but that coordinator lives in Spain and is a Spanish citizen. Although the U.S. tax regime does not reach into other countries to levy income taxes, some U.S. companies choose to report these types of payments by filing Forms 1042 in case they are audited by the IRS, particularly companies making a lot of payments to foreign persons. Even though the reporting is not legally required in this instance because the U.S. cannot tax services performed outside of the country, having the Form 1042-S for these payees on file can help speed the process of clarifying to the IRS where a company’s offshore payments went and why they were not withheld upon in the event of an audit.
Stay on Top of Reporting
The most important advice companies can follow when it comes to Forms 1042 is to stay on top of documenting payments to foreign persons throughout the year. Don’t wait until the end of the year to review all your payments and determine whether you have a filing requirement or payment due. It’s best to have a process in place that identifies reportable and/or withholdable payments before funds are transmitted to a foreign payee. Withholding tax payments are generally due within 3 business days after the close of the week that the payment is made. There are multiple penalties for failure to file the Form 1042 if there is tax due, penalties for failure to deposit the withholding tax on time, and penalties for failure to provide Forms 1042-S on a per-form basis even if there was no associated withholding tax liability.
If your company makes payments to foreign persons: employees, contract workers consultants, lenders, or vendors, and you would like assistance with Forms 1042, contact your KRD tax advisor.
