Form 1042-S: What Your Business Needs to Know

If your company pays independent contractors or other service providers who are foreign persons for U.S. tax purposes, you may have reporting and withholding obligations that don't apply to your domestic contractors. Form 1042-S, also known as “Foreign Person’s U.S.-source Income Subject to Withholding” is used to track U.S.-source payments made to nonresident and foreign entities. Getting this wrong can lead to penalties.

 

Who Actually Needs a Form 1042-S.

Services performed inside the United States by a nonresident alien or foreign entity generally produce U.S.-source income. That income may be reportable on Form 1042-S and may be subject to withholding, generally at a 30% rate, unless a treaty, exemption, or other provision reduces or eliminates the withholding requirement.

Form 1042-S isn't limited to contractor compensation. It covers various types of U.S.-source income paid to foreign persons, including interest, dividends, rents, royalties, certain scholarships, and other income. For the purposes of this article we will focus on contractors.

 

Example:
A Canadian contractor travels to the United States and performs the services while physically working in the U.S. The portion attributable to services performed in the U.S. is generally U.S.-source income and may be subject to Form 1042-S reporting and withholding.

Services performed entirely outside the United States generally produce foreign-source income, which is not subject to 1042-S reporting or withholding, even though the contractor is foreign.

 

Example:
A Canadian contractor lives in Canada and performs all services remotely from Canada for a U.S. company. The contractor's foreign status alone does not make the payment subject to 1042-S reporting. Because the services are performed outside the United States, the compensation is generally foreign-source income.

 

What You Need from the Contractor Before You Pay Them

The core compliance document is a Form W-8, collected before the first payment:

The appropriate form depends on the type of contractor, the type of income, and the contractor's circumstances. While Form W-8BEN is generally used by foreign individuals and Form W-8BEN-E by foreign entities, other forms, such as Form W-8ECI or Form 8233, may apply in certain situations.

The form establishes the payee's foreign status and, when applicable, documents the payee's eligibility for a reduced rate of withholding or an exemption under a tax treaty or other provision of the tax law. Without valid documentation establishing the payee's foreign status and any applicable exemption or reduced rate, U.S.-source income that is subject to Chapter 3 withholding is generally subject to the 30% statutory withholding rate.

To properly complete a W-8 and support a treaty claim, you'll typically need from the contractor:

- Full legal name and permanent foreign address

- Country of tax residency

- Foreign tax identifying number (or a U.S. ITIN/EIN if they have one)

- If a treaty benefit is being claimed, the contractor should provide the information required to support the treaty claim, including the applicable treaty article and other required information.

- Signature and date

W-8 forms generally remain valid through the end of the third succeeding calendar year, unless a change in circumstances makes the information incorrect. The contractor should notify the payer if circumstances change that would make the information on the form incorrect.

If a foreign payee does not provide the required documentation, the payment may be subject to the applicable statutory withholding rate, generally 30% for U.S.-source FDAP income, and the payment may need to be reported on Form 1042-S.

A completed W-8 should be reviewed for completeness and consistency with the information known about the contractor. A W-8 is not a substitute for determining where services are performed or whether the payment is subject to withholding. If the information provided raises questions about the contractor's status or the applicable withholding treatment, additional documentation may be necessary.

 

Filing

- Form 1042-S is furnished to the recipient and filed with the IRS by March 15 of the year following the payment.

- Form 1042 reports the withholding agent's overall U.S. withholding activity and generally accompanies the Form 1042-S filings. It is due the same date, March 15.

- Electronic filing is generally required for filers that are required to file 10 or more information returns during the calendar year. The 10-return threshold applies across information return types (1099, W2, 1042-S, etc.)

- Reporting and withholding are two separate requirements. A payment may need to be reported on Form 1042-S even when no federal income tax was withheld. For example, a treaty provision or other exemption may reduce the withholding rate to zero while the payment remains reportable.

AHP can help you prepare these forms!

When you have paid a foreign contractor, provide AHP with:

• The contractor's completed Form W-8 or other applicable documentation
• The contractor's legal name and address
• A description of the services provided
• The location where the services were physically performed (Whether any portion of the services was performed in the United States)
• The dates the services were performed
• Total amounts paid during the calendar year, including the dates and amounts of individual payments, if available
• Copies of any contracts or agreements that may help establish the nature of the services
• Information regarding any treaty or other withholding exemption claimed

 

Please reach out to AHP for additional questions or if you would like to start the process of preparing these forms.