Foreign Income & Taxpayers
Beginning with the 2011 tax year, the IRS has doubled the per form penalties for late filings of Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, and for a Form 1042-S that was improperly completed. In some cases, the maximum penalty for businesses under Sec. 6721 has more than tripled for forms filed late; for forms filed more than approximately four and a half months late, penalties have increased sixfold. In May 2011, an IRS official stated that the IRS intends to more strictly enforce the rules and will begin to impose the harsher penalties to encourage more accurate reporting of U.S.-source income of foreign persons. The IRS will consider whether the filer had reasonable cause for lateness and errors, which can be a significant mitigating factor when notices of penalties are issued. It is important for practitioners to take note of the increased penalties and to comply in a timely and accurate manner with all filing requirements.
The function of Form 1042-S is to give the IRS information about the U.S.-source income of foreign persons that is not reported elsewhere, such as on a Form 1099 or a Form W-2, Wage and Tax Statement. A separate return must be filed by March 15 of the year following receipt for each foreign person receiving U.S.-source income and for each type of income received by the foreign payee. Withholding agents, excluding individuals not making the payment as part of their trade or business and also not required to withhold, must file the informational return. However, a withholding agent is not required to file in certain circumstances where another withholding agent is already reporting the same amount paid to the same recipient.
Foreign persons are defined broadly to include nonresident alien individuals, foreign corporations, foreign partnerships, foreign trusts, foreign estates, and any other non-U.S. person. Notably, the definition includes a foreign branch or office of a U.S. financial institution or clearing organization if the foreign branch is a qualified intermediary. A U.S. branch of a foreign person will be considered a foreign person.
A withholding agent is similarly defined with a broad scope. The term includes any withholding agent as defined in Sec. 1441(a). It also includes qualified and nonqualified intermediaries, withholding foreign partnerships and trusts, flowthrough entities, a U.S. branch of a foreign insurance company, or a foreign bank that is treated as all of the following: a U.S. person, a nominee under Sec. 1446, and an authorized foreign agent. There is no requirement that the withholding agent actually be required to withhold; another person could even properly withhold the amount required on that income.
The list of types of income to be reported on Form 1042-S is extensive (see Regs. Sec. 1.1461-1(c)(2) and the instructions for Form 1042-S). Included is U.S.-source fixed and determinable annual or periodic gains (FDAP). FDAP includes interest, rents, royalties, annuities, and compensation. Corporate distributions, both actual and deemed, must be reported in their entirety. An important category of income also included on the list is income effectively connected with the conduct of a trade or business in the United States. This includes a foreign partner’s share of effectively connected income from publicly traded partnerships but not from closely held partnerships, as that is properly reported on a different form. Cancellation of debt income, gambling winnings, notional principal contract income, and original issue discount (OID) paid upon redemption of an OID obligation must also be reported.
Just as important as the list of income types that are required to be reported on Form 1042-S are the types of income that are not subject to reporting. Nonreportable income includes such items as interest on deposits, interest and OID from short-term obligations, accrued interest and OID, registered and bearer obligations targeting foreign markets, and amounts previously withheld upon.
For forms filed within 30 days after the March 15 deadline, the penalty for late filing is now $30 per form, with a maximum penalty of $250,000 per year. Small businesses—those with average annual gross receipts of $5 million or less for the three most recent tax years ending before the calendar year in which the form is due—have a reduced maximum penalty of $75,000. These figures are an increase from 2010 when the penalty per form was $15 and the maximum penalties were $75,000 and $25,000, respectively.
Forms that are filed at least 30 days late but before August 1 will incur a penalty of $60 per form. The maximum penalty is increased to $500,000 per year generally and $200,000 for small businesses. In 2010, the penalty per form was $30 and the maximum amounts were $150,000 and $50,000.
After August 1, the late-filing penalty increases to $100 per form, up from $50 last year. The maximum penalty for withholding agents is $1,500,000, with a limit of $500,000 for small businesses. The 2010 maximum penalties were noticeably lower at $250,000 and $100,000.
The penalty for intentionally disregarding the requirement to report correct information has increased from $100 or 10% of the total amount of items required to be reported, whichever is greater, to $250 or 10% of the total amount of items required to be reported, whichever is greater. There is no limit on the cumulative penalty that the IRS may impose.
It is also necessary to provide foreign persons with correct Form 1042-S statements. Absent reasonable cause, a penalty of $100 is imposed where the withholding agent fails to provide the foreign person with the Form 1042-S by March 15 or fails to include all required information correctly on the form. The maximum penalty for this failure is $1,500,000. This is double the penalty imposed in 2010, and the maximum has increased fifteenfold.
The penalty for failing to file electronically remains the same in 2011 as 2010. It is $50 per failure to file electronically if required to do so, with a maximum penalty of $100,000. Withholding agents that file 250 or more forms in a given year must file the forms electronically. The threshold and penalties apply separately to original and amended returns.
Extensions of Time to File
It will be more important than ever to timely request an extension to prevent late-filing penalties. An automatic 30-day extension is available by filing a Form 8809, Application for Extension of Time to File Information Returns, before March 15. A second extension for another 30 days may be granted if filed before the end of the first 30-day period. An extension of the due date to provide foreign taxpayers with their forms may also be obtained by writing a letter to the Extension of Time Coordinator, IRS Information Returns Branch, Kearneysville, WV.
Final Guidance on FBAR
In February 2011, final rules clarifying Form TD F 90-22.1, Foreign Bank and Financial Account Report (FBAR), were issued by the Financial Crimes Enforcement Network (FinCEN). The final rules explain who must file an FBAR and what is considered to be a foreign account. Each person who has a financial interest in or signature or other authority over foreign financial accounts with an aggregate balance that exceeds $10,000 at any time during the year must report that account to the IRS. A financial interest exists where a person is the owner of record or has legal title, and the account is maintained for his or her own benefit or that of others.
The final rules elaborate upon the signature authority requirement. An individual with the authority “to control the disposition of money, funds or other assets held in a financial account by delivery of instructions . . . directly” to the person who maintains the account has signature authority. The rule recognizes that often more than one individual must contact the financial institution to complete a transaction. Consequently, each of the parties whose signature is necessary is treated as having signature authority.
FinCEN has proposed a few exceptions to the signature authority requirement that will apply, provided the person does not also have a financial interest in an account. One exception would apply to officers or employees of a bank that is examined by one of the federal banking agencies. Officers and employees of financial institutions and authorized service providers that are registered with and examined by the Securities and Exchange Commission are also exempt from the requirement. Similarly, officers and employees of an entity that is traded on a national securities exchange or an entity with a registered class of securities under Section 12(g) of the Securities Exchange Act are not required to report their signature or other authority.
Generally, each person with a financial interest or signature or other authority over an account must maintain records for the account for five years. However, officers or employees with signature authority are no longer required to maintain separate records of their employer’s foreign financial account. FinCEN recognized that this requirement would be overly burdensome because the records belong to the employer involved, not the person with signature authority.
Foreign accounts do not include accounts maintained with a financial institution located in the United States. Owning securities of a foreign company through an institution with a U.S. office does not trigger the requirement of an FBAR filing, nor does having an account with a U.S. institution that holds foreign assets for the person, as long as the person cannot directly access any foreign holdings maintained at a foreign institution.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.