Editor: Mary Van Leuven, J.D., LL.M.
Secs. 871(a) and 881(a) impose a tax of 30% of the fixed and determinable annual or periodical (FDAP) income received from sources within the United States by a nonresident alien. All persons having the control, receipt, custody, disposal, or payment of certain items of that income are withholding agents and are required to deduct and withhold from those items the 30% tax imposed by Secs. 871 and 881 (Regs. Sec. 1.1441-7(a)(1)). While the mechanics of this withholding regime seem straightforward, they can be difficult for certain tiered partnership structures. The primary reason for this is a lack of income information at the time withholding and reporting is required.
Over the years, Treasury and the IRS have made several accommodations to the rules to address this problem, including the lag method for deposits and reporting; the escrow procedure; and, most recently, proposed regulations with new reporting deadlines. While these rule accommodations are helpful, they bring their own set of complexities; and, for many partnerships, the problem stemming from the lack of knowledge persists. Significantly, a combination of two simple modifications could provide a workable solution. This item outlines the accommodations that Treasury and the IRS have made, their limitations, and a potential solution.
The lag method
Generally, as a withholding agent, a U.S. partnership is required to withhold on distributions of FDAP income to its non-U.S. partners. If, however, the partnership does not actually distribute its income currently, the regulations provide for a deemed distribution of a non-U.S. partner's allocable share of any undistributed FDAP income on the earlier of: (1) the date the Schedule K-1 is mailed or otherwise furnished to the partner; or (2) the due date for the Schedule K-1 (including extensions) (Regs. Sec. 1.1441-5(b)(2)(i)(A)).
For a calendar-year partnership, the extended due date is Sept. 15 following the close of the tax year, and, assuming the partnership does not furnish the Schedule K-1 earlier, any undistributed FDAP income would be subject to withholding at that time. For purposes of deposits and reporting, the instructions for Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, make clear that these requirements both follow the year of the deemed distribution. This means that the income reported on the Schedule K-1 (and the non-U.S. partner's U.S. tax return) will not match the deemed distributions of FDAP income reported on the Form 1042-S.
Because of this mismatch, the lag method has been problematic for non-U.S. partners that need to claim a credit or refund. Of equal importance, the method does not resolve the stated problem (the lack of information at the time withholding and reporting is required) for a U.S. partnership in a tiered structure. Specific to this, the Schedule K-1 issued to the partnership, delineating its items of income and deductions, may not be furnished to it from the lower-tier partnership in which it is a partner until the extended due date of Sept. 15(or later if the schedule is sent via physical mail).Consequently, the partnership will not have the income breakdown it needs to properly withhold and report any actual distributions it makes and likely will not have the breakdown for any deemed distributions that occur during the subsequent year. This results in a costly and time-consuming obligation for the partnership to amend the Forms 1042 and 1042-S each year.
Use of the escrow procedure
The escrow procedure allows a withholding agent who lacks information necessary to determine the source or character of the payment to withhold the tax at the time of the payment but, instead of depositing the amount withheld with the IRS, put it into escrow (Regs. Sec. 1.1441-3(d)(1)). For this purpose, the IRS has informally stated a formal escrow account is not required. Instead, the withholding agent may track all withheld amounts in a separate liability account. The procedure allows the withholding agent to maintain the withheld amount in escrow until the earlier of the time it obtains knowledge relating to the payment type or one year from the date of payment, at which time the withholding agent must either release the amount withheld to the payee or deposit it with the IRS, depending on the circumstances.
While the escrow procedures may be useful for withholding agents that are able to obtain the requisite knowledge within the stated time periods, this is not always the situation with tiered partnerships. For example, partnerships in tiered structures that make quarterly distributions will not know the makeup of those distributions until the Schedule K-1 is received. As indicated above, this may not occur until Sept. 15 of the following year, or later. Thus, for distributions made during the early part of the year, the escrow period will expire months before the partnership is able to classify the payment. Given the difficulties with the withholding and reporting rules applicable to partnerships, Treasury and the IRS recently attempted to make compliance with these rules more practicable in proposed burden reduction regulations.
Proposed burden reduction regulations
In December 2018, Treasury and the IRS released proposed burden reduction regulations (REG-132881-17) addressing many industry concerns with the withholding and reporting rules under Chapters 3 and 4 of the Code. The proposed regulations modify the lag method as it pertains to Form 1042-S reporting and deposit requirements for partnerships outlined above. Instead of reporting the deemed distribution in the subsequent year, the proposed regulations generally require the partnership to report distributions to non-U.S. partners on Forms 1042 and 1042-S for the year in which the income was earned by the partnership (even if the distributions were actually, or deemed to have been, made in the subsequent year). The proposed rules contain corresponding changes to the deposit rules, requiring the partnership to designate the deposits associated with the deemed distributions to the year in which the underlying income was earned by the partnership.
Notwithstanding the previous paragraph, the proposed regulations provide an exception for non-calendar-year partnerships (i.e., fiscal-year partnerships). These partnerships may, but are not required to, report distributions to partners on Forms 1042 and Forms 1042-S, and designate deposits, for the year in which the distribution occurs (i.e., in line with the lag method required under prior guidance). (Note that per the cover sheet to the instructions for Form 1042-S (2019) and instructions for Form 1042 (2019), calendar-year partnerships may also elect to remain on the traditional lag method of reporting for the 2019 calendar year.)
When a partnership withholds on a distribution after March 15 of the year following the year the underlying income was earned by the partnership, the due date for the associated Forms 1042-S is extended six months, from March 15 until Sept. 15. The IRS has added a check box to Form 1042-S so the partnership can indicate that it qualifies for the later Sept. 15 due date for a particular payment. While the regulations specifically address partnership reporting when withholding is required, the 2019 Instructions for Form 1042-S makes clear that the extended due date also applies to distributions (or deemed distributions) made after March 15 of the subsequent year in which no withholding is required (such as amounts falling within the portfolio interest exception or subject to complete tax relief under an income tax treaty).
When the postponed due date for Form 1042-S reporting applies, the due date will align with a calendar-year partnership's extended deadline for furnishing a partner's Schedule K-1. This change is intended to allow the partnership in a tiered structure to delay the filing of the Form 1042-S until it has the income information it needs from the Schedule K-1 and, therefore, better align tax reporting to non-U.S. partners. As noted above, however, if the partnership does not receive the requisite income information on the Schedule K-1 until the extended due date (or later, depending on the delivery method), it still will not have the ability to timely file by Sept. 15, even under the proposed rule, resulting in the same need to file amended forms that exists today. Further, for distributions made prior to March 15 of the subsequent year, the normal March 15 due date applies (subject to a 30-day extension). This has two negative consequences. First, the proposed change does not eliminate the need for amended returns. Second, the partnership may be burdened with two different Form 1042-S due dates for the same reporting year, depending on when it makes a distribution. These outcomes seem unusual given that the stated intent of the new rules was to reduce the burden on taxpayers.
As outlined above, compliance with the withholding and reporting rules for partnerships in tiered structures has been a vexing issue. Treasury and the IRS have acknowledged these issues and, over the years, made various attempts to achieve a workable solution. Notwithstanding that, substantial problems remain. Two seemingly simple rule modifications could provide the necessary solution.
First, the escrow procedure deadlines for partnership distributions could be extended to the Schedule K-1 filing deadline or, preferably, to a couple of weeks after the Schedule K-1 filing deadline (i.e., Sept. 30) to ensure that partnerships would have the requisite Schedule K-1 information before the end of the escrow period. Were the escrow procedure to allow partnerships to escrow amounts withheld for partnership distributions until the earlier of actual knowledge or Sept. 30 of the following year (as opposed to one year from the date of the payment), partnerships would be able to obtain the Schedules K-1 for the lower-tier partnerships by Sept. 15 of the following year (or soon thereafter, depending on the delivery method) and would have the information they need to determine the correct tax liability. Providing a Sept. 30 deadline would provide those partnerships 15 days to process the data from the Schedules K-1 and ensure that proper withholding tax is deposited. This would eliminate unnecessary refund claims that are currently caused by partnerships over-depositing amounts with the IRS when payment information is still unknown.
Second, and for the same reason, permitting partnerships to apply a single Sept. 30 due date for Form 1042-S reporting for all partnership distributions would ensure that these partnerships could file correctly without the need to amend. This would make reporting more cohesive and eliminate the inevitable errors that will result with two filing deadlines for the same reporting year. These simple modifications should provide partnerships in tiered structures the ability to withhold correctly, eliminating the need for excessive refund claims, while also eliminating the need for amended Form 1042-S filings year after year.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.