Failure-to-deposit penalty when tax is not withheld on payments of US-source income

Editor: Christine M. Turgeon, CPA

Sec. 1441(a) provides, as a general rule, that all persons, acting in whatever capacity, who have the control, receipt, custody, disposal, or payment of any item of U.S.-source income specified in Sec. 1441(b) of any nonresident alien individual, or any foreign partnership, shall deduct and withhold from such items a tax equal to 30% thereof. Sec. 1442 applies those same withholding tax requirements to payments of such items of income to foreign corporations that are subject to U.S. tax.

A failure to properly deduct, withhold, and deposit the applicable withholding tax may result in the imposition of various penalties. This item provides an overview of those potential penalties and presents an argument as to why the Sec. 6656 failure-to-deposit penalty may not apply in some instances.

The items of income subject to withholding include, with certain exceptions, U.S.-source interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income. In some cases, the Code or tax treaties exempt certain types of payments from withholding or prescribe a rate lower than the normal 30%.

Regs. Sec. 1.1461-1(a)(1) requires that every withholding agent who withholds tax pursuant to Chapter 3 of the Code (Secs. 1441-1446 and 1451-1465, relating to the withholding of tax on nonresident aliens and foreign corporations) deposit the tax with the U.S. Treasury. Regs. Sec. 1.1461-1(b) requires withholding agents to file an annual income tax return reporting the amount of income paid and tax withheld. Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, is used for that purpose.

Relatedly, Regs. Sec. 1.1461-1(c) requires withholding agents to file an annual information return for each recipient of an amount subject to reporting and for each single type of income payment with the IRS and to furnish a copy of the information return to the recipient of the income. Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, is used for this purpose.

Potential liabilities

In relevant part, Sec. 1461 provides that every person required to deduct and withhold any tax under Chapter 3 of the Code is made liable for the tax. However, pursuant to Sec. 1463, if a withholding agent fails to deduct and withhold tax when required to do so, but the tax is paid by the recipient of the income, the tax that should have been deducted and withheld will not be collected from the withholding agent. This exception, though, does not relieve the withholding agent from liability for interest or any applicable penalties or additions to tax.

If a withholding agent made payments to a foreign person but failed to deduct, withhold, and deposit the applicable withholding tax, does not file a timely Form 1042, and does not timely file or timely furnish Form 1042-S, an analysis of the withholding agent’s potential exposure should address: (1) liability for the tax itself; (2) the penalties under Secs. 6651(a)(1) and 6651(a)(2) for failure to file and failure to pay; (3) the failure-to-deposit penalty under Sec. 6656; and (4) the penalties under Secs. 6721 and 6722 for failure to file and furnish correct information returns with respect to each Form 1042-S.

The Secs. 6651(a)(1), 6721, and 6722 failure-to-file penalties would clearly apply. The Sec. 6651(a)(2) late-payment penalty would apply if the withholding agent files (or is compelled to file) the delinquent Form 1042. However, if the above-described failures are identified by the IRS as the result of an examination, and the withholding tax liability is assessed without a Form 1042 having been filed, the late-payment penalty arguably should not apply because the misconduct to which that penalty is directed is the failure “to pay the amount shown as tax on any return” on or before the applicable due date.

Failure-to-deposit penalty

The Sec. 6656 late-deposit penalty, which would be 10% where the failure is for more than 15 days, merits further consideration. The penalty would apply in a situation where the withholding agent withheld tax from the payments it made to the foreign person but failed to deposit the tax with the IRS by the applicable deadline.

However, Rev. Rul. 75-191, which addresses the failure to deposit employment taxes, may provide some support for a position that the failure-to-deposit penalty does not apply if no tax is withheld. In Situation (1) in the ruling, Employer X did not withhold any income or Federal Insurance Contributions Act (FICA) taxes from amounts paid to his employees and did not make any deposits of taxes, and it was later determined that taxes should have been withheld and deposits made.

Rev. Rul. 75-191 holds that the Sec. 6656 failure-to-deposit penalty does not apply to the failure to deposit FICA and income taxes that should have been withheld from compensation paid to employees but were not withheld. Relying on Regs. Sec. 31.6302(c)-1 — which provides that the taxes required to be deposited include withheld income tax and employee FICA tax, together with any FICA tax imposed on the employer — the ruling concludes that Employer X is subject to a penalty only on the amount of underpayment of the employer share of FICA tax for failure to deposit that tax on or before the prescribed deposit date (unless the employer establishes reasonable cause for such failure).

In Medieval Attractions N.V., T.C. Memo. 1996-455, the IRS assessed the Sec. 6656 penalty against the taxpayers because they failed to withhold and periodically deposit tax on payments to various foreign entities and individuals that were subject to 30% withholding under Sec. 1442. The taxpayers argued that Rev. Rul. 75-191 supported their position that the late-deposit penalty did not apply. The Tax Court stated that such reliance was misplaced but did not set forth an analysis beyond stating that Rev. Rul. 75-191 addresses employee FICA and income taxes, which were not at issue in the case.

However, while Rev. Rul. 75-191 does not, on its face, address Chapter 3 withholding, the ruling’s analysis can be viewed as lending itself to the language in Regs. Secs. 1.1461-1(a) and 1.6302-2(a). The former regulation provides that “[e]very withholding agent who withholds tax pursuant to chapter 3 . . . shall deposit such amount of tax as provided in § 1.6302-2(a)” (emphasis added). And although the latter regulation does not explicitly use the term “withholding,” it does refer to amounts of “undeposited taxes” that the withholding agent has “accumulated,” which suggests that such amounts had been withheld.

Considering the applicability of Rev. Rul. 75-191

It is not clear, but it is possible that in Rev. Rul. 75-191, Employer X was incorrectly treating workers as independent contractors rather than employees. If so, that would seem analogous to a withholding agent mistakenly treating payments to a foreign person as the return of capital rather than income, or incorrectly concluding that the Code or a tax treaty exempted the payments from withholding. Accordingly, in at least those types of circumstances, a withholding agent against whom a late-deposit penalty has been assessed may wish to consider requesting that the IRS, or if need be, a court, reconsider the applicability of Rev. Rul. 75-191 in the context of Chapter 3 withholding.

EditorNotes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Ms. Turgeon at 973-202-6615 or christine.turgeon@pwc.com.

Contributors are members of or associated with PricewaterhouseCoopers LLP.