Why non-US directors can rarely exempt US-source compensation from US income tax

Editor: Jeffrey N. Bilsky, CPA

Non–U.S. directors who attend board meetings in the United States may discover that their temporary presence can create unexpected U.S. tax implications — both for themselves and for the company. The IRS considers directors’ fees to be self–employment income and, when paid to a nonresident alien, such fees will generally be subject to 30% withholding at the source and require the filing of tax reporting forms.

Nonresident aliens have few opportunities under the Internal Revenue Code (IRC) to exempt U.S.-source compensation from U.S. income tax. Only one provision, the de minimis exception of Sec. 861(a)(3), would generally apply to nonresident alien directors. Given this provision’s history and limitations, however, these directors will often need to rely on an income tax treaty between the United States and their home country for potential relief.

The de minimis exception of Sec. 861(a)(3)

Compensation for services performed in the United States is generally taxable for nonresident aliens. Under the de minimis exception of Sec. 861(a)(3), compensation for services performed in the United States is not U.S.-source income and therefore not taxable if:

1. The nonresident alien performing the services is present in the United States during the tax year for fewer than 90 days in the aggregate;
2. The total compensation earned for services performed in the United States does not exceed $3,000 in the aggregate; and
3. The compensation is for services performed as an employee of or under contract with:
   • A nonresident alien, foreign partnership, or foreign corporation that is not engaged in a U.S. trade or business; or
   • An individual who is a U.S. citizen or resident, a U.S. partnership, or a U.S. corporation, if such services are performed for an office or place of business maintained in a foreign country or in a U.S. possession by such individual, partnership, or corporation.

The de minimis exception has remained generally unchanged in every IRC iteration since 1939. While 90 days is a generous amount of time for a nonresident alien director to perform services in the United States as a board member, the accompanying remuneration for these services will generally exceed the modest $3,000 limitation in Sec. 861(a)(3)(B). Notwithstanding the issues with Sec. 861(a)(3)(B) discussed below, a nonresident director will generally fail the de minimis test because the payer of the director’s fees would typically be a domestic company, and the requirements of Sec. 861(a)(3)(C) would therefore not be met.

Legislative history of Sec. 861(a)(3)

Since first appearing as Sec. 119(a)(3) in the 1939 IRC, the gross income limitation under the de minimis exception has never been adjusted for inflation. Enactment of the 1954 IRC made substantive changes to the 1939 IRC, in part as a response to severe inflation during the postwar period. Congress stated that another reason for the changes was to “reduce tax barriers to future expansion of production and employment” (H.R. Rep’t No. 13337, 83d Cong., 2d Sess. 1 (1954)). But while other IRC provisions benefited from inflation adjustments, Congress made no such change to the gross income limitation in the new Sec. 861(a)(3)(B).

The Economic Recovery and Tax Act of 1981, P.L. 97–34, indexed many IRC provisions for inflation but excluded Sec. 861(a)(3)(B) from those adjustments. Congress again made comprehensive changes to the IRC in 1986 and, predictably, ignored the de minimis exception.

With the lack of adjustment to the de minimis amount, a nonresident director’s only potential relief may be through tax treaties.

Income tax treaty implications

Treaties that follow the 1977 and 1981 U.S. Model Conventions generally do not include a separate article for directors’ fees. However, with the 1996 U.S. Model Income Tax Treaty, Treasury added an article that specifically addresses directors’ fees. While this article allows the United States to tax directors’ fees paid by a U.S. company, it exempts fees paid by a non–U.S. company from U.S. tax. The 2006 U.S. Model Income Tax Convention retained this position.

Even when a U.S. company pays the fees, nonresident directors may find some relief in an in–force U.S. income tax treaty that predates the 1996 U.S. Model. For example, the 1985 U.S.-Tunisia income tax treaty provides that a nonemployee director will not be subject to U.S. tax on the director’s fees unless they are taxable under the independent personal services article — i.e., unless the nonemployee director is present in the United States for 183 days or more in the tax year, has a fixed base in the United States, or the fees exceed $7,500 (Tax Convention With Tunisia, Article 14).

However, even when a treaty supports excluding income, the U.S. state where the director performs services must also be considered, since not every state conforms to the federal treatment.

The company’s withholding and reporting requirements

Directors’ fees that are not exempt under the de minimis exception or an income tax treaty are subject to 30% withholding at the source under Sec. 1441(a). The company’s withholding and reporting requirements are unchanged by the characterization of the fees as effectively connected income (ECI) under Sec. 871(b) or as fixed, determinable, annual, or periodical (FDAP) income under Sec. 871(a)(1)(A). However, it is more likely that a director’s income will be characterized as ECI.

The company must also file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and report the income and withholding to the individual on Form 1042–S, Foreign Person’s U.S. Source Income Subject to Withholding. Even if the income is exempt under a treaty, the company must still file Forms 1042 and 1042–S. In addition, as the withholding agent, the company is responsible for reviewing, accepting, and filing Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual, received from the director.

The above withholding and reporting requirements apply whether the fees are paid by a U.S. or a non–U.S. company, as foreign employers must generally follow the same requirements as domestic employers for deposits of withholding and the timely filing of information returns. This can be problematic for a foreign company with no significant ties to the United States because the foreign company will usually need to obtain a U.S. taxpayer identification number. While foreign companies may be reluctant to participate in the complexities of the U.S. tax system, it would be prudent for them to do so, because noncompliance with respect to Forms 1042 and 1042–S is an active campaign under the IRS’s Large Business and International division’s compliance campaign program.

The director’s reporting requirements

In the typical case when fees paid to the nonresident director are treated as ECI, the director will have a Form 1040–NR, U.S. Nonresident Alien Income Tax Return, filing requirement because they have been engaged in a U.S. trade or business. Unlike FDAP income, ECI is subject to tax at graduated rates, and any overwithholding under Sec. 1441(a) will be refunded upon the filing of Form 1040–NR. This requires obtaining a U.S. individual taxpayer identification number (ITIN), which can be an onerous process. If there is any relief to be found, it may be in the general exclusion of self–employment tax for a nonresident alien.

While an income tax treaty can reduce or eliminate withholding under Sec. 1441(a), it will not completely alleviate the director’s (or the company’s) U.S. reporting requirements. When a nonresident director is eligible for a treaty exemption, Form 8233 must be filed with the payer — whether that payer is domestic or foreign. This will also require the director to obtain a U.S. ITIN and will not remove the director’s obligation to file Form 1040–NR.

The nonresident director’s U.S. state tax obligations should not be forgotten, especially when U.S. treaties are involved. Many states, including California and Connecticut, do not recognize treaties and will disregard the U.S. federal treatment of this income. This means that the director may have a U.S. state filing requirement and a potential balance due.

Closing thoughts

Although potential tax relief may be available under a treaty, nonresident alien directors are unlikely to benefit under Sec. 861(a)(3). Given the natural rate of inflation from the interwar period to the new millennium, the de minimis exception is of limited use to a modern board member whose meeting fees and retainers often exceed $50,000 in a tax year. Because of the minimal gross income limitation of Sec. 861(a)(3)(B), allocating income to just one day of meetings in the United States can cause a nonresident alien director to fail the de minimis exception, even if a non–U.S. company pays the compensation. Had Sec. 861(a)(3)(B) ever been adjusted for inflation in its almost 100–year history, the increased dollar limitation may have more readily allowed nonresident alien directors to avoid the burdensome reporting requirements discussed above.

Once a useful tool for some nonresident directors, Sec. 861(a)(3) has now become a hollow IRC provision that is insufficient to meet the needs of modern–day taxpayers.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.