IRS Designated Withholding Tax as Tier I Audit Issue


By Cynthia Hoffman

The IRS concerns regarding quality of overall withholding reporting and procedures for U.S. source withholding under Section 1441 has led to the elevation of this issue to “Tier I” audit issue by the Large and Mid-sized Business Division (LMSB). The IRS categorizes certain tax issues for audit based on the strategic importance of the issue by “tiers”. Tier I issues are those issues the IRS believe pose the highest risk across multiple industries, include a large number of taxpayers, have significant dollar risk and substantial compliance risk.

Although IRS examination of a Tier I issue is not required by an examiner, a taxpayer in the LMSB audit division should anticipate this issue to be raised under audit. A systematic review of withholding tax compliance procedures is recommended for all taxpayers. In many cases, companies don’t realize that withholding is required.

The withholding tax rules apply to U.S. persons (which includes individuals, corporations, and partnerships) who make payments of certain types of U.S. sourced income to non-resident aliens. Generally, the payor must withhold tax at a rate of 30% on such payments, unless an applicable treaty provision applies to allow a reduced (or zero) tax rate. These payments must be reported on 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. The person making these payments (referred to as “U.S. withholding agent”) is responsible for the withholding of tax and reporting. In order to reduce the withholding rate, the taxpayer must have documentation (Form W-9, Form W-8BEN, or other similar form) that the payee is a U.S. person or otherwise eligible for a reduced rate. Income subject to U.S. withholding tax includes income effectively connected with a U.S. trade or business (income from a US business or services performed in the US), and fixed, determinable, annual or periodic income (such as interest and dividend payments).

Special rules apply to partnerships with foreign partners with income from U.S. sources. The partnership is required to withholding (pay on behalf of the partner) tax of 35% on the partners’ allocable share of income effectively connected with a U.S. trade or business. The amount of withholding tax may be reduced for certain partner-level deductions and losses if the partner so request by certifying such deductions or losses to the partnership. The tax must be reported and paid by the partnership on a quarterly basis using Forms 8813 and Forms 8804-W. Other forms are required to be completed for the partner certification and annual reporting by the partnership.

Schneider Downs provides accounting, tax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA, and Columbus, OH.

This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.

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