The IRS issued proposed regulations (REG-132881-17) on Dec. 18, 2018, to modify the Form 1042-S reporting rules for domestic partnerships. The proposed regulations change the application of what is commonly referred to as the “lag method,” generally requiring a U.S. partnership that withholds in a subsequent year to designate the deposit as attributable to the preceding year and report the amount on Forms 1042 and 1042-S for the preceding year. For the 2019 tax year, domestic partnerships may either remain on the traditional lag method of reporting or apply the new rules in the proposed regulations.
The term “lag method” refers to the procedures provided in the instructions for Form 1042 and in Treas. Reg. Sec 1.1441-5(b)(2)(i)(A) and 1.1473-1(a)(5)(ii). Under these procedures, a domestic partnership must withhold and report any required amounts with respect to an amount of U.S. source fixed, determinable, annual or periodic (FDAP) income that a partnership received but did not distribute to a partner in a calendar year (preceding year) on the partnership’s Form 1042 for the following calendar year (subsequent year).
For example, if a foreign partner earned U.S.-source dividends through a domestic partnership during 2019, the partnership would withhold in 2020, at the time the 2019 Schedule K-1 is issued. The income and related withholding are both reported to the IRS and the partner on a 2020 Form 1042 and Form 1042-S. Under these rules, withholding must occur on the earlier of three dates:
- The date the income is distributed to the foreign partner
- The date the partnership furnishes a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., to the foreign partner
- The due date (taking into account any extensions) for furnishing Schedule K-1 to the foreign partner.
While administratively practical for partnerships, issues can arise under the lag method when a foreign partner files an income tax return to report the U.S. partnership income allocated to the foreign partner and to claim a credit under Section 33 (or a refund) based on the U.S. partnership’s withholding. When a partnership applies the lag method, it issues a Form 1042-S for the subsequent year that generally reflects the income received by the U.S. partnership in the preceding year. However, the income is reported to the partner on Schedule K-1 for the preceding year, resulting in a mismatch between the income allocated to the partner and the withholding on that income. Because a foreign partner must attach to its U.S. federal income tax return a Form 1042-S that it receives from a U.S. partnership to claim a credit or refund of over-withholding, the partner cannot support the claim with the Form 1042-S until after the year in which the partner is required to report the income shown on the Schedule K-1.
The proposed regulations issued in December 2018 require a U.S. partnership that withholds in a subsequent year to designate the deposit as attributable to the preceding year and report the amount on Forms 1042 and 1042-S for the preceding year. The Proposed Regulations also provide a revised due date to file Form 1042-S when it withholds the tax after March 15 of the subsequent year that it designates as deposited for the preceding year. The due date for a U.S. partnership to file and furnish a Form 1042-S in such a case will be Sept. 15 of the subsequent year.
The preamble to the proposed regulations provided that taxpayers could not rely on the proposed regulations until Form 1042 and Form 1042-S were updated for the 2019 calendar year. Recent updates to the 2019 forms and instructions make clear that taxpayers have the option of, but not an obligation to, apply the proposed regulations to the 2019 calendar year.
Whether a taxpayer adopts the approach in the proposed regulations in 2019 or defers until a later year as may be required by future guidance, there will likely be a transition year in which a taxpayer is required to file two sets of Forms 1042-S. One would be for payments subject to withholding in the preceding year (due by March 15) and the other for payments subject to withholding in the subsequent year (due to Sept. 15). For example, if the taxpayer adopts the proposed regulations in 2019, amounts subject to withholding from 2018 will be reported on a 2019 Form 1042-S filed by March 15, 2020, and the 2019 amounts subject to withholding will also be reported on a 2019 Form 1042-S filed by Sep. 15, 2020. The taxpayer’s Form 1042 for 2019, filed in 2020, will reflect both Forms 1042-S.
The proposed regulations may benefit foreign partners who wish to file U.S. tax returns and claim a refund or credit for taxes withheld. However, transition for the 2019 tax year may come with some administrative hurdles including potential IRS penalty notices when Forms 1042 are filed between March 15 and Sept. 15. Taxpayers should consider changes to current withholding procedures and controls to ensure compliance. For these reasons, some U.S. partnerships may wish to postpone adopting the proposed regulations until a later year as may be required by future guidance.
David has over 40 years international tax experience advising clients on a global basis and is currently a senior member of Grant Thornton’s California offices.
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