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Form 1042 and 1042-S Season - Post-Mortem

Contributed by Comply Exchange
March 26, 2019

Who is Impacted

Any withholding agent, making payments of U.S. source fixed, determinable annual, or periodical (FDAP) income to non-U.S. persons or nonresident aliens (NRA) will be interested in a quick post mortem exercise that is loosely based on the February 2019, IRS Ten most common errors for completing the Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding and the IRS Internal Revenue Manual section dealing with U.S. Withholding Agent Audits.

What Changed

As withholding agents wrap up their Forms 1042 and 1042-S reporting seasons, it makes sense to take a look back on the process. Undertake a review of the workpapers for these forms and for completeness. Identify processes that worked and those that did not work. Identify issues that arose this year and confirm that they are documented in your workpapers. Is there anything that can be done to alleviate those issues for next year?

The IRS continues to publish a list each year to enhance the processing of Chapter Three Withholding Program information returns. Many find this helpful and use the list as a way to spot check their own efforts. While some organizations try to use this list prior to filing, the list is published in February after many processes are fixed. In each scenario, you should ask yourself, what controls do I have in place to monitor for these issues and does my reporting application or software highlight these issues for me?

Some of the more common errors noted by the IRS include the following:

Income Code. Required field! This field must be complete and include an accurate income code that reflects the type of income paid. If this field presented issues, did you identify if the issue is systemic or a one off. Did you document your resolution and cure for going forward?

Tax Rate. Required field! This field must be complete and include the correct rate of withholding that applies to the income reported in the Gross Income or Net Income field. The format of the rate should be two digits, a decimal, followed by two digits. If you found rates that were not valid, did you track down the source? For example, was the rate blended from multiple transactions, was a rate table incorrect, etc.

U.S. Federal Tax Withheld. Be sure that this value is consistent with a valid tax rate. The IRS has noted a number of miscalculations that result in incorrect withholding rates. Be sure to calculate correctly! Did you have any withholding discrepancies or areas of underwithheld or overwithheld tax?

Recipient Code 20 (Unknown Recipient). The IRS will cross reference Recipient Code 20 with Recipient Name and Address fields. They assume that these fields will be blank, because you have chosen Recipient Code 20. Further, they expect that you applied the maximum rate of withholding to any payment made to an Unknown Recipient. If you are using this code there are a number of questions you should be asking. Why do I have an Unknown Recipient? Did this person not provide any tax documentation? Do I need to go back and request documentation? What information do I have on file? Am I able to rely on the presumption rules? Having an Unknown Recipient is something you may want to explore and rectify before next season.

Recipient Name does not match Recipient Code. In the IRS example, they would not expect the name of a pension plan in the Recipient Name field to have the Recipient Code of an Individual. If this is happening, do you need to review your data sources? One of the main issues with reporting is the quality of data that maps into the reporting application. If the quality of the data mapped into the system is not reliable or consistent, the quality of the reporting will be equally unreliable.

Source system information must be correct in order for the Form information to be correct. Many source systems contain stale or inconsistent information, which impacts reporting on Forms 1042-S and 1042. If you noted any issues, it may make sense to take a look at all of your source data for those issues and correct or normalize the data. Here are a few items to keep in mind:

  • If using the Effectively Connected Income Exception Code (01), be sure you have a taxpayer identification number on file that reflects on a Form W-8ECI, also on file. Otherwise, 30 percent withholding applies without exemption.
  • If using a Qualified Intermediary Employer Identification Numbers (QI-EINs), the Recipient Code must be 12 for Qualified Intermediary.
  • Recipient's Country of Residence for Tax Purposes field must be the same as the Recipient's Country Code. Generally, the country of tax residence is the same as the recipient's address country. If using 'OC' or 'UC' you should expect an error or notification and, more importantly, you should never apply a reduced rate of withholding.

Round all amounts to the nearest dollar! Many often forget this simple rule, but it may cause other error related issues! Be sure to double check that your reporting application is not deleting the decimal point, such that it appears you are reporting 100 times the income you mean to report.

Form 1042 Section 2, Reconciliation of Payments of U.S. Source FDAP Income. Required to be complete! It has been a few years since the IRS required Section 2, but it is worth reminding to double check that this section is complete. It will without a doubt generate an IRS Notice sooner than you would like!

How to Implement

Each year following a Form 1042 reporting season, we recommend that organizations take a look back at their processes, almost as a post mortem. It is important to review your workpapers for completeness and identification of year end issues and how you determined resolution. It is equally important to ask your team and vendors what worked, what did not work, and how you can make the next reporting season even more successful. As always, we offer a few items for you to explore:

  • If any issues were noted or rectified during the season, be sure to document the steps taken and identify whether any systems, process manuals or staff training should be updated.
  • Make sure workpapers are complete and all issues are managed. Remember that the IRS may request these workpapers as part of an audit.
  • Have a yearend review discussion with your software vendors to ensure any issues are being addressed.

What challenges did you face during this Form 1042 and 1042-S reporting season? Was there anything new that has not been an issue in prior years? Let us know what you think in the comment section on LinkedIn or e-mail us!


Tags: United States | tax | accounting



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