NRA Tax Reporting

A number of companies have relationships with contractors who are not U.S. citizens. Companies may employ day-laborers to assist with varying needs. This item discusses the different classes and definitions of individuals who are subject to wage withholding, the new wage-withholding method for nonresident aliens (NRAs), the Service’s individual taxpayer identification number (ITIN) program, and the preparation of a wage-only income tax return for an NRA.

Overview

Individuals who are subject to tax in the U.S. fall into two classes: (1) citizens and resident aliens taxable under Sec. 1; and (2) NRAs taxable under Sec. 871 or 877. Businesses must identify whether a worker is a citizen, resident or NRA as part of the hiring process. In some cases, employers treat these individuals as independent contractors. Employers may be asked or required to withhold taxes (Federal, state or both) from these workers.

A resident alien is an individual who is not a citizen or national of the U.S. and meets the green-card or substantial-presence test. The green-card test is met when an individual can show that he or she has an immigrant visa (“green card”). The substantial-presence test requires that the individual be present in the U.S. for 31 days during the current year and a total of 183 days during the current and two preceding years. For this purpose, all the days of physical presence in the current year are counted, as are one-third of the days in the first preceding year, and one-sixth of the days in the second preceding year. An NRA is an individual who is not a U.S. citizen or resident alien; see IRS Pub. 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, p. 6.

U.S. citizens and resident aliens are subject to withholding in the same way. NRAs differ, because they are subject to a 30% rate, unless an exemption or treaty applies. A tax adviser can check the IRS’s website to determine if there is a treaty with a foreign country or review Pub. 515, Table 3, List of Tax Treaties. However, if an NRA is married to a U.S. citizen, withholding on compensation will be processed in the same way as for a U.S. citizen or resident alien.

Employers and other payers are required to withhold taxes on various types of income (i.e., gross income from sources within the U.S.) of NRAs pursuant to Sec. 1441. The practical problem is how to report multiple payments and pay the withholdings to the respective taxing authorities without identification numbers. An employer is re-quired to report payments subject to NRA withholding on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, and to file Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.

Computing Withholding

Pub. 515, p. 24, specifies the following procedure for calculating withholdings. For wages paid after 2005, a new procedure is used to compute Federal income tax withholding on NRA employees’ wages. An amount is added to an NRA’s wages solely to compute the income tax withholding for each payroll period; see the exhibit below. The amount to be withheld is determined by applying the income tax withholding tables to the wage amount plus the additional chart amount.

The amounts on the chart are not added to the employee’s Form W-2 and do not increase his or her income tax liability or affect Social Security, Medicare or FUTA wages. However, the procedure is not used if the 35% mandatory flat rate, or 25% flat-rate withholding, is being used to calculate income tax withholding; see IRS Pub. 15 (Circular E), Employer’s Tax Guide, p. 15.

ITIN Program

To facilitate the collection of funds from NRAs, the IRS has instituted a new identification number program. The Service developed this system to address how to provide an individual with an identification number for withholding purposes only. An ITIN does not entitle an alien to any other benefits under U.S. law. An ITIN may be obtained by an NRA or a resident alien; see Pub. 515, p. 27.

The ITIN program requires certain documentation to be provided to an acceptance agent who will help the NRA or foreign entity obtain an ITIN or employer identification number; alternatively, it can be mailed directly to the IRS. An individual must submit Form W-7, Application for IRS Individual Taxpayer Identification Number, along with documentation that proves identity and employment status. In addition to the ITIN application, a current-year tax return must be submitted.

Returns

An NRA should file Form 1040-NR, U.S. Nonresident Alien Income Tax Return, or 1040-NR-EZ, U.S. Income Tax Return for Certain Nonresident Aliens With No Dependents. A resident alien may use Form 1040. Under Sec. 873(a), an NRA is not entitled to a personal or dependency exemption in computing tax on income that is not effectively connected with a U.S. trade or business. Sec. 873(b)(3) states that in computing tax on income effectively connected with a U.S. trade or business, an NRA is entitled to only one personal exemption, unless he or she is a resident of Mexico or Canada or is a U.S. national. A resident of Mexico, Canada or a U.S. national may claim an additional personal exemption for his or her spouse, if the spouse has no gross income for U.S. tax purposes and is not a dependent of another taxpayer for the calendar year in which the NRA’s tax year begins; see IRS Pub. 519, U.S. Tax Guide for Aliens, p. 25. Residents of Mexico or Canada or U.S. nationals may claim dependency exemptions using the same rules that U.S. citizens use to determine who is a dependent; see Pub. 519, p. 25.

Conclusion

Businesses must appropriately determine the classification of employees or independent contractors when they are hired, to comply with the laws, regulations and paperwork. The individual’s status (as a resident or nonresident) will also determine how withholding is computed and, in some cases, if an ITIN is needed. Businesses also need to heed the new procedures for calculating an NRA’s withholdings, as well as the particular components of NRA withholdings (i.e., filing status, personal exemptions and ability to claim dependents).

From Sharon M. Urban, CPA, J.D., MBA, LL.M., and H. Martin Fetsch, CPA, Ellin & Tucker, Chartered, Baltimore, MD