More than a year ago, the IRS released a set of proposed regulations with the intent of reducing the burden associated with Chapter 3 and the Foreign Account Tax Compliance Act (FATCA, otherwise known as Chapter 4). This 50-page document alleviated the Chapter 4 reporting and withholding requirements for certain foreign financial institutions doing business with U.S. taxpayers, but this wasn’t the only pro-taxpayer change made by the IRS. The proposed regulations also summarized the operational challenges U.S. partnerships encounter withholding and reporting in a subsequent year under Chapter 3, i.e. pursuant to the “lag method.” More specifically, the proposed regulations outlined the difficulty created by Schedules K-1 and Forms 1042-S having different filing deadlines and provide hope for the elimination of the mismatch.
What is the Lag Method?
Under current U.S. tax laws, partnerships are generally required to:
- File IRS Form 1065, U.S. Return of Partnership Income, inclusive of a Schedule K-1 to each partner detailing their share of income, deductions, credits, etc.;
- File IRS Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, inclusive of Forms 1042-S to each non-U.S. (i.e. “foreign”) partner, detailing their share of certain types of U.S. source income (USSI), specifically, “fixed, determinable, annual or periodic income (FDAP)” and its respective withholding tax; and
- Satisfy their withholding tax requirement by holding the tax back from distributions to foreign partners that include an amount subject to withholding.
The lag method historically helped accommodate a timing issue. Partnerships oftentimes may be unable to determine their reportable FDAP income allocable — and therefore the withholding tax associated with it — until the calendar year after the tax year in which the income was earned (if the income was not distributed in that earlier tax year). Furthermore, partnerships in a fund of funds structure may encounter difficulty tracing when the FDAP income was distributed. To address this, regulations stipulate that U.S. partnerships should calculate and remit their withholding tax on the earlier of the date:
The income is distributed;
The partnership provides the Schedule K-1 to the foreign partner; or
The partnership’s extended due date for issuing Schedule K-1 (9/15).
This creates a “lag” in reporting if the income is not distributed in the tax year it was earned. Take the following examples:
U.S. partnership receives FDAP income in 2019 but does not distribute it
March 15, 2020
(+ 6 months if extended)
U.S. partnership issues Schedules K-1 to report 2019 FDAP income to partners which triggers the payment of withholding tax to the IRS on behalf of its foreign partners
March 15, 2021
(+ 30 to 60 days if extended)
U.S. partnership files 2020 Form 1042-S to report 2020 withholding tax remittance that occurred in 2020 relating to “lagged” 2019 income
Enter the first issue the IRS is attempting to address with the proposed regulations: the deadlines for providing Schedules K-1 and Forms 1042-S do not fall in the same reporting year if the income reportable on Forms 1042-S is not distributed to the partners in the tax year the income is earned and thus reported on Schedule K-1. The filing deadline for Schedule K-1 is 2.5 months following the close of the tax year with an option to extend the due date an additional six months.
Tax for foreign partners must be withheld by this due date or when the Schedule K-1s are provided to the partner — whichever occurs first — in the year following the tax year. Once the tax is withheld, partnerships have 2.5 months following the close of the year to file Forms 1042-S with, at most, a 60-day extension.
The lag method was adopted to prevent taxpayers from reporting withholding that had not yet been distributed or withheld, but this solution also created the second issue the proposed regulations attempt to tackle. When foreign partners seek to claim a refund, they must wait almost a full calendar year for their Form 1042-S. Without the Form 1042-S, foreign partners cannot support their claims for credit or refund of any over-withheld tax.
How Do the Proposed Regulations Affect the Lag Method?
The lag method will continue to exist insofar as the withholding tax remittances are concerned. The proposed changes endeavor to align the reporting year, i.e. match Schedule K-1 income with Form 1042-S income. Here’s how the proposed regulations alter the example above:
Partnership receives FDAP income in 2019 but does not distribute it
March 15, 2020
(+ 6 months* if extended)
Partnership issues Schedules K-1 to report 2019 FDAP income to partners which triggers the payment of withholding tax to the IRS on behalf of its foreign partners
Partnership files 2019 Forms 1042-S* to report 2020 withholding tax remittance that occurred in 2020 relating to “lagged” 2019 income
* The proposed regulations align the partnerships’ 1065 and 1042-S extension period. Note: F-1042, the summary return of all Forms 1042-S for the tax year, already follows 1065 extension timeline, further complicating filings.
Fiscal year partnerships have a bit more flexibility. Rather than assigning all tax withholdings to the prior year, they are permitted to assign only a portion to the prior period and can delay the remainder to the subsequent year. This partial lag will give fiscal year partnerships the flexibility they need to better match withholdings to their associated income.
Reliance on Proposed Regulations
The proposed regulations explicitly state taxpayers may not rely on them for the revisions pertaining to credits and refunds of withheld tax until such time as the 2019 Form 1042 and 1042-S are updated.
As of the time of this publication, 2019 Form 1042-S Instructions were final, though instructions to Form 1042 were not. Instructions to Form 1042-S were supplemented by a January 2020 IRS update, which encouraged withholding agents to rely on the regulations as proposed; however, in practice this may be premature.
There are still a number of uncertainties left by the proposed regulations and currently available form instructions. One such uncertainty is the insufficient instruction guidance for the accelerated reporting of lag method income. Additionally, it is unclear how lag method filers can request to extend the due date for Forms 1042-S beyond the current 30-60 day window. Currently, U.S. partnerships file Form 8809 to request an additional 30-day extension beyond the original March 15 due date. It appears that filing this form would not provide the maximum 6-month extension a lag method filer may seek. It is further not clear if Form 7004 — which is used to extend the due date for Form 1042 — would also cover Forms 1042-S. Therefore, lag method filers relying on the proposed regulations for the 2019 filing season may be inundated with automatically generated notices from the IRS. An IRS update advises how to respond to penalty notices if extended deadline is leveraged under the proposed regulations, yet the administrative burden to potentially having to respond to a large number of notices may be too much to risk for many tax departments of private equity and venture capital firms.
For these reasons, many lag method filers may wish to hold off on implementing the provisions for the proposed regulations for the 2019 reporting season and prefer to wait until final regulations and more detailed IRS guidance is available.
If you have any questions about this rule change, please contact us.
Published on February 21, 2020