Successful companies need robust financial processes that can handle increased compliance complexities. It is imperative for businesses of all sizes to successfully comply with all U.S. tax information reporting and withholding requirements.
In the webinar, Best Practices in Accounts Payable Tax Compliance with KPMG, I provided insights on what I believe to be the most critical topics in tax compliance today—NRA (1441) withholding, the impact of COVID-19, and how to prepare for a Form 1042 audit in our current landscape.
These are my top best practices for staying compliant with present-day tax requirements.
IRC Section 1441 Compliance Initiative
Currently, the IRS has a significant interest in section 1441 chapter 3 of the Internal Revenue Code (withholding on fixed determinable, annual or periodical payments (FDAP) to non-U.S. persons.) Specific to this, the IRS is aggressively pursuing withholding agents’ compliance by:
- Drafting sections for auditing U.S. withholding agents in the Internal Revenue Manual (IRM)
- Training over 3,000 examiners
- Creating a national team in New York to assist auditors around the country with the routine implementation of these audits
- Creating 9 territory offices to deal exclusively with compliance relating to NRA withholding
Given the increased scrutiny, it’s imperative for a withholding agent to understand the current U.S. withholding and reporting rules. Here is the basic overview:
Payment to U.S. Person:
- Potential Form 1099 reporting & 24% backup withholding
- Applicable to interest, dividends, rents, royalties, and fees for services (U.S. and non-U.S. source)
- Form 1099 reporting required if payee is a U.S. nonexempt recipient
- Form 1099 data matched against a person’s U.S. income tax return
- Backup withholding is required if the payee fails to provide a TIN (tax identification number) in the manner required
Payment to Non-U.S. Person:
- Potential Form 1042-S Reporting and 30% NRA withholding
- Applicable to U.S. source payments only
- 30% gross basis withholding required (unless an exception applies under the Code or an income tax treaty)
- Form 1042-S data provided to treaty partners (information exchange)
IRS agents must now inquire about Form 1042 compliance, including reviewing any 1042 filed, determining that non-filing was proper, and ensuring that the right inquires relating to Form 1042 took place.
These new requirements have created a significant uptick in IRS examinations across the accounts payable function. These exams are easy for the IRS. If you don’t have the proper documentation in place or haven’t followed the right compliance processes, there will be significant consequences to your business.
The Impact of COVID-19 on Tax Compliance
- No extension of Form 1042-S deadlines due to COVID-19
The IRS did not provide additional COVID-19 extensions for Form 1042-S because the original deadline occurred just prior to the initial shutdowns. Because of this, COVID-19 did not have a considerable impact on withholding agents who targeted the March 15th filing deadline. However, withholding agents that utilized the 30-day extension were greatly impacted by the shutdowns due to:
- Required transitioning to a remote environment during reporting season
- Harder access to necessary data for research and reporting
- IRS assistance was generally not available or substantially slower
Many withholding agents filed for the second extension, but this extension was not guaranteed and did not apply to recipient copies.
- Updated Internal Revenue Manual (IRM)
The IRS recently updated the IRM for Form 1042 audits. The new IRM specifically highlights IRS interest in IRW issues encountered in the following industries:
- Professional Services Partnerships: Law, Accounting, Architecture, Engineering, etc.
- High Tech Industries, Computer Software & Hardware providers, medical equipment
- Intellectual Products Providers: Entertainment Industry, Publishing Industry
- Pharmaceutical Industry
- Real Estate Industry
How to Prepare for an Audit
Within the last two years, the IRS examiners have been very proactive in their audit preparation. Specifically, examiners have been reviewing taxpayer websites and details relating to their business activities. They’re asking very detailed questions about the payments that you’re making. As a result, you’re not just telling an examiner what you’re doing—they’re taking a deep dive into your contracts, statements of work, and similar documents.
The scope of review is much more extensive than previous audits:
- The IRS is diligently researching and gathering external information about your company
- The exam teams are using Form 1042-S software to analyze and breakdown the payments by codes to look for anomalies
- The IRS is reviewing contracts and SOWs to determine character and source of payment
- Current audits are covering due diligence, withholding, reporting policies & procedures, and deposits
- For non-financial entities, the IRS is reviewing Form 5471 closely
- The review of Form 1042-S not only includes gross income and withholding but also, exemption codes, inconsistent data, invalid treaty claims, etc.
- Penalties have rapidly increased, even on minor coding errors
The only way to mitigate these new risks is to prepare ahead of time—preparation now reduces liability later. Ensure that all policies and procedures are up to date and accurately reflect organizational processes. When preparing for an audit, keep these best practices in mind:
- Know where you stand
- Review documentation (as if a form is being audited)
- Review withholding rates applied
- Review deposits
- Review reporting
- Remedy past problems
- Retroactive forms for missing or invalid documentation
- Curative documentation for due diligence failures
- Amend inaccurate reporting
Now is the time to discover errors, not at the same time as your auditor. Do a business health check. Pick a sample of payments, and analyze the process from end to end—determine the character & source of the payment, review tax documentation, double-check the withholding rate & ensure reporting codes were accurate. If you find problems, be sure to quickly remediate, with retroactive tax documentation, form amendment, and, where appropriate, a voluntary disclosure.
Today, businesses must institute smart financial and cash controls by avoiding non-compliance penalties. The best way to do this is by establishing audit-proof accounts payable best practices—know where you stand before the IRS comes in.
