Are you a withholding agent making payments of U.S. source income to non-U.S. persons? Stay informed about the IRS guidelines, key insights and what the IRS will request in the event of an examination.
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) and who will be filing Forms 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding.
Understanding the IRM:
The IRM (Internal Revenue Manual) is a collection of official internal guidelines used by the IRS to conduct audits on various U.S. tax topics. Although intended for IRS personnel in the Large Business and International unit (LB&I), U.S. withholding agents find value in these documents to assess their processes and procedures as it serves as a roadmap to the items the IRS will request while conducting Form 1042 examinations.
Key Items Requested in an Examination:
- Operational Tax Procedure Manuals: Operational procedures including those for new accounts, payments and sourcing, withholding tax functions, tax and information reporting, depositing and remitting to the IRS, reimbursement and escrow procedures, withholding certificate collection and analysis, due diligence standards, changes in circumstances, procedures for undocumented accounts, application of the presumption rules and any other manuals that have a withholding tax implication! This includes flow charts, documented policies and procedures manuals, and any training materials to aid in these processes.
- Internal Controls and Audit Reports: Documentation of internal controls that verify systems and test procedures are in place to cover any processes or functions related to chapter 3 or 4 of the IRC. This includes comparison of withholding certificates to account file/account opening documentation and validation of same and comparison of Forms 1042-S to year-end account statement information (generally a statistical sample). Internal audit reports related to account opening, withholding certificate analysis and collection, transactions, determination of source, income types, withholding and reporting.
- Summary of Systems: Account opening systems, tax reporting systems, withholding tax systems, electronic withholding certificate systems (see our article here on how Electronic Form Collection Can Reduce Withholding & Reporting Penalties), payment systems, etc. For each system, this includes design documents, flow charts, procedure manuals, and other important documentation of systems. If a Memorandum of Understanding (MOU) was entered into with the IRS for a withholding certificate validation system, the examiner may have a copy to ensure the system is being utilized in accordance with the agreement.
- Tax and Information Reporting Workpapers and Reconciliation: Form 1042-S/1042 reconciliation workpapers should document payments and withholding from the payment systems to the relevant return. Any issues or out of balance items should be explained and resolution documented.
- Tax Returns: Form 5471 and Form 5472 identify transactions that reflect payments made by U.S. persons to non-U.S. entities or affiliates, which highlight payments that may be subject to withholding tax. Form 945 (for backup withholding that may apply under the presumption rules) may need to be adjusted based on the Form 1042 audit. The examiner likely will have protected the statute of limitations for Forms 1042 and 945.
How to Implement:
The best defense for an IRS audit is to be prepared! Consult the IRM regularly, because it will
highlight areas of interest to the IRS and items that an examiner will request. As a U.S. withholding agent, you should consider the following steps to make sure you are always ready for an IRS examination:
- Review the updated IRM and communicate with key stakeholders.
- Review the items the IRS will request and confirm that your organization has current
materials/procedures/manuals so you can be responsive to any request. Update
documents as necessary.
- Review any agreements, such as a MOU, entered into with the IRS and confirm your organization is adhering to the terms.
- Make sure all reconciliation workpapers are complete and any open items or out of balance items are resolved and resolution documented.
- Consider performing a mock audit to confirm your level of compliance.
- Implement a plan to address any identified deficiencies in your processes and procedures.
By reviewing and implementing the key items requested during an examination, withholding agents can be well-prepared and compliant, minimizing potential issues during an IRS audit.
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– IRS: Part 4. Examining Process, Chapter 10. Examination of Returns, Section 21. U.S. Withholding Agent Examinations – Form 1042. https://www.irs.gov/irm/part4/irm_04-010-021