On January 7, 2020, the IRS released an update to the 2019 Form 1042-S instructions, which provides finality into how lag method reporting will be handled for 2019 and future-year reporting.
Based on the update, it’s likely that 2019 will be the final year that lag method reporting will be a filing option for US partnerships. The following is an overview of the changes and implications for US partnerships with foreign partners.
Lag Method Overview
The lag method applies when a US partnership has earned, but not distributed, income to its foreign partners. This may occur when a partnership reports income on its foreign partner’s 2019 Schedule K-1, which wouldn’t be distributed, and associated tax wouldn’t be withheld or paid until 2020.
Under the current lag method rules, partnerships can report US-source fixed, determinable, annual, periodic (FDAP) income allocated, but not distributed, to foreign partners in the year that aligns with the withholding-tax deposit requirement—rather than the year when the partnership receives and reports income on Schedule K-1, which is typically the preceding year.
A US partnership with foreign partners must deposit withholding tax applicable to undistributed income on the earlier of the due date, or distribution date of Schedule K-1, which is during the year after the income is received by the partnership.
As a result, income and associated withholding on a partner’s Schedule K-1 often doesn’t align with Form 1042-S reporting, which historically created issues for partners requesting a refund of, or a local credit for, tax withheld.
Updated Filing Procedures for US Partnerships
Consistent with the draft Form 1042 instructions, the Form 1042-S supplemental instructions indicate that lag method reporting will still be allowed in 2019.
This means that, for purposes of 2019 1042-S reporting and withholding, a partnership or trust will be allowed to withhold in a subsequent year with respect to a foreign partner’s share of income for the preceding year. However, this option will become obsolete in 2020. The 2019 forms allow filers to move away from the lag method prior to 2020 reporting.
The supplemental 2019 Form 1042-S instructions clarify how reporting should be handled when the withholding occurs in a year that’s subsequent to the year in which the income was earned, but not distributed. The 2019 Form 1042-S introduces a new box, 7c, which will notify the IRS if there’s a disparity between the year when income is earned and the year of withholding.
To accommodate for the common situation wherein a partnership or trust doesn’t know the character of the income by the Form 1042-S filing deadline, the IRS has extended the Form 1042-S filing date to September 15, 2020, which aligns with the extended filing deadline for Schedule K-1 reporting.
If a partnership distributes and withholds on a foreign partner’s share of income earned in 2019—reportable on the 2019 Schedule K-1—on May 1, 2020, the partnership may deposit that tax into the 2019 Form 1042 account, and report the liability and tax withheld on the 2019 Form 1042-S and 1042.
The partnership would select Box 7c of the Form 1042-S to notify the IRS that it’s electing this filing and deposit procedure to avoid a late filing notice and corresponding penalties. This extended deadline of September 15, 2020, also applies if no withholding was required on the undistributed income attributable to a foreign partner.
IRS Notices for Late Filing
The supplemental instructions provide detailed information about how partnerships and trusts should respond if they incorrectly receive penalty notices for late filing Forms 1042-S after March 15, 2020, but before September 15, 2020. It’s reasonable to expect that IRS systems haven’t yet been adjusted to accommodate this change, and late filing notices—and associated penalties—will be common occurrences in 2020.
Impact on Filers
The 2019 Form 1042-S filing season will present additional challenges for US partnerships with foreign partners. If partnerships are planning to move off the lag method in 2019, it’s likely that 2019 Form 1042-S reporting will include previously lagged 2018 income, and real-time 2019 income. However, the extended deadline should provide additional opportunities for planning and finalizing reporting data.
We’re Here to Help
For more information on how this update could affect you and your business, or for help preparing to complete Form 1042 or 1042-S, contact your Moss Adams professional or email firstname.lastname@example.org.