Proposed Modifications to the “Lag Method” for Form 1042 Reporting

February 2020

Summary

In December of 2018, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued proposed regulations (REG-132881-17) that, among other items, modified the rules regarding the “lag method” of reporting. This alert discusses the traditional lag method of reporting and the modifications made by the proposed regulations. For the 2019 tax year, calendar year partnerships and trusts may elect to either remain on the lag method of reporting or apply the rules in the proposed regulations discussed below.
 

Details

1. Traditional Lag Method of Reporting
Because the extended due date for filing a Form 1042-S generally occurs before the extended due date for furnishing a Schedule K-1 to a foreign partner, a partnership may be required to report an amount subject to withholding on a Form 1042-S before it performs all the withholding required on such amount under §1.1441-5(b)(2)(i)(A) or §1.1473-1(a)(5)(ii) and (vi).
 
To address this type of situation, the instructions for Form 1042 generally require a domestic partnership that is not applying the rules in the proposed regulations to report any withholding that occurs with respect to an amount that a partnership received but did not distribute to a partner in a calendar year (preceding year) on the partnership’s Form 1042 for the following calendar year (subsequent year) (referred to as the “lag method” of reporting). In this case, the partnership would deposit the amount in the subsequent year and designate the deposit as made for that year for reporting on Form 1042. To correspond to the timing of the reporting on Form 1042, the partnership must also report this withholding on Forms 1042-S filed and issued for the subsequent year.
 
Similar reporting rules apply to domestic trusts, withholding partnerships and withholding trusts.

2. Potential Issue with the Lag Method of Reporting
When a partnership applies the lag method, it issues a Form 1042-S for the subsequent
year (and the related withholding) that generally reflects the income received by the partnership in the preceding year. However, the income is reported to the partner on Schedule K-1 for the preceding year, thus resulting in a mismatch between the income allocated to the partner and the withholding on that income. Because a partner must attach to its income tax return a Form 1042-S that it receives from a partnership to claim a credit or refund of overwithholding under §301.6402-3(e), the partner cannot support the claim with the Form 1042-S until after the year in which the partner is required to report the income shown on the Schedule K-1.

3. Proposed Regulations Method of Reporting
The proposed regulations generally require a withholding agent (including a partnership or trust) that withholds in a subsequent year to designate the deposit as attributable to the preceding year and report the amount on Forms 1042 and 1042-S for the preceding year. This proposed rule incorporates the existing rule for withholding agents (other than partnerships and trusts) from the form instructions and extends the rule to partnerships and trusts. An exception to this requirement for a partnership that is not a calendar-year partnership (a fiscal-year partnership) provides that such partnership may designate a deposit as made for the subsequent year and report the amount on Forms 1042 and 1042-S for the subsequent year. This exception allows a fiscal-year partnership flexibility to determine the year for reporting that will result in the best matching of the income and the related withholding.
 
The proposed regulations also provide a revised due date for a partnership to file and furnish Form 1042-S when it withholds the tax after March 15 of the subsequent year that it designates as deposited for the preceding year. Under this new rule, the due date for a partnership to file and furnish a Form 1042-S in such a case will be September 15 of the subsequent year. This revised due date corresponds to the due date for a partnership to file Form 1042 with an extension and the due date for a calendar-year partnership to furnish a Schedule K-1 to a partner with an extension so that the partnership has sufficient time to determine the amount of withholding due and to coordinate with the extended due date for furnishing the Schedule K-1.
 
For example, under the proposed regulations, if a partnership withholds on April 1, 2020, with respect to a foreign partner's share of undistributed income for the 2019 calendar year, the partnership designates the deposit as made for 2019 and reports the liability and tax withheld on the 2019 Form 1042 and the 2019 Form 1042-S for the partner.[1]
 

BDO Insights

Applying the reporting rules in the proposed regulations may require partnerships or trusts to report income apportioned to a foreign partner or beneficiary in an earlier year compared to partnerships or trusts applying the lag method of reporting in certain situations. Please contact an International Tax Specialist if you would like more information regarding the content of this tax alert.

 



[1] See proposed §1.1461-1 for additional details.

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