Investment Partnerships and Form 1042 Withholding Requirements: “Lag Method” Revisited
Background
Domestic funds that have foreign partners could have withholding agent obligations, which include filing Form 1042 and remitting payment to the IRS for certain types of income allocable to foreign investors. Form 1042 reports income that is fixed, determinable, annual or periodical (FDAP). The most common example is dividend income from U.S. corporations, but FDAP income also includes other types of income, such as rents, royalties and interest income from U.S. sources (subject to some important exceptions). FDAP income is subject to 30-percent withholding unless a tax treaty applies.
Most funds have been using the “lag method” of reporting, whereby they withhold in a subsequent year for undistributed income earned in the prior year. The withholding trigger for funds under the lag method is typically the issuance of Schedule K-1s. For example, if a foreign partner earned U.S.-source dividends from a domestic hedge fund during 2019, the hedge fund would withhold on that partner in 2020, when the 2019 Schedule K-1 is issued. The withholding is reported to the IRS and the partner on a 2020 Form 1042 and Form 1042-S. This creates a mismatch for the foreign partner, whereby the income (on Schedule K-1) is reported in 2019 and the credit (on Form 1042-S) is reported in 2020.
Recent IRS Guidance
The IRS attempted to resolve the mismatch through proposed regulations in December 2018. The proposed regulations would keep the same withholding timing as the lag method but would allow the credit to be taken in the earlier year. Thus, in the above example, the Form 1042 and Form 1042-S credit would be for 2019, the same year as the income reported on Schedule K-1. While this approach resolves the mismatch, there are a number of transitional questions and challenges that need to be addressed by the IRS.
The final Form 1042 instructions for 2019 allow partnerships to apply the proposed regulations, but it is optional. Partnerships can continue to follow the historical lag method for 2019.
Conclusion
Fund managers should consider the new guidance when deciding on an approach and discuss the issues with their tax advisor before going forward. There are a number of tax reporting and investor relations considerations involved in the decision.
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