by Paula Singer, Esq.
(Taken from A View from the Crow's Nest, Windstar's Eye on the Horizon,
Special Edition—Nov 2005)
On October 31, 2005, the IRS issued Notice 2005-76 announcing new rules for income tax withholding on wages paid to nonresident employees (technically “nonresident aliens”) for services in the United States. The rules, which are effective for wages paid on or after January 1, 2006, are designed to provide withholding on wages of nonresident employees that more closely approximates their income tax liability.
THE PRE-2006 PROBLEM
The wage withholding tables provided by the IRS are designed for U.S. citizens and foreign employees who are resident aliens for tax purposes. There are two tables, one for single status and one for married status based on married-filing-jointly tax rates. The standard deduction is built into these tables. Only nonresident employees who were residents of India when they came to the United States as a student or business apprentice are allowed to use the standard deduction, a benefit under the tax treaty with India.
Because of the special tax rules that apply to nonresidents, they are required to use restrictive Form W-4 rules. Nonresident employees must:
- Not claim exemption from withholding
- Claim single status even if married (because they cannot file using married-filing-jointly rates)
- Claim only one personal allowance (with a few exceptions)
- Add an additional withholding amount based on pay period (to compensate for the standard deduction built into the wage withholding tables)
- Students and business apprentices from India were excluded from the additional withholding amount requirement because of the tax treaty benefit.
These wage withholding requirements were intended to prevent underwithholding. However, they resulted in nonresident employees with small amounts of wages being overwithheld because the additional withholding amount applied to the first dollar. Under these rules even nonresident employees with wages less than the personal exemption amount, who had no tax liability, had to submit a tax return to obtain a refund of the overwithheld taxes.
THE IRS SOLUTION
The IRS solution to overwithholding on wages of nonresident employees involves changes to employer calculations of withholding and revised Form W-4 rules.
1. Employer Calculations of Withholding on Wages
Under the new rules, employers are required to calculate income tax withholding on wages of nonresident employees under a new procedure. Before applying the wage withholding tables, they must add to the wages of nonresident employees an amount that varies by pay period to offset the assumed standard deduction that is incorporated into the wage tables. Because of the benefit under the treaty with India allowing the standard deduction, students and businesses from India are not covered by the new procedure. For 2006, the pay period amounts are:
|Payroll Period||Add’l Amount||Payroll Period||Add'l Amount|
|Weekly||$ 51||Quarterly||$ 663|
These amounts do not affect income for Form W-2 purposes, social security or Medicare (FICA) wages or taxes, or wages for federal unemployment tax (FUTA) liabilities.
The Notice includes an example of how this procedure avoids withholding on nonresident employees whose pay is less than the personal exemption amount. The IRS issued Notice 2005-77 eliminating the tax return filing obligation of nonresidents with wages less than the personal exemption amount. Nonresidents may still file a return to obtain a refund of overwithheld taxes.
These new rules require that payroll processes be able to identify nonresident employees and calculate withholding on their wages under these new procedures. The IRS has provided a year for the transition. They will not assess liabilities for underpayment of withholding taxes plus penalties and interest on wages paid to nonresident employees prior to January 1, 2007 provided the employer has made a good faith effort to implement the new withholding requirements as soon as possible.
2. New Form W-4 Rules
When completing Form W-4 under the new rules, nonresident employees must:
- Not claim exemption from withholding
- Use single status even if married
- Claim only one allowance (with a few exceptions)
- Write “nonresident alien” or “NRA” on the dotted line on Line 6
Additional personal allowances may be claimed by residents of Canada, Mexico, or South Korea. Although not mentioned in the Notice, students and business apprentices from India may claim an allowance for an accompanying spouse and dependent children who are U.S. citizens or residents (Rev. Proc. 93-20). Nationals of American Samoa and the Northern Mariana Islands may also claim allowances for dependents.
Nonresident employees may request an additional withholding amount to make up for underwithholding pending their employer’s implementation of the new procedure. Otherwise, they may be subject to underwithholding penalties on their tax return.
The Notice instructs employers to:
- Request a Form W-4 completed under the new rules from nonresident employees hired on or after January 1, 2006
- Advise current employees who have a Form W-4 completed with the additional withholding amount under the prior rules to file a new Form W-4 to be effective for wages paid on or after January 1, 2006
A nonresident employee’s Form W-4 must be put into effect no later than the beginning of the first payroll period ending on or after the 30th day after the form is filed with the employer. Employers may elect to make the Form W-4 effective on or after the day it is furnished.
A Form W-4 completed with the additional withholding amount under the prior rules will remain valid until such time as a new Form W-4 is submitted to the employer. Nonresident employees need to be made aware that they may be subject to underwithholding penalties on their tax return if they submit the new Form W-4 before their employer implements the new procedures.
Notice 2005-76 and Notice 2005-77 are reported in IRS Bulletin 2005-46, November 14, 2005.
Paula Singer, Esq., Co-founder and Chairman of Windstar Technologies, Inc. and partner in the tax law firm, Vacovec, Mayotte & Singer, Newton, MA has over 25 years of experience providing advice and compliance services to individuals, their employers, and payors on cross-border employment matters.