Form 1042 for the 2016 tax year is the official annual withholding tax return required by the Internal Revenue Service. This filing consolidates all reporting on source income subject to U.S. income tax withholding when payments are made to foreign persons. It is a central compliance document ensuring the federal government receives accurate information about tax withheld on such payments.
Withholding agents include U.S. entities and foreign branches that handle payments to nonresident aliens, foreign corporations, foreign partnerships, foreign estates, and foreign trusts. Each agent must report amounts paid, calculate federal tax liability, and demonstrate how deposits were made throughout the preceding calendar year. Proper filing confirms both tax paid and unpaid tax still outstanding under the Internal Revenue Code.
This guide provides detailed instructions for completing Form 1042 in 2016. It explains updates to the form, requirements for different categories of income subject to withholding tax, and the role of income tax treaties. Withholding agents will also learn responsibilities specific to financial institutions, foreign intermediaries, and flow-through entities, ensuring accurate reporting, reconciliation of gross income, and compliance with Internal Revenue Service standards.
Overview of Form 1042
Form 1042 is an annual withholding tax return filed by any withholding agent making payments of U.S. source income to foreign individuals. It summarizes tax withheld, deposited, and any unpaid tax for the year.
Who Must File Form 1042
- Withholding agents: Any entity or individual required to report tax withheld or report payments to foreign payees must file the return.
- Financial institution: Banks, brokers, or a territorial financial institution with primary withholding responsibility must file Form 1042 on gross income paid to foreign individuals.
- Foreign partnerships and trusts: A withholding foreign partnership or withholding foreign trust must file to report amounts paid to a foreign partner or foreign partner’s share.
- Qualified intermediaries: A foreign intermediary or flow-through entity assuming primary withholding responsibility must file a separate form and provide a valid withholding statement.
Types of Income Subject to Reporting
- FDAP income: Fixed, determinable, annual, or periodical income of foreign persons remains the main category of source income subject to withholding tax.
- Withholdable payments: Certain income, such as dividends, interest, and notional principal contract payments, is subject to FATCA withholding rules for foreign financial institutions.
- Special categories: Eligible deferred compensation items, specified federal procurement payments, and income from real property interests are also reportable on Form 1042.
- Exempt amounts: Some income subject to a tax treaty or administrative exemption still requires reporting even if no tax liability remains.
Required Identification Information
- Employer identification number: Every withholding agent making payments must include its EIN or a special EIN for a qualified intermediary or entity.
- Status codes: A withholding agent’s chapter 3 or chapter 4 status must be reported to indicate whether liability falls under traditional rules or FATCA.
- Beneficial owner details: Reporting requires identifying each beneficial owner, foreign payee, or foreign national receiving income subject to income tax withholding.
- Supporting records: Withholding certificates, documentation of effectively connected income, and any applicable income tax treaty claims must be retained for audit purposes.
What Is New in the 2016 Annual Withholding Tax Return
The 2016 version of Form 1042 introduced several changes that affect how withholding agents calculate federal tax liability and report amounts paid to foreign persons.
Line Revisions and Additions
- Line 63c split: Adjustments for overwithholding and underwithholding were separated into two lines to clarify how such payment corrections are reported.
- Lines 65a and 65b: Reporting now distinguishes between tax paid during the calendar year and the subsequent year before the due date.
- Mandatory reconciliation: Section 2, covering reconciliation of gross income, became a required section for every withholding agent regardless of activity.
- Enhanced status codes: Foreign branches and territory financial institutions gained new codes, ensuring the correct classification of each withholding agent’s chapter.
Expanded FATCA Implementation
- Withholdable payments: Separate reporting for withholdable payments under FATCA continued to expand, ensuring the Internal Revenue Service received detailed paid income information.
- Entity classifications: New codes were required for qualified investment entities, publicly traded partnerships, and qualified derivatives dealers subject to withholding tax.
- Documentation: Withholding agents must maintain updated withholding statements and W-8 forms to support reporting on foreign entity classifications.
- System adjustments: Reporting systems required modifications to track FATCA-related income and withholding separately.
Federal Tax Liability on Form 1042
Form 1042 calculates federal tax liability by comparing amounts subject to withholding tax with tax paid or deposited during the year. Accuracy is critical to avoid penalties for unpaid tax.
Structure of Federal Tax Liability
- Quarter-monthly tracking: Liability is recorded for each quarter-monthly period, not when deposits were made, ensuring proper reflection of source income subject to tax.
- Reconciliation requirement: Gross income from all Forms 1042-S must equal the total shown on Form 1042, preventing mismatches that delay processing.
- Separate chapters: The withholding agent’s chapter 3 and chapter 4 liability must be reported separately to distinguish traditional and FATCA withholding.
- Final balance: Any unpaid tax appears as a balance due, while excess tax deposited is reported as an overpayment or credit to the next year.
Income Subject to Withholding
- Certain income: Fixed or determinable income paid to foreign persons, such as dividends and royalties, is taxable at the statutory 30 percent rate.
- Independent personal services performed: Fees for services by nonresident aliens, unless exempt under an income tax treaty, are subject to income tax withholding.
- Deferred income: Payments of eligible deferred compensation items are included in amounts subject to tax for covered expatriates.
- Other special cases: Notional principal contract payments and real property interests require careful reporting to avoid underreporting.
Gross Income Reporting
- Income code use: Each category of income paid must be matched to its correct income code.
- Report amounts paid: The return must reconcile gross income with amounts paid during the preceding calendar year for all foreign payees.
- Flow through entities: Where a foreign intermediary or non-withholding foreign partnership is involved, separate forms and statements confirm the foreign partner’s share.
- Verification: The Internal Revenue Service uses these reconciliations to confirm that the total gross income, tax withheld, and tax paid match across returns.
Completing the Form 1042
Withholding agents completing Form 1042 for 2016 must carefully follow each return section. Each step ensures that the tax withheld and tax deposited match the total liability.
Step 1: Gather Required Identification
Assemble the employer identification number, foreign intermediary documentation, and supporting withholding statements. Confirm foreign entity classifications and tax treaty claims for each beneficial owner.
Step 2: Enter Withholding Agent Information
List the legal name, address, and correct EIN. Identify whether filing as a withholding foreign partnership, foreign trust, or other entity assuming primary withholding responsibility.
Step 3: Record Federal Tax Liability
Use lines 1 through 60 to report liability in quarter-monthly periods. Do not confuse tax deposited with liability; the Internal Revenue Code requires separation.
Step 4: Reconcile Gross Income
Complete Section 2 using income code categories. Ensure gross income and amounts subject to withholding on all 1042-S forms equal the totals reported on the annual return.
Step 5: Report Tax Withheld and Paid
Summarize tax withheld at source, withheld by another withholding agent making such payment, or amounts paid using own funds. Distinguish over- and under-withholding adjustments.
Step 6: Calculate Total Tax Liability
Show Chapter 3 liability, Chapter 4 liability, specified federal procurement payments, and other amounts subject to reporting. Report the total as federal tax liability for the year.
Step 7: Report Tax Deposited
List taxes paid and taxes deposited using EFTPS. Distinguish tax paid in the preceding calendar year versus early deposits made in the subsequent year before the due date.
Step 8: Determine Balance or Overpayment
Compare total liability with amounts reported as tax paid. Report any unpaid tax as a balance due, or similarly apply an overpayment to the next year.
Filing Form 1042 with the Internal Revenue Service
Filing Form 1042 requires meeting strict deadlines and choosing between paper and electronic filing. Compliance ensures timely acceptance and reduces the risk of penalties.
Paper Filing
- Mailing address: Returns must be mailed to the designated Internal Revenue Service service center by the annual March 15 due date.
- Attachments required: Paper filers must include Form 1042-T when submitting accompanying Forms 1042-S to report amounts paid to foreign payees.
- Signatures: Every return must be signed by the withholding agent making the filing, confirming the accuracy of gross income, tax withheld, and tax liability.
- Payment enclosed: Where unpaid tax exists, payment must accompany the return unless already satisfied by deposits.
Electronic Filing
- Mandatory for volume: A financial institution or other filer with 250 or more Forms 1042-S must use the FIRE system for electronic filing.
- Advantages: Faster processing, reduced errors, and immediate confirmation that the Internal Revenue Service received data on income subject to withholding tax.
- Record keeping: Electronic filing creates an accessible record for future reconciliation with tax deposited and gross income reported.
- System compatibility: Withholding agents must ensure that their systems align with IRS electronic formatting for income codes and amounts subject to withholding.
Extension Requests
- Form 7004 filing: An extension provides more time to file the annual withholding tax return, but does not extend the time to pay federal tax liability.
- Deadlines: Requests must be filed by the original due date. Tax paid after this date accrues interest on the unpaid tax.
- Second extension: In some cases, an additional extension may be granted, but withholding agents must demonstrate that they will not willfully neglect their responsibilities.
- Practical caution: Always pay estimated liability on time, even with an extension, to avoid penalties for failure to deposit tax withheld.
Zero Activity and Dormant Year Filing
Even when no income is paid, withholding agents may still need to file Form 1042. A dormant year filing confirms that compliance obligations remain intact.
When Filing Is Still Required
- Forms 1042-S filed: Filing Form 1042 is mandatory whenever any 1042-S is issued, even if no tax liability exists for such entity.
- Treaty-exempt income: Payments covered by an income tax treaty still require reporting, even when no tax withheld is due on such payment.
- Agreement obligations: A withholding foreign partnership or foreign trust must file annually to uphold primary withholding responsibility.
- Other reporting: Specified federal procurement payments or deferred income items still require filing the annual withholding tax return.
How to File a Zero Activity Return
- Identification: Complete the EIN, address, and withholding agent information exactly as in an active year return.
- Zeros on liability lines: Enter zero for federal tax liability lines when no income subject to withholding occurred.
- Reconciliation section: Fill Section 2 with zeros unless Forms 1042-S were filed; then include report amounts paid for foreign payees.
- Payments section: Leave lines for tax paid blank if no liability exists, confirming no unpaid tax is owed.
First-Time Filer Guidance
Withholding agents completing Form 1042 for the first time must establish identification, understand filing obligations, and set up systems for deposits and reporting.
Required Setup Steps
- EIN application: Obtain an employer identification number from the Internal Revenue Service before filing.
- EFTPS enrollment: Register early with EFTPS since processing can take days. Early registration ensures timely deposits of income subject to withholding tax.
- Documentation collection: Gather W-8 forms, withholding statements, and certifications from foreign persons to validate tax treaty or administrative exemption claims.
- Internal systems: Build controls for tracking gross and deferred income, and effectively connect income across foreign entities.
Common First-Year Questions
- Service income: Independent personal services performed by nonresident aliens may be exempt under treaty rules, but still require reporting on a separate form.
- Amended returns: If errors are discovered after filing, the withholding agent must correct the 1042-S first, then amend the annual withholding tax return.
- Entity classifications: Confirm whether a financial institution, qualified investment entity, or publicly traded partnership classification applies to ensure proper income code selection.
- Extension requests: File Form 7004 if more time is needed, but pay the estimated tax liability to avoid interest on unpaid tax.
Responsibilities of the Withholding Agent
A withholding agent’s responsibilities extend beyond filing. They include proper withholding, deposits, reporting, and maintaining supporting documentation for every foreign payee.
Core Responsibilities
- Identification: Apply the correct income tax withholding rules to determine whether the recipient is a foreign individual, a foreign intermediary, or a U.S. person.
- Withholding tax: Deduct withholding tax at the statutory or reduced rate under a tax treaty before amounts paid are released.
- Depositing tax: Make deposits of tax withheld through EFTPS by the required due date for each period.
- Reporting: File accurate Forms 1042, 1042-S, and 1042-T to report amounts subject to income tax.
Liability and Risk
- Primary liability: Withholding agents assume primary withholding responsibility and remain liable for unpaid tax, even if caused by a foreign intermediary.
- Joint liability: Both a withholding agent and a foreign partner may be liable for underwithholding or reporting failures.
- Penalty exposure: Late filing, failure to deposit, or incorrect gross income reporting all trigger penalties and interest.
- Relief options: Penalties may be waived if the error results from reasonable cause and not willful neglect.
Coordination Between Form 1042 and Form 1042-S
Form 1042 must reconcile directly with all Forms 1042-S. Totals for gross income, income subject to withholding, and tax withheld must align.
Key Reconciliation Points
- Gross income: Box 2 on every 1042-S must equal the total gross income reported on Form 1042 for the preceding calendar year.
- Tax withheld: Box 7 on 1042-S showing amounts subject to withholding must be reconciled with the Form 1042 line reporting total tax withheld.
- Chapter indicator: Each 1042-S requires an income and chapter codes matching the withholding agent’s chapter reporting on Form 1042.
- Overpayment adjustments: Any tax paid using own funds or credited for overwithholding must appear consistently across both forms.
Correction Procedures
- Correct the 1042-S first: Amendments start with corrected 1042-S forms issued to the Internal Revenue Service and foreign persons.
- Amend Form 1042: Once 1042-S totals are corrected, the withholding agent files an amended annual withholding tax return showing the new liability.
- Adjust deposits: If additional tax liability is uncovered, new deposits must be made promptly to cover the unpaid tax.
- Documentation: Supporting withholding statements and income code details should be retained to verify corrections.
Chapter 3 and Chapter 4: Withholding
Form 1042 requires separate reporting for Chapter 3 withholding on fixed income and Chapter 4 FATCA withholding on withholdable payments to foreign financial institutions.
Chapter 3 Withholding
- Coverage: Applies to U.S. source income paid to nonresident aliens, foreign estates, and foreign trusts, unless reduced by an income tax treaty.
- Rate: Standard 30 percent withholding rate unless an exemption or tax treaty reduction applies to such payment.
- Documentation: Valid W-8 forms and withholding certificates confirm eligibility for exemptions or reduced rates under treaty rules.
- Responsibility: Withholding agents must report amounts paid and tax withheld in their annual withholding tax return.
Chapter 4 Withholding
- Coverage: Targets withholdable payments to noncompliant foreign financial institutions or certain foreign entities.
- Rate: Requires 30 percent withholding with no treaty relief, ensuring compliance with FATCA regulations.
- Entity categories include nonparticipating FFIs, passive NFFEs with substantial foreign owners, and certain foreign intermediary classifications.
- Precedence: Chapter 4 withholding takes precedence when Chapter 3 and Chapter 4 apply to the same income paid.
Examples of Income Paid to Foreign Persons
Different income categories determine how amounts are reported on Form 1042. Accurate reporting requires matching each category to its correct income code.
Types of Income
- Dividends: Income paid on shares of U.S. corporations to foreign persons, subject to withholding unless reduced by a treaty.
- Interest: Income subject to tax includes most U.S.-source interest unless exempt under the portfolio interest rule.
- Royalties: Payments for the use of intellectual property are taxable when paid to a foreign national or entity.
- Real property interests: Gains from U.S. real estate dispositions are reportable and taxable, unless exempt under specific provisions.
Special Income Categories
- Deferred income: Eligible deferred compensation items for expatriates are included as income subject to withholding tax on the return.
- Notional principal contracts: These payment streams are subject to specific rules and require correct income code classification.
- Independent personal services performed: Payments for work by a nonresident alien employee or contractor are taxable unless exempted by treaty.
- Administrative exemptions: Certain income categories are exempt by statute or IRS ruling, but they still require reporting on a separate form.
Case Scenarios for Withholding Agents
Different circumstances illustrate how Form 1042 applies in practice. These scenarios show how withholding agents should calculate liability, deposit tax withheld, and meet reporting obligations for foreign persons and foreign entities.
Scenario 1: Income Paid to Foreign Students
Scholarship stipends to international students may be taxable if a tax treaty does not cover them. Withholding agents must validate exemptions with W-8 forms and report all scholarship amounts on Forms 1042-S and 1042.
Scenario 2: Payments by a Financial Institution
When a financial institution pays dividends or interest to foreign persons, FATCA rules apply. If the recipient is a nonparticipating foreign financial institution, Chapter 4 withholding is required, and the amounts must reconcile with the annual withholding tax return.
Scenario 3: Withholding Foreign Partnership
A withholding foreign partnership assumes primary withholding responsibility for each foreign partner’s share. The partnership must issue accurate Forms 1042-S, deposit tax withheld through EFTPS, and ensure totals reconcile with the gross income reported on Form 1042.
Scenario 4: Deferred Income and Expatriates
Deferred income paid to expatriates, including eligible deferred compensation items, is treated as income subject to withholding. These payments must be reported with the correct income code, and withholding agents must deposit taxes according to quarterly or monthly rules.
Recordkeeping and Documentation
Accurate records are essential for proving compliance with Form 1042 obligations. Withholding agents must preserve documents that show how tax withheld, deposits, and reporting were calculated and verified.
Documentation to Retain
- Withholding certificates: Forms W-8 and W-9 establish whether a payee is a foreign or a U.S. person subject to different rules.
- Withholding statements: Foreign intermediaries and flow-through entities must provide reports allocating each foreign partner’s share of gross income and tax liability.
- Deposit confirmations: EFTPS receipts and bank confirmations prove that federal tax liability was satisfied by timely deposits.
- Supporting records: Copies of Forms 1042-S, 1042-T, income code references, and records of amounts paid must be preserved.
Retention Period
- IRS requirement: Documents must be kept for at least three years after the due date of the annual withholding tax return.
- Extended needs: Four years is often recommended for federal withholding records to cover potential Internal Revenue Service inquiries.
- Audit readiness: Records should be organized for quick access in case of questions about income paid or unpaid tax.
- Best practice: Retain all correspondence and certifications supporting income tax treaty claims to demonstrate non-willful neglect.
Frequently Asked Questions
How are overwithholding and underwithholding adjustments reported?
Form 1042 distinguishes adjustments for accuracy. Overwithholding is reported on line 63c(1), while underwithholding is reported on line 63c(2). Each adjustment must reconcile with Form 1042-S totals. Withholding agents must document refunds to beneficial owners or additional deposits made, ensuring federal tax liability, tax withheld, and tax paid are consistent across all returns.
Can Form 1042 be filed electronically?
For the 2016 tax year, Form 1042 is usually filed on paper. However, certain withholding agents were subject to mandatory electronic filing rules for Form 1042-S. Financial institutions and filers submitting 250 or more 1042-S forms had to use the FIRE system to report income codes, amounts paid, and withholding details.
What happens if deposits are made late?
Late deposits expose withholding agents to penalties and interest on unpaid tax. The Internal Revenue Service imposes penalties depending on how late the deposit is made. Payments not designated properly may also create liability. Relief from penalties may be granted if the agent proves errors resulted from reasonable cause and not willful neglect.
How does a tax treaty affect Form 1042 reporting?
A valid income tax treaty may reduce or eliminate withholding taxes on certain incomes subject to tax. Withholding agents must obtain proper documentation, such as a W-8BEN, confirming the beneficial owner’s eligibility. Even when withholding is reduced to zero, amounts paid to foreign persons must still be reported on Forms 1042 and 1042-S.
Are independent personal services performed by nonresident aliens taxable?
Independent personal services performed in the United States by nonresident aliens are taxable unless exempt under an income tax treaty. Withholding agents must request documentation proving treaty eligibility and apply the correct income code. If withholding is required, the income must be included on Form 1042-S and reconciled with the annual return.
