If you’re new to the payroll industry or have recently started working with a company that has employees who are not U.S. citizens, it is important to know that there are a number of things you have to remember in regards to income tax withholdings. The first thing you’ll want to do is identify all noncitizens on your company's payroll and divide those people into residents and nonresidents. You can find instructions on how to do this by using the Internal Revenue Code Section 7701(b) or by a tax treaty.
For those noncitizens that are residents, you can withhold income tax the same way you do for U.S. citizen employees. (Not sure how to do this? Check out our blog Calculating Michigan Payroll Tax in 2018.) Nonresident, noncitizens, on the other hand, take a few more steps to withhold taxes. These withholding rules are described in IRS Publication 15 (Circular E) and Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities, found here. However, I find those IRS documents incredibly dry and difficult to understand, so I’m going to simplify the process below so you can get an idea about what you have to do without sifting through pages and pages of tax jargon.
Nonresidents may not mark “exempt” on line 7 when filling out their Form W-4. Additionally, regardless of whether or not he or she is married, they are only allowed to claim “single” filing status on line 3. Except in very few cases, nonresidents may not claim more than one personal exemption. There are three exceptions to this rule:
Residents of Canada, Mexico, or U.S. Nationals may claim additional exemptions if their spouse has no gross income or is not the dependent of another U.S. taxpayer or if his or her dependents otherwise qualify as dependents under the normal rules in Publication 17, Chapter 3.
Residents of the Republic of Korea may claim additional exemptions for a spouse and children if they meet the same 3 conditions shown above, if the spouse and all children claimed have lived with the taxpayer at some time during the tax year, if the additional deductions for the spouse and children are prorated based on the ratio of the person's U.S. income effectively connected with a U.S. trade or business to the person's worldwide income from all sources, and if the additional deductions for the spouse and children are limited to the extent of the person's taxable income.
Residents of India who are students and business apprentices may claim exemptions if the spouse had no income and cannot be claimed by another taxpayer or if the children meet ALL dependency tests, including the citizenship/residency test. That is, the nonresident noncitizen Indian Student cannot claim a dependency exemption for his child unless the child is a U.S. citizen or a resident noncitizen.
Keep in mind, nonresidents that fail to properly fill out their Form W-4 will have their federal income taxes withheld at a rate pertaining to single status with zero exemptions.
Income Tax Reporting
It’s your responsibility to report all wages paid out to the nonresident, noncitizens that are exempt under a tax treaty on Form 1042 and Form 1042-S. The main difference between the two forms is that Form 1042-S is concerned with payments made to the nonresident, while Form 1042 is concerned with determining how much income will be withheld for tax withholding purposes. Additional wages paid to the employee over and above the exempt amount then has to be reported on Form W-2 as usual. In some situations, if all of the nonresident’s wages are exempt from federal income tax, you will still have to file the Form W-2 in order to report the state and local wages.
As usual, the rules and guidelines for income tax withholdings are ever-changing. You can get a full update on what has changed in 2018 here. Is income tax reporting taking up too much time and energy for you? By using a Payroll Software as a Service company like Dominion, not only is it easier than ever to process payroll, they ensure all your federal, state, and local taxes are taken care of for you. Learn more here or request a demo below.