2019 Draft Instructions for Form 1042 Provide Insight into Lag Method Update

On September 9, 2019, the IRS released the 2019 draft instructions for Form 1042, which provide insight into several updates that will impact reporting on the form. The instructions also contain important information on the changes to what is commonly known as lag method reporting in 2019 for US partnerships with foreign partners.

As the IRS increases scrutiny over how forms are filed, it’s important to follow instructions carefully to avoid penalty. An overview of updates to the draft instructions follows. 

Lag Method Overview

The lag method applies when a US partnership has earned, but not distributed, income to its foreign partners. Under the current lag method rules, partnerships can report US source fixed, determinable, annual, periodic (FDAP) income allocated, but not distributed, to foreign partners in the year that aligns with the withholding tax deposit requirement rather than the year the partnership receives and reports income on Schedule K-1—typically the preceding year.

A US partnership with foreign partners must deposit withholding applicable to undistributed income the earlier of the due date, or distribution date of Schedule K-1, in the year after the income is received by the partnership.

As such, income and associated withholding on a partner’s Schedule K-1 often won’t align with the Form 1042-S reporting, which historically created issues for partners requesting a refund of, or a local credit for, tax withheld.

New Approach for US Partnerships

The 2019 draft instructions clarify a filers’ requirement to comply with proposed regulations issued in December of 2018 that eliminate lag method reporting for US partnerships that have foreign partners.

In early 2019, last-minute instructions were issued for Form 1042 that allowed partnerships to rely on the 2018 draft regulations in issuing their 2018 Form 1042. The 2019 instructions were expected to require partnerships to comply with the elimination of the lag method, but the draft maintains that lag method reporting will be optional for US partnerships with foreign partners that allocate undistributed US source income for 2019.

Additionally, the draft instructions reveal the approach that the IRS is taking with regards to Form 1042-S reporting once the lag method is eliminated. According to the draft 2019 instructions, Form 1042-S reporting will be extended for US partnerships electing to forego the lag method for 2019 to September 15. This date will align with the extended deadline for the Schedule K-1 reporting.

Additional Updates

Rounded Figures

The 2019 draft instructions include a requirement to round numbers on the form to full dollar amounts. In the past, numbers reported on Form 1042-S were required to be rounded, and numbers on the Form 1042 were allowed, but not required, to be rounded.

This often led to rounding differences and reconciliation issues. Reconciliation may still be an issue in the future because payments made to foreign persons and corresponding withholding amounts deposited aren’t rounded. Numbers reported on the Form 1042-S and 1042, however, should be aligned moving forward.

Schedule Update

There will be a new schedule required for Qualified Derivatives Dealers (QDDs) to document their tax liabilities, even if the QDD has a zero tax liability. This schedule will replace a previous requirement to attach a free-form statement to the Form 1042.

Chapter 3 and 4 Classifications

Another issue that’s become more important this year is the requirement for filers to include their own Chapter 3 and Chapter 4 classifications on the form. These will likely be used to determine if the filer is a partnership that qualifies for an extension to file Form 1042-S based on the updated partnership reporting deadline. These fields are often neglected when submitted, so it’s important to pay attention to the classifications when completing your form.  

Impact on Filers

IRS scrutiny on Forms 1042 has increased in recent months with the announcement of Campaign 817. The campaign aims to review 2017 Forms 1042 filed, or neglected to be filed, and increases attention to a more thorough review of Form 1042 filings.

With this new scrutiny, it’s more important than ever to ensure your organization correctly reports payments made to foreign persons, and that the instructions to the Form 1042 are followed closely.

We’re Here to Help

For more information on how this update could affect you and your business, or for help preparing to complete Form 1042, contact your Moss Adams professional or email jill.dymtrow@mossadams.com or erin.fennimore@mossadams.com.

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