Understanding U.S. Tax Implications for Non-U.S. Directors
Editor: Jeffrey N. Bilsky, CPA
Non-U.S. directors attending board meetings in the United States often find themselves navigating a complex web of tax implications. This article delves into the significant U.S. tax obligations that can arise for both these directors and the companies that employ them.
Tax Classification of Directors’ Fees
For the IRS, directors’ fees are treated as self-employment income. When paid to nonresident aliens, these fees typically face a steep 30% withholding tax at the source. Moreover, this also necessitates the filing of specific tax reporting forms. Understanding the classification and implications of these fees is crucial for both the directors themselves and their U.S.-based companies.
The Challenge of Exemptions under the Internal Revenue Code
Nonresident aliens face limited avenues to exempt U.S.-source compensation from taxation under the Internal Revenue Code (IRC). One such avenue is the de minimis exception outlined in Sec. 861(a)(3). However, the stringent conditions of this provision make it often unattainable for nonresident directors.
The De Minimis Exception of Sec. 861(a)(3)
This exception stipulates that compensation for services performed in the U.S. may not be classified as U.S.-source income—and thus not taxable—if:
- The director is present in the U.S. for fewer than 90 days within the tax year.
- Total compensation for U.S.-based services does not exceed $3,000 in aggregate.
- The compensation is derived from a nonresident alien entity, foreign partnership, or foreign corporation not engaged in U.S. trade or business.
Despite the seemingly lenient 90-day rule, many nonresident alien directors fail to meet the second condition. Directors’ fees often exceed the $3,000 cap, thus nullifying any benefit under the de minimis exception.
Legislative History of Sec. 861(a)(3)
The de minimis exception has remained unchanged since its introduction in the 1939 IRC. Since then, substantial detours through legislative amendments have failed to address the exception’s gross income limitation, leaving it stagnant despite inflation. For instance, the Economic Recovery and Tax Act of 1981 introduced indexing for many IRC provisions but excluded Sec. 861(a)(3)(B).
This historical lack of adjustment leads nonresident directors to rely heavily on tax treaties for any potential relief from U.S. tax obligations.
Income Tax Treaty Implications
While many treaties predating the 1996 U.S. Model Income Tax Treaty don’t directly address directors’ fees, the updated models do. Under these treaties, the U.S. may tax directors’ fees paid by a U.S. company, yet fees from a non-U.S. company are exempt. Moreover, even when U.S. companies pay the fees, relief may still come from existing treaties.
For example, the 1985 U.S.-Tunisia treaty states that a nonemployee director will only incur U.S. tax on fees if they spend 183 days or more in the country or have a fixed base there, or if the fees exceed $7,500. Such provisions offer a lifeline, but states may not always conform to federal guidelines, adding more layers of complexity.
Withholding and Reporting Requirements for Companies
When fees are not exempt under either the de minimis exception or a tax treaty, they face 30% withholding at the source as dictated by Sec. 1441(a). This responsibility doesn’t change regardless of whether the income is classified as effectively connected income (ECI) or fixed, determinable, annual, or periodic (FDAP) income.
U.S. companies must file Form 1042, the Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and issue Form 1042-S, which details the income and the withholding to the director. This requirement persists even when a tax treaty may absolve the director from U.S. taxation.
Foreign companies must adhere to the same withholding requirements, leading to potential challenges, especially if they lack significant ties to the U.S. The bureaucracy surrounding tax compliance can deter foreign companies from engaging, yet it’s critical they do so to avoid penalties.
Director’s Reporting Obligations
When directors’ fees are categorized as ECI, these nonresident directors must file a Form 1040-NR, the U.S. Nonresident Alien Income Tax Return—because they participated in a U.S. trade or business. Unlike FDAP income, ECI is taxed at graduated rates, and if there is over-withholding, it can be refunded upon the completion of Form 1040-NR.
Navigating this process entails acquiring a U.S. individual taxpayer identification number (ITIN), which can be complex. Even with treaty exemptions, the director must still file Form 8233 and obtain an ITIN, which does not eliminate the obligation to file the 1040-NR.
Additionally, state tax considerations require careful attention. Not all U.S. states honor federal tax treaties, which can result in additional liabilities for nonresident directors.
Overview of Current Challenges
Despite potential tax relief through treaties, nonresident alien directors are unlikely to benefit from Sec. 861(a)(3) due to its outdated framework. The gross income limitation has failed to adjust with inflation, paving the road for unnecessary complexities that plague modern-day taxpayers. This stagnation illustrates a broader issue within the tax code, which does not effectively accommodate the challenges facing contemporary boards of directors.
By understanding the intricacies of taxation and compliance, nonresident alien directors and their companies can better navigate the potentially onerous landscape of U.S. tax obligations.
