What to Know About U.S. Tax Withholding for Foreign Contractors and Non-Residents

Reporting payments to employees and contractors is a standard part of doing business for all U.S. companies. If an organization only hires U.S.-based employees, things are relatively straightforward. Even reporting non-employee compensation for freelancers and contractors is easy with the right IRS forms. But what about when you hire foreign nationals and non-residents to complete work for your business?

The beauty of running a company in the digital age is that you have greater access to a global talent pool. Businesses big and small can easily hire independent contractors from anywhere in the world to complete work. Hiring foreign contractors can lead to many benefits, including lower operational costs, fresh perspectives and the chance to tap into new skills.

However, managing tax withholding, and reporting can become confusing. This guide will cover the basics of what U.S. companies must do regarding tax withholding when paying foreign contractors and non-residents, giving you some important insights into tax compliance.

A Brief Overview

More companies are looking beyond the U.S. border for talent. Foreign independent contractors often charge lower rates for services than those living stateside. It's also a great opportunity to bring new talent into a company without hiring individuals directly as employees. With gig work becoming so widespread worldwide, finding great contractors is easier than ever.

Whether you're hiring a foreign person to provide professional services remotely over the long haul or want additional workers to complete short-term projects, there are tax obligations you must fulfill. Failing to comply with tax laws, especially tax withholding, can lead to steep penalties.

Understanding U.S. Tax Withholding

The withholding of tax refers to the process of deducting funds from a contractor's compensation and sending it directly to the IRS. When you hire U.S. citizens as contractors, there's usually no obligation to withhold taxes because individuals must report self-employment income and pay personal income taxes. However, foreign independent contractors don't have that same obligation to pay personal U.S. taxes.

Depending on many factors, it might be up to you, the payer, to withhold taxes. The general withholding rate is 30 percent of the gross compensation. This amount is referred to as “Non-Resident Alien (NRA) withholding.” Thirty percent is a significant amount, and failing to withhold it when required could result in your business footing the bill plus penalties.

So, when do you have to withhold taxes? Ultimately, it all depends on the citizen status of the contractor you hire and where the work occurs. 

The easiest tax situation is hiring a foreign national who completes work outside the United States. In that case, there are no tax withholding obligations. The IRS considers where an individual performs their work to determine the source of income for tax purposes. If you hire someone from the Philippines to create graphics for your website, that foreign contractor will work remotely, completing the entire job outside the United States. Therefore, it's not U.S. source income.

Conversely, you might hire a foreign national to work in the United States. For example, you could hire someone from the Philippines to work on a graphic design project in your office stateside. While that worker is not a U.S. citizen, they completed the work in the U.S. As a result, the compensation they receive is U.S. source income. Thus, it's subject to tax withholding.

The currency of monetary compensation doesn’t matter to the IRS. What’s important is the foreign status of the freelancer and where they complete the work you hire them to do.

Different Types of Income Subject to Withholding

All forms of compensation to a foreign person are subject to tax withholding. That includes base monetary compensation (in USD or foreign currency), benefits, commissions, bonuses, rewards, and even gifts. Anything your company provides to foreign nationals as payment for goods or services related to your business is subject to withholding.

Another important thing to know is that a U.S. company may have to withhold taxes for foreign contractors regardless of the total compensation they provide. This is much different for freelance and self-employed U.S. citizens. When you hire U.S.-based contractors, you only have to report compensation above the $600 threshold. For foreign contractors, you must report and withhold taxes where applicable, no matter the amount of compensation.

Tax Treaties and Exemptions

Generally, where the work occurs is what dictates your tax withholding obligations. When the freelancer performs work within the United States, you must withhold taxes and report the compensation. However, there are several exceptions.

The United States has treaties with many countries. Businesses may qualify for different withholding rates if the foreign contractor you compensate is a resident of a country with a tax Treaty with the United States. In those cases, the reduced rate may be significantly less than the 30 percent standard. Consult with tax professionals to better understand tax treaties and their impact on your withholding obligations.

Form W-8 Series

You'll need to collect a few important IRS tax forms when you hire a foreign contractor and non-resident freelancer. The W-8 series of forms verify that the individuals you compensate aren't residents of the United States. The forms help clarify the country of residence and show that the work you hired the individual to do isn't occurring within the United States.

There are two versions of this form. The first is Form W-8BEN, which you must supply and collect when hiring foreign independent contractors. The second is Form W-8BEN-E, which is for self-employed workers who operate under a business entity.

What's unique about the W-8 series of forms is that you don't submit them to the IRS. Instead, you keep them in your files and must have separate applicable forms for every foreign national you hire. The W-8 forms are only valid for three years. Therefore, foreign contractors must fill out new ones if you continue to hire them in subsequent tax years.

Form 1042 and Reporting

When you hire foreign nationals or non-residents on a contract basis, but they complete work within the United States, you must withhold taxes and report it. That's what Form 1042 is for. 

Form 1042 reports how much income your business withholds. Meanwhile, 1042-S reports compensation payments made to foreign nationals. Both forms are required of any company that hires foreign contractors to complete work in the United States. They're due to the IRS by March 15th (the next business day if March 15th is a weekend or holiday).

Compliance and Best Practices

The best thing companies can do when hiring foreign contractors is to be vigilant about record-keeping. Businesses should have a streamlined process for verifying residency and citizenship. Contractors not working in the U.S. should receive the appropriate W-8 forms as soon as possible, and it's wise to store those forms securely for as long as possible. 

If you must withhold taxes, it's important to deposit them on time. If the amount of withheld taxes is more than $2,000 a quarter, companies must send the amount to the IRS within three business days after the end of the quarter. When the withheld tax is more than $200 but less than $2,000 per month, you must send it within 15 days of the end of the month. Anything less than that and withheld taxes are due by March 15th of the next calendar year.

Simplify Your Contractor Payouts with Dots Today

Complex tax duties shouldn't keep your business from tapping into a massive global talent pool. Foreign contractors have so much to provide companies like yours. Speak with tax professionals for guidance.

At Dots, we make fulfilling tax obligations much easier. The Dots platform streamlines how you collect information. Send relevant tax forms to foreign contractors during onboarding, verify information with the IRS directly, and store all documents in a PCI-compliant vault. Generate and file forms with the IRS through a single, easy-to-use platform.

Contact Dots today to schedule a consultation and see how we can make hiring foreign contractors a breeze.