August 15th, 2012 by Angela Offerman
By now, you are all well aware of the infamous taxmageddon—the unprecedented convergence of tax events all set to hit simultaneously at the end of the year. And as expected, the potential of tax increases, across-the-board government spending cuts, and the Treasury losing its ability to borrow money is igniting anxiety everywhere. The impending upheaval could be avoided if Congress can reach an agreement before the year ends, but things are not looking good.
The main controversy bouncing back and forth between the Senate and the House is whether or not to extend the so-called “Bush tax cuts.” These cuts refer to the changes in the tax code from the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Act of 2003. Despite a few proposed bills, none are likely to reach the President’s desk as Democratic plans birthed in the Senate cannot pass the Republican-dominated House and Republican plans birthed in the House cannot pass the Democratic-dominated Senate.
No matter if the tax cuts are fully extended or just partially extended; there is one provision that definitely needs to go—the reduction in withholding rates on third party information returns. Prior to 2001, the withholding rate for all information returns was 30 percent. Then with the tax cuts, this number was reduced to 28 percent on all information returns, except Form 1042-S, putting a major flaw in the tax reporting system.
How exactly? As way of background, the United States operates on an international tax system, meaning U.S. persons are subject to U.S. taxes on their worldwide income, and foreign persons are subject to U.S. taxes on their U.S.-sourced income. In order to report income payments appropriately, the IRS uses information returns to ensure correct payment amounts are being reported by taxpayers. Forms such as 1099s and W-2s are used to identify U.S. income while 1042 forms are used to identify foreign income.
In determining U.S. or foreign status, the IRS asks individuals to identify themselves as a U.S. or foreign citizen and provide proper documentation to prove their claimed citizenship. However, if the IRS does not receive any proof—as is often the case—they will simply assume the individual has citizenship wherever he or she stated on their tax form. And, since the “Bush tax cuts” only addressed domestic withholding rates and not foreign withholding rates, foreigners have an incentive to remain undocumented and consequently be subject to lower withholding rates.
So no matter who wins, the variation in withholding rates on U.S. and foreign citizens needs to be addressed. The current system encourages individuals to take advantage of loopholes and keep information from the IRS. And, among the several issues being furiously debated in Congress, this matter is something everyone should be able to agree on.
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