A View from the Crow's Nest

Foreign workers who are nonresident aliens are subject to income tax on ECI under special rules because they do not pay U.S. income taxes on their worldwide income. Their ECI is taxed after limited deductions at either single or married-filing-separately rates. Nonresident aliens cannot claim the standard deduction, except for students and business apprentices from India, and, with few exceptions, can claim only one personal exemption.

The federal wage withholding rules for nonresident employees mirror the tax return limitations for these taxpayers:

The “Phantom Gross-up”
Because the wage-withholding tables provided by the IRS are designed for U.S. citizen (and resident alien) employees, the tables cause underwithholding for employees who are not eligible for the standard deduction which is built into the tables. To solve this problem, the IRS introduced a special gross-up procedure for payroll processing effective January 1, 2006, announced in IRS Notice 2005-76 (Oct. 2005). These changes were designed to provide withholding on wages of nonresident employees that more closely approximated their actual income tax liability. The pre-2006 procedure was to take an additional fixed withholding amount from each paycheck depending on the employee’s pay period. This withholding procedure resulted in significant overwithholding for employees with low wages such as students and employees with few U.S. work days such as nonresident flight crews as well as numerous tax returns filings merely to obtain a refund of the overwithheld taxes.

The new protocol eliminated the existing pattern of withholding an additional amount, and instead implemented a “phantom gross-up” that required employers to add to the wages of nonresident employees an amount that varied by pay period to offset the assumed standard deduction that was incorporated into the wage withholding tables. The wage withholding tables were then applied to the inflated wages for withholding purposes; however, the additional “phantom” amount did not affect income for Form W-2 purposes, social security or Medicare (FICA) wages or taxes, or wages for federal unemployment tax (FUTA) liabilities. Individuals who were tax residents of India at the time they entered the U.S. for the purpose of education or training were exempt from this procedure because they were (and still are) eligible for the standard deduction. This was not a problem at the time because the standard deduction was the only consideration driving the “phantom gross-up” process.

The Making Work Pay Adjustments
With the passage of the American Recovery and Reinvestment Act of 2009 (ARRA), which included the $400 Making Work Pay Credit (MWPC), the IRS updated the wage-withholding tables for the general population and published them in IRS Publication 15-T in March 2009. These tables were designed to reduce withholding for many employees immediately, in anticipation of their claims for the Credit on their tax returns, and were required to be implemented no later than April 1, 2009. However, because nonresident aliens were specifically excluded from eligibility for the MWPC, it became necessary for the “phantom gross-up” amount already in place to be increased so that this population was not underwithheld. Again, students and trainees from India were exempted from the procedure, which was now an issue because they, like all other nonresident aliens, were not eligible for the MWPC.

In November 2009, the IRS issued Notice 2009-91, modifying the rules in Notice 2005-76, to take effect with wages paid on or after January 1, 2010. This notice announced that employers would need to make two modifications in withholding from the wages of nonresident aliens, not just one as was previously the case, because there were now two issues in play that needed to be accommodated: the standard deduction and the MWPC. (The general assumption was that this two-step process was not implemented in March 2009 because of the speed with which ARRA was passed and the need to get something in place quickly to accommodate it for withholding purposes.)

Notice 2009-91 was followed quickly by a revision of Notice 1036 setting forth the new rules for 2010. It included the 2010 withholding tables and a table for calculating adjustments for nonresident aliens to make up for the fact that they were not eligible for the MWPC. The new Notice 1036 reduced the “phantom gross-up” amount to be applied to the wages of nonresident aliens for 2010 (the amounts for 2009 were based on the full year’s worth of the MWPC being accommodated for over only 9 or 10 months of payments) and explains in detail the multi-step process that needed to be followed to account for the standard deduction and MWPC issues.

The new process involves four separate steps:

Adding the appropriate new phantom gross-up amount to gross wages;
Using the result from Step 1 and the number of withholding allowances on the employee’s W-4 to figure a base withholding amount on the new
withholding tables;
Subtracting the value of withholding allowances from the result of Step 1 and figuring an amount from an NRA-specific adjustment table; and
Adding the amounts from Steps 2 and 3 to determine the total withholding due per pay period.

The following example illustrates the application of these steps by an employer using the percentage method tables to the bi-weekly compensation of $754.80 paid to a single nonresident alien employee, claiming one withholding allowance:

$754.80 plus $78.85 = $833.65
$833.65 less $140.38 bi-weekly withholding allowance = $693.27. Base withholding is $16.80 plus $43.84 (15% of excess over $401), or $60.64
Corresponding additional withholding from the NRA adjustment chart is $15.40
$60.64 (Step 2) plus $15.40 (Step 3) = $76.04 withholding

The India Student/Trainee Problem

Since Notice 1036 mentioned at the beginning of the four steps that “Nonresident alien students from India and business apprentices from India are subject to special rules” and referred readers to IRS Publication Circular E for more details, the appropriate process would be to exempt these employees only from Step 1, involving the standard deduction, and only subject them to the remaining steps relating to the inability of all nonresident aliens to claim the MWPC.

Unfortunately, when IRS issued Publication 15 in mid-December 2009, the tip saying “Nonresident alien students from India and business apprentices from India are not subject to this procedure” appears at the end of all four steps, not at the end of Step 1 where it logically should have appeared. This resulted in payroll software providers not making any special provisions for Indian students and business apprentices in their phantom gross-up programming, even in cases where the inconsistency was explained to and understood by them. They simply were not willing to program something that was contrary to the letter of the IRS publication, even though it was clearly inaccurate in light of the provisions of the treaty with India.⁸

Summary
The U.S. tax and wage-withholding rules are different for non-U.S. citizens who are nonresident aliens. Since they were first issued for 2006, the IRS procedures describing how payroll systems should compute the “phantom gross-up” for wage-withholding table purposes have been modified and refined several times because of the Making Work Pay Credit. Employers using systems that do not handle this processing need to alert their nonresident alien employees to their potential underwithholding so they may act accordingly. Even if an employer’s payroll system handles the “phantom gross-up,” employees who are students and business apprentices from India may be underwithheld under the current system processes because the special rules for these nonresident alien employees have not been correctly incorporated into most payroll systems.

¹ The rules for determining federal tax residency status of non-U.S. citizens are described in IRS Publication 519, U.S. Tax Guide for Aliens.
² See Article 21 of the tax treaty with India and Rev. Proc. 93-20, 1993-1 C.B. 528.
³ IRS Notice 2005-76, IRB 2005-46. Although it’s not mentioned in Notice 2005-76, U.S. nationals may claim additional personal exemptions.
⁴ See IRS Notice 2009-1392, Supplemental Form W-4 Instructions for Nonresident Aliens (Dec. 2009).
⁵ See article 4(7) of the treaty with South Korea.
⁶ To comply with these rules, self-service payroll processes must prevent nonresident employees from using the W-4 rules for U.S. citizens and residents.
⁷ IRC section 6013 (g) and (h) does not specify that a nonresident alien who elects to file a joint return under IRS section 6013 (g) or (h) shall be treated as a resident alien for the purposes of chapter 21 of the code (FICA taxes).
⁸ NRA experts within IRS unofficially acknowledged the error in the placement of the tip when it was brought to their attention, but to date the placement of the tip has not been corrected.

©Copyright 2010 by Windstar Technologies, Inc. Windstar reserves all rights to this electronic material. Information contained in this publication is based on the best information available at the time of publication. While believing the information in this publication to be accurate, Windstar accepts no legal responsibility for its accuracy.

Since 1995 educational institutions, hospitals, research institutions, and corporations have relied on Windstar Technologies, Inc. to deliver the expertise to comply with the U.S. tax residency rules, tax rates, and special tax exemption rules under the law and U.S. treaties. When government agencies require information about foreign nationals in the workplace, Windstar provides straightforward analysis and reporting. Comprehensive software for analysis and reporting, expert knowledge, and unparalleled customer service combine to make Windstar the first choice for nonresident alien tax compliance.