Well, we’re in late May now, which means you should have submitted your original 1042-S information returns filing using the IRS’s Filing Information Returns Electronically (FIRE) portal. You might be patting yourself on the back, kicking your feet up and thinking you’re down for the year.

Well, not necessarily.

You see, some types of investment vehicles can change the classification of distributed income after the end of the US tax year (December 31^st). Two good examples of this would be US mutual funds and Real Estate Investment Trusts (otherwise known as REITs). These investment vehicles will usually advise the top of the payment chain. For example, they might say that a distribution made last year originally classified as a dividend has now been re-classified as a return of capital. This is not only annoying, but it means that some of the 1042-S forms that were created down the payment chain (and then issued to the IRS and recipients) are now wrong.

What now?

What’s The Impact of Re-Classification?

If this happens (and it does happen), then there are some steps you need to take. Because now, if you’re a QI, then your pooled reporting might not be correct any more. The gross amount won’t have changed at all, but the income code associated with the payment (and perhaps the tax rate) will have changed. For example, your original 30% pool for dividends (income code 6) may need to be reduced, and your pool for return of capital (income code 37) may need to be increased. If you didn’t have a code 37 pool to begin with, then you might get a late filing penalty for the new pool being reported now, because it wasn’t in the original filing.

If your reporting is pooled, then only the pools should be affected. If you had to issue a recipient copy, either because your client’s a financial institution or flow-through entity, or because you had indirect recipients disclosed to you by a disclosing NQI, some of those recipient copies may also now be wrong.

You may also find that some clients were invested in more than one vehicle that re-classified its income – and it’s unlikely that you’ll find out about them at the same time. If that’s the case, you might be filing more than one amendment. The top of the 1042-S (and the file specification for the IRS file) allows you to specify which number of amendments you’re filing if you’re filing more than one. It can get confusing, which is one of the reasons many firms wait and file just one set of amendments. But don’t forget that if you delay filing, your counterparty could be affected if they have clients downstream who need to know. In the example, the dividends may have been taxed at 30% or 15%, but return of capital is not taxed. So, if you’re amending a return due to this kind of re-classification, you need to remember that you may be asking for a refund from the IRS via your 1042 tax return in order to balance the books.

What if I Disclosed Clients?

If you’re a disclosing NQI, the good news is that you don’t have to worry. The act of disclosure places any reporting obligations (including amendments) onto your counterparty, which is typically a QI. They should collect and send the amendments directly to your customers, or to you to forward on if you have an arrangement in place with them.

However, if you’re a non-disclosing NQI, then you have pretty much the same obligations as a QI, but without the benefit of being able to pool your returns. This means you’ll need to spend time figuring out which specific clients received the income, submit an amended file to the IRS and issue new recipient copies. That can be an awful lot of work.

Putting that aside for a second, there is a lot of room for error here. No one’s perfect, and if a withholding agent makes a mistake and doesn’t find it until after they submitted it to the IRS, then the IRS may issue you with an amended 1042-S. If this happens, the same processes I’ve described above will apply. You’ll also have to make an amendment if you made an error, or if you’re asking a counterparty for a refund of over-withheld tax.

Can I Use Amended Reporting for Refunds?

Yes. Reclassifications can often mean that the tax rate changes. In the example quoted above, a dividend, taxable at 390% re-classified as a return of capital (non-taxable) means that anyone owning that security over the record date will have been over-withheld the previous year. The question then becomes – how do I recover that over-withheld tax?

For QIs, the IRS provides three mechanisms to refund over-withheld tax, the reimbursement procedure, the set-off procedure and the collective refund procedure. However, the first two of these will mean additional work for your counterparty and potential re-filing to the IRS. So, most withholding agents do not support these two procedures for operational and cost reasons. Instead, your counterparty will issue an amended 1042-S and refuse a refund. The amended 1042-S is the evidence that you need to implement the collective refund procedure. In this procedure, you will claim a refund from the IRS on your US tax return form 1042 which is typically filed in September if you requested an extension from the March 15th deadline. You would have to provide the amended 1042-S anyway so that your filing and your counterparty’s filing match. The difference is that you are able to claim the refund because of the change in tax between the original filing (that reported it as a dividend), and the amended return (that reports it as a return of capital). For the 2023 tax year, this would be done in boxes 67a or 67b. At box 71, you can choose either to have the refund credited to your 2024 submission (in 2025) or you can choose to get a cheque in the mail.

For NQIs, the situation is a bit different. There is no impact for a disclosing NQI, because the financial institution has disclosed and is effectively out of the loop for reporting purposes. The beneficial owner themselves would receive the amended 1042-S and, assuming they have a clue what they are doing, they could file a refund claim directly to the IRS using form 1040-NR if they are an individual, or form 1120-F if they are an entity. The process is long and difficult, so most beneficial owners never claim. If you’re a non-disclosing NQI, then you’ll have the obligation, as described, to provide amended recipient copies to your clients. As an  ND-NQI, your US-sourced FDAP income will have been taxed at 30%, so a re-class of the type described could have a significant dollar value to you. That doesn’t change the difficulty of claiming directly from the IRS, it may just change the economics of whether it’s worth your while.

What do I do With an Amended 1042-S?

A lot of people think the best answer is ‘nothing’ – unfortunately it’s not the right one. If you do nothing, then your original 1042-S submission won’t match what your counterparty reported that they paid you. That’s an instant penalty!

So when you issue recipient copies, you’ll need to make sure that you tick the box at the top that marks the 1042-S as an amendment. You’ll also need to include the UFI (Unique Form Identifier) that you used on the original 1042-S on the amendment so that the person reading it can clearly see that this isn’t a new form, but an amendment to an existing form. Without noting it as an amendment and including the original UFI, the IRS will automatically assume what you’re submitting is a new form, and you might end up with a late filing penalty.

When do I Submit an Amended 1042-S to The IRS?

The good news is that not all re-classifications happen at the same time. Typically, you’ll receive them between late March and the end of May (sometimes you can get them any time until September, but we rarely see that). The idea is that you should make an amended filing as soon as possible, but if you applied for an extension to file your US tax return form 1042, then you can wait and submit all of your amended returns at the same time that you file your 1042, by September 14^th. This is one of the most common methods, so you won’t be on your own here.

All of this speaks to something we at TConsult have been saying for a long time. Many financial institutions treat US tax reporting as something that will only take a month or two at best. But in reality, it’s a 9-month long task that starts in January with the applications for an extension of time to file, and ends in September with the submission of US tax returns. And yes, while there are months where there is nothing to do, it’s not something you can forget about in March or April. This year in particular seems to be one of the worst for receiving the recipient copies that most financial institutions rely on to complete their own returns.

Why is That Important?

Well, because the returns you file are what tells the IRS what you paid your clients. The recipient copies tell your client what you told the IRS you paid your client counterparty, and the two much match to within a rounding error margin. If not? Yep, that’s right – it’s a penalty!

So as we sit here in late May, we’re still seeing financial institutions that haven’t received recipient copies from their counterparts relating to 2023. When you overlay that delay with the amended returns cycle, it’s easy to end up in a very complicated position. If you’re struggling with amended reporting, we would be happy to help. Just contact us today here, or email [email protected].