On Oct. 21, 2019, the IRS’ Large Business and International (LB&I) division released a “practice unit” intended as a job aid or guidance for examiners reviewing electronic books and records and the reliability of Forms W-8. (See link) The practice unit provides insight on steps for examining compliance with Form 1042-S reporting and withholding requirements under chapter three of the Internal Revenue Code. It sets forth eight steps, summarized in the table below, that examiners will use for evaluating electronic data needed to determine the reliability of information provided in Forms W-8:
Step |
Objective |
Instructions |
Step 1 |
Evaluate Withholding Agent’s reporting using IRS Systems. |
During pre-audit, obtain and review the Withholding Agent’s data and records maintained in IRS systems. |
Step 2 |
Determine reliability of systems used by Withholding Agent. |
Understand the Withholding Agent’s system to accumulate documentation and assess the reliability of supporting documentation. |
Step 3 |
Use Information Document Requests (IDRs) to assess reliability of Withholding Agent’s systems. |
Use IDR inquiries to a Withholding Agent who maintains electronic W-8/W-9 systems to evaluate reliability. |
Step 4 |
Analyze Withholding Agent’s procedures for opening accounts. |
Develop questions to ask the Withholding Agent about the systems used to open accounts. |
Step 5 |
Assess reliability of introducing brokers’ documents. |
Review documentation and responses obtained from an introducing broker. |
Step 6 |
Assess reliability of third party repository documents. |
Review documentation and responses obtained from third party repositories. |
Step 7 |
Assess reliability of agency agreements on shared documentation systems. |
Review of agency agreements between Withholding Agent and agent maintaining a shared documentation system. |
Step 8 |
Assess reliability of Withholding Agent’s books and records. |
Review of Withholding Agent’s electronic storage and maintenance of Forms W-8. |
While the practice unit does not present many surprises conceptually, there are a few overarching themes that emerge from the discussion which should help taxpayers prepare for Form 1042-S exams going forward. Specifically, based on the guidance issued, Taxpayers should:
- Be prepared to present a reconciliation of your 1042 and 1042-S forms for the years at issue.
- All machine-sensible data used for recording, consolidating, and summarizing accounting transactions and records within a taxpayer’s Automated Data Processing (“ADP”) system is in scope and may be subject to exam, so have it ready.
- PowerPoint presentations with overviews of your business model, onboarding processes, and systems will be requested, so be prepared.
- Copies of any internal training materials, policies, and procedures that you have which describe your account opening processes will also be requested, so have them prepared.
- Be prepared to provide any W-8/W-9 or other documentation that you collect, if any, from introducing brokers and others that may not be captured in your database.
- Specific questions about your account opening systems, electronic storage, and overall compliance with Rev. Proc. 97-22 governing record retention requirements will be asked. The IRS will likely focus on systems, including repository, imaging, exporting, centralization, along with indexing functionality and may ask specific questions on these items. If possible, you should have system specifications handy and IT personnel available to assist you with documenting these items well in advance of any examination.
- If you use an electronic W-8 system, be prepared to provide a detailed description of how the system validates the consistency of each form and which fields are validated.
- Your processes for scanned W-8s uploaded from third party repositories will be highly scrutinized to determine whether you received authorization from the payee to download the W-8s.
- Consider testing your controls and self-assessing gaps in onboarding, W-8/W9 collection, and 1042 and 1042-S reporting and withholding processes well before the Service comes in.
- A sample of W-8 forms will be selected for review by the examiner. To the extent that errors or deficiencies are identified, additional samples may be selected and the resulting error rate extrapolated to the larger population of payments associated with these W-8 forms. If the error rate from that small number of forms is high, the resulting exposure for your larger population may be significant, so be prepared.
To address these points, companies should consider performing their own health checks and mock audits under exam like conditions to identify potential gaps in their policies and procedures for complying with the rules. With the Service’s announcement several months ago of new compliance campaigns focused on NRA withholding and reporting, the practice unit is a much needed step in the right direction for setting expectations with respect to these exams. We expect more guidance.
