Taxation Guidance on Fellowship Payments to Nonresident Aliens

Purpose

This document describes the Internal Revenue Service (IRS) taxation rules, requirements, and Research Foundation responsibilities associated with fellowship payments to nonresident aliens for tax purposes.

Note: This procedure addresses income tax rules only. Social Security and Medicare taxation is not applicable for fellowship payments. Social Security and Medicare taxes are only applicable for employee payments. For more information on Social Security and Medicare taxation, refer to "Social Security and Medicare Taxation."

Residency for Tax Purposes

The residency status of nonresident aliens refers to residency for tax purposes. For more information, see "Classifying Aliens as Resident or Nonresident Alien for Tax Purposes."

Fellowship Definition

Fellowships are non-wage payments in support of the recipient's academic study or fellow-initiated research and in recognition of the recipient's promise as a research or teaching scholar. Fellowship awards administered by the RF on behalf of SUNY are for scholarly study or research by faculty members, postdoctoral scholars, and undergraduate and graduate students at a SUNY campus or at other locations in conjunction with SUNY academic programs.

Assisting Fellowship Recipients

Operating locations should, if necessary, assist nonresident aliens in the preparation of any necessary forms. However, operating location staff must not offer tax advice.

Taxation Overview

A separate tax system exists for nonresident aliens within the Internal Revenue Code (IRC) section 1441. Payments to nonresident aliens are subject to very different tax withholding, income reporting and liability requirements than that of U.S. citizens, permanent residents, and resident aliens. The most significant difference is that nonresident alien payments, by definition of the IRS tax laws, require tax withholdings unless an exemption from income taxation applies. The specific tax rules are described in this document. Various factors determine if payments are reportable and taxed, depending on the specific circumstances of each nonresident alien's payment and their country of residence.

It is extremely important to determine the tax status of each fellowship payment separately when one individual holds more than one fellowship. In some cases one fellowship may be exempt, while the other is taxable. The tax withholding and reporting information that must be entered in the RF business system and the documentation requirements are different for the different taxation statuses.

Qualified Versus Non-Qualified Fellowship Payments

Fellowship payments are typically divided into two separate groups to define taxability under the IRS laws. These groupings are qualified (non-taxable) or non-qualified (taxable) fellowship payments. Qualified
payments are typically payments for tuition, books, and fees required to attend classes. Non-qualified payments are typically any other payments, such as payments for room and board.

Under IRS law the institution paying the individual must be able to specifically substantiate how the payments are used. Typically, the payments at educational institutions are substantiated by itemization
on a student's account. Because the RF pays the fellowship payment directly to the individual, the payments cannot be treated as qualified payments by the RF when we pay the funds.

Tax Withholding Rules for Nonresident Alien Fellowships

Nonresident aliens are only subject to taxation on income deemed "U.S. source" income. As set forth in IRC section 1441, the RF is required to withhold tax at a standard rate of 30% for "U.S. source" payments that constitute taxable income to a nonresident alien. There are several exceptions to the general 30% tax withholding requirement. Exceptions to the 30% rule are described below.

Foreign-Source Funding:

Full tax and reporting exemption if the funds for the payment are determined to be foreign source. For more information, see "Determine Foreign Source Funding."

Income Tax Treaty:

Full or partial exemption if the person's country of residence has an income tax treaty exemption agreement with the U.S. and he or she claims the exemption by completing an IRS form W-8BEN. Form
W-8BEN must be complete and on file to allow the tax exemption.

Prerequisite: The fellow MUST have or obtain a U.S. Taxpayer Identification Number to claim income tax treaty exemption.

For more information, refer to "Completing the Certificate of Income Tax Treaty Exemption Form (IRS Form W-8BEN)."

Reduced Tax Rate of 14%:

Internal Revenue Code Section 1441(b) provides that for payments made to certain nonresident alien recipients, the standard 30% tax withholding rate is reduced to 14%. To qualify for the lesser rate, the nonresident alien must be temporarily present in the U.S. under an F, J, M or Q visa, a candidate for a degree, or the recipient of a grant for study, training, or research at an educational organization in the United States.

USAID Training Programs Grants

The RF processes some United States Agency for International Development (USAID) fellowship stipend payments via the RF business system.

Under IRC Section 1441 (c)(6), the recipient is exempt from taxation if the payments are a "per diem for subsistence" made in connection with a USAID training program grant. Per diem for subsistence generally means "food and lodging."

Note: Operating locations must examine each USAID grant for tax withholding and reporting requirements, since different grants may have different requirements. If a payment under a grant is found to be exempt because it is a per diem for subsistence, the applicable contract must be further examined for possible requirements related to all other payments.

Processing Taxation and Exemption in the RF Business System

Overview

The payroll module of the RF business system was designed to bypass fellow assignment taxation and exclude the payments from any standard graduated rate table withholdings within the system. When reviewing a fellowship assignment in the payroll module, you can access the tax information forms, but this information is not used. Instead, fellow taxation is processed using the fellowship payment elements (see next section).

Fellowship Payment Elements

Fellowships are paid in the payroll module of the RF business system using the Stip Fel NQual element. If the payment is taxable, an additional element must be assigned to the individual’s record, called FIT NRA Fel NQual. The system then automatically calculates 14% withholding on the payment. For more information, refer to "Processing Taxation or Exemption of Fellowship Payments to Nonresident Aliens."

Special Information Types and Reporting

Special Information Types (SITs) are added to a fellowship assignment in the payroll module to record data, primarily for reporting purposes. The Non Citizen Residency Information SIT and Non Citizen Reporting Information SIT are used for recording residency status for tax purposes and tax status. These two SITs must be completed and updated when residency or tax status changes.

The Non Citizen Reporting SIT data appears on the year-end 1042-S tax statement. The tax status must be entered in the Non Citizen Reporting SIT for each calendar year. If there are multiple fellowships or multiple portions to a fellowship, it will require multiple Non Citizen Reporting SIT lines.

For Example:

Importance of Reviewing Data in the System

Information contained in reports and year-end tax statements is collected from the data stored in the RF's business application. If data are missing or inaccurate, tax statements will be missing or inaccurate. Correcting tax statements after they have been created and distributed is an administrative burden for staff at both the operating locations and at the central office. Corrections are also an inconvenience to the person receiving the corrected tax statement from the RF.

Any errors, such as misclassification or tax withholding errors, may bring significant risk exposure to the RF, and may result in penalties and fines, which would be passed on to the operating location responsible. Operating locations should have a procedure in place for reviewing the input in the RF business application so that accurate income tax withholding or exemption is maintained throughout the year.

Refer to the procedure "Processing Taxation or Exemption of Fellowship Payments to Nonresident Aliens" for important information on entering nonresident alien fellowship data into the RF business system and monitoring residency status.

Key Data to Review

Areas that should be reviewed for accuracy are described below.

Review for proper withholding (key to monitoring tax risk):

All or a portion of fellow payments may be exempt from tax withholding. In cases where taxation at the reduced rate of 14% is required, it is important to review and verify that the 14% is withheld on all payment
required. This can be done easily by reviewing the taxable fellowship amount paid and multiplying that amount by 14%. Then, verify the amount of calculated withholding against the actual amount that was
withheld. If there are under withholdings, you need to recoup the required amount in future payments or obtain a personal check for the amount due from the individual.

Refer to “Tax on Tax Issues” section of this document for ramifications.

Fellow assignment classification:

Is the payment classified correctly? What is the relationship of the individual with the RF?

To minimize any possible risk in this area, evaluation of the fellow assignment should be made before the person is ever added to the RF business system. The nature of the activity should meet the RF definition for fellowships. If any services are provided, the fellowship payment classification is incorrect.

Errors in misclassification typically have a significant impact on taxes, reporting, or fringe benefit charges (e.g. if an employee is paid in error as a fellow). For more information on classification, see "Administration of Fellowships", "Fellowship and Participant Stipend Policy" and "Participant Stipends Versus Fellowship - Comparison Table."

Residency status

Operating locations should have non citizen aliens fill out the "Request for Alien Information for Employees and Fellows” (pdf) (excel) form to gather pertinent information and should use the Substantial Presence Test (Test 3 located on the back of the form to determine residency for tax purposes.

If a fellow’s residency status changes during the calendar year, taxes and reporting are based on residency status at the time that a payment is made to the fellow. For those non U.S. citizens who meet the criteria of the IRS Substantial Presence Test, the “residency starting date” for tax purposes is the first day of presence in the U.S. during the calendar year in which the individual meets the test.

The IRS rules explain that income tax withholding or exemption must be processed each pay period based on the residency status for tax purposes and tax status of the fellow. Although the IRS residency determination rules are not in full agreement with the IRS withholding rules, to ensure that withholdings are processed in a compliant manner, taxes should be withheld (if applicable) based on the tax status at payment (according to IRS withholding rules).

Proper coding in the RF business system is critical to ensure that payments are taxed appropriately based on the residency status and tax status at the time of payment, and that year-end reports are accurate. For example, residency changes may require "split reporting" at year end. The payments processed under nonresident alien status will require a 1042-S tax statement and the payments processed under resident alien status will require an "Payment Reporting Letter." As long as there are two Non Citizen Reporting Special Information Type (SIT) lines coded in the system, central office will be able to account for the split reporting at year-end.

Refer to "Processing Taxation or Exemption of Fellowship Payments to Nonresident Aliens" for information on inputting taxation information to the RF business system and processing residency changes.

Income tax treaty exemption:

Not every country has an income tax treaty agreement with the United States. A treaty must exist between the individual’s country of residence and the United States. If the fellow completes, signs, and dates an IRS W-8BEN to claim income tax treaty exemption, you must review the form to ensure data is complete and the income tax treaty exemption appears valid. Also ensure that the fellow has a U.S. Taxpayer Identification Number on file.

Non Citizen Residency and Reporting SITs:

All nonresident alien for tax purpose fellows must have data in the Non-Citizen Reporting Info special information type (SIT) form. This data drives how the 1042-S will be produced.

Key in this area is the listing of multiple Non Citizen Reporting SIT lines if multiple fellowships or portions of fellowships must be reported separately. For example, if a portion of a fellowship is taxable and the other portion is not.

Refer to "Processing Taxation or Exemption of Fellowship Payments to Nonresident Aliens" for information on inputting taxation information to the RF business system.

Tax-on-Tax Issue when Taxes are Under Withheld

It is the operating locations responsibility to withhold the proper amount of income taxes based on an individual’s tax status at the time of each payment. If taxes are under withheld, operating locations should attempt to recoup the under withholdings directly from the individual.

Under the law, if the operating location pays taxes due on behalf of the fellow instead of withholding them, the RF is required to report the amount of tax paid as additional income to the individual. When you add the additional income to the original record it creates a "tax-on-tax" issue and a "tax-on-tax calculation" must be performed. This results in the proper withholding amount for reporting purposes (final gross x14% = proper withholding amount). Since the operation location is office of record, any under withholding and tax on tax calculation will be charged to the responsible operating location at year end.

Example:

A fellow has income of $1,000.00 and the fellowship is taxable at the reduced 14% rate. During the year the FIT NRA Fel NQual element was never set up on the record and 14% was not withheld. At year end it becomes apparent when the preparation begins for the 1042-S that there were no taxes withheld. The RF will assume the tax liability to ensure that the year-end tax statement is correct.

At first glance it appears that the amount that must be assumed is $ 140.00 (1,000.00 x 14%). However, since the $140.00 was not withheld and instead will be paid by the RF on the fellow's behalf, this amount must be added to the fellow's reportable income for the year and a "tax-on-tax calculation" must be performed.

Formula: Under withheld amount / (1 - tax rate of .14)

Calculation: $140 / .86 = $162.79

Result: $140 was the under withheld amount and $22.79 is the tax-on-tax "gross up" amount. The total of the two is $162.79, which becomes additional income that must be added to the original income amount. Original income amount of $1,000 + $162.79 = adjusted gross income of $1,162.79.

1042-S Reporting: New income amount reported on 1042-S from is $1,162.79 and the tax amount reported is $162.79. ($1,162.79 x .14 = $162.79)

Year-end Charge Backs for Under Withholding

At the end of the year when the 1042-S tax statement are produced, if there are under withholdings for a record, the central office will process tax-on-tax calculation. The under withheld amounts and tax on tax calculations will be charged for the amount of additional liability assumed by the RF. The additional liability then must be transmitted to the Internal Revenue Services as part of the corporate annual 1042 reconciliation.

Change History

 

 

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