Chapter 3 withholding for payers who are not banks: who is foreign, what is U.S.-source, and what to withhold

You are a withholding agent

Chapter 3 of the Internal Revenue Code (sections 1441 to 1464) taxes certain U.S.-source income of foreign persons by withholding at the source. The person who has control, receipt, custody, disposal or payment of that income is a withholding agent, whether it is a bank or a software company paying a licensor in Germany. Under IRC 1461 the withholding agent is liable for the tax it should have withheld, plus interest and penalties, whether or not it withheld it. The payee's own liability does not reduce yours.

The three questions

Is it U.S.-source? The rules that decide most cases

Most of the payments an operating business makes to foreign persons turn on source. Foreign-source income paid to a foreign person is outside chapter 3 entirely: no withholding and no Form 1042-S.

When the source cannot be determined at the time of payment (fees paid in advance of services, for example) the payment is treated as U.S.-source, and an over-withholding can be fixed later. Pay for services performed partly in the United States is apportioned, usually by days.

What to withhold

From 2026 a chapter 3 exemption code is required on Form 1042-S whenever less than 30% is withheld. Bank deposit interest and some short-term original issue discount are not subject to chapter 3 at all. Wages paid to a nonresident alien employee follow the wage-withholding rules on Form W-4 and are reported on Form W-2, except wages exempt under a treaty, which go on Form 1042-S.

If you agree to pay the vendor's tax for them (a "gross-up"), the tax you pay is itself additional income to the payee and is withheld on as well.

Documentation and the presumption rules

A reduced rate needs a valid certificate before the payment: W-8BEN for individuals, W-8BEN-E for entities, W-8ECI for effectively connected income, W-8EXP for governments and exempt organizations, W-8IMY for intermediaries and flow-throughs, and Form 8233 for an individual's treaty-exempt pay for services. The W-8 form selector picks the form. You may rely on it unless you know or have reason to know it is unreliable or incorrect.

Without a valid certificate, the presumption rules in Treas. Reg. 1.1441-1(b)(3) decide how to treat the payee. An undocumented individual is generally presumed to be a U.S. person: Form 1099 and, for reportable payments, 24% backup withholding. An undocumented entity is presumed U.S. or foreign according to its type and the facts on file. A payee presumed foreign is withheld on at 30% with no treaty benefit. The W-8 validity calculator covers expiry and the rules for curing a late form.

Depositing the tax

Tax withheld under chapter 3 is deposited by electronic funds transfer on the Form 1042 schedule, which depends on how much has accumulated: by the 3rd banking day after the end of a quarter-monthly period once undeposited tax reaches $2,000; by the 15th of the following month for $200 to under $2,000 at the end of a month; and with the Form 1042, by March 15, for less than $200 at the end of December. The Form 1042 deposit penalty calculator works out each due date and the failure-to-deposit penalty.

Forms 1042-S and 1042

• Form 1042-S goes to the IRS and to each recipient by March 15 of the following year, one form per recipient per type of income, with an income code, the exemption code or rate, and the recipient's chapter 3 and chapter 4 status. The 1042-S code finder lists every code.
• Form 1042, the annual withholding return, is due March 15 and reconciles the tax withheld with deposits. It is required whenever you are required to file a Form 1042-S, even if nothing was withheld.
• E-filing is required if you file 10 or more information returns of all types in the year (financial institutions must e-file regardless). For 2026 Forms 1042-S, due March 15, 2027, IRIS is the only electronic route; FIRE is retired.
• Over-withholding can be adjusted with the reimbursement or set-off procedures up to the due date (including extensions) for Form 1042-S. After that, the payee claims a refund on its own U.S. return.

Where payers go wrong

• Withholding on foreign-source pay. Services performed abroad are not U.S.-source. Withholding 30% on them creates a refund the vendor has to chase and a 1042-S that should not exist.
• Issuing a 1099 to a foreign payee. A foreign person belongs on a 1042-S or nothing. A 1099 to a foreign vendor shows up later as a CP2100 mismatch.
• Applying a treaty rate with no form, or an expired one. The liability for the difference is yours.
• Accepting a W-8BEN treaty claim for U.S. services. An individual claims a treaty exemption for pay for services performed here on Form 8233.
• Skipping Form 1042 when nothing was withheld. Every Form 1042-S filer files Form 1042.
• Royalties to a "sales" vendor. Software and content licenses are often royalties (income code 12), not payments for goods, and are U.S.-source to the extent of U.S. use.

Questions people ask