THE SCENARIO:

1. We are a small software/web development company incorporated as an
LLC in the state of Minnesota.

2. We would like to hire an individual based in the Netherlands on a
CONTRACT basis, not as an employee. He effectively will be a
sub-contractor working on a client project of ours.

3. He will be performing his work in the Netherlands.

4. He will be paid a fee of $3,000 USD.

THE QUESTIONS:

1. Generally, how do we handle our taxes for this expense?

2. Can we simply pay him $3,000, and then have him deal with taxes in
the Netherlands?

3. How do we report the expense on our taxes?

4. Is the answer different depending on the country? We also have
people in the U.K. and Australia who we may do business with at some
point. Are there general rules of thumb to follow?

Yes, we have an accountant. But he cannot give me a good answer, and
rather than search for a new accountant right away, I thought I would
try here for a definitive answer. Please, no vague answers! I have
already gotten plenty of vague answers from our accountant. :-) I need
a definitive answer, so please let me know if you need additional
details.

Hi vonbrocklin,

Ok, here is the information that you are seeking, taken from the
official IRS website.

The most important thing to realize is that payments made to
nonresident aliens are not taxable or reportable, as long as the
services were performed outside of the U.S. You will find this in
Section 1441(a) of the Internal Revenue Code. In other words, Uncle
Sam can't tax an alien for work performed outside the US.

1. Generally, how do we handle our taxes for this expense?

To file information concerning your business, the forms to use are
1042 & 1042-S and you will use Code 03 to explain his withholding
exemption.

Form 1042: Annual Withholding Tax Return for Source Income of Foreign Persons:
http://www.irs.gov/pub/irs-pdf/f1042.pdf

Form 1042-S: Foreign Person?s U.S. Source Income Subject to Withholding:
Box 6, Exemption Code 03: Income is not from U.S. sources:
* "Non-U.S. source income received by a nonresident alien is not
subject to U.S. tax. Use Exemption Code 03 when entering an amount for
information reporting purposes only."
http://www.irs.gov/pub/irs-pdf/f1042s03.pdf

"You must file Form 1042 if:
You are required to file Form(s) 1042-S (whether or not any tax was
withheld or was required to be withheld). File Form 1042 even if you
file Forms 1042-S only on magnetic media or electronically."
http://www.irs.gov/pub/irs-pdf/f1042.pdf

2. Can we simply pay him $3,000, and then have him deal with taxes in
the Netherlands?

Yes, pay him the $3,000 and then send him a copy of the 1042-S next
year - other than that, there's nothing else for you to do.

3. How do we report the expense on our taxes?

As you normally would, Schedule C, Profit or Loss From Business, Line
11, Contract Labor. Just attach your forms 1042 & 1042-S.

4. Is the answer different depending on the country? We also have
people in the U.K. and Australia who we may do business with at some
point. Are there general rules of thumb to follow?

The key is whether the work performed was in the U.S. or not. If not,
it doesn't really matter which country the contractor is in.

An explanation of "U.S. Source Income":
US TAX FOR ALIENS: Publication 519: US Tax Guide for Aliens:
Chapter 2, page 11:
"A nonresident alien usually is subject to U.S. income tax only on
U.S. source income (services performed in the U.S)."
Table 2?1, page 11: 
Summary of Source Rules for Income of Nonresident:
 A. Factor Determining Source:
  1. Salaries, wages, other compensation: Where services performed
  2. Business income: Personal services:  Where services performed
Chapter 2, page 12: 
"All wages and any other compensation for services performed in the
United States are considered to be from sources in the United States."
"If your compensation is for personal services performed both inside
and outside the United States, you must figure the amount of income
that is for services performed in the United States."
http://www.irs.gov/pub/irs-pdf/p519.pdf

>>>>>>>>>>>>>>>>

Additional Links:

Pay for Personal Services Performed: Withholding Tax:
"You generally must withhold tax at the 30% rate on compensation you
pay to a nonresident alien individual for labor or *personal services
performed in the United States*..."
http://www.irs.gov/pub/irs-pdf/p515.pdf

International Taxpayer - Effectively Connected Income (ECI)
http://www.irs.gov/businesses/small/international/article/0,,id=96409,00.html

Pay for Personal Services Performed:
http://www.irs.gov/businesses/small/international/article/0,,id=105085,00.html


Please note the "Important Disclaimer" at the bottom of this page - I
am not an authority of IRS tax laws and I would like to encourage you
to contact the IRS for confirmation.

IRS: Help by email:
http://www.irs.gov/help/page/0,,id=13162,00.html

IRS: Local Offices:
http://www.irs.gov/localcontacts/index.html

I hope I've been able to explain this in an easy to understand way. If
you have any questions, please post a clarification request before
closing/rating my question and I will be happy to respond.

Thank you,
hummer

I searched the IRS website, but I've had experience with similar
questions in the past.

Thank you for an excellent answer. The reason we have an accountant is
for just this sort of thing, and you did a much better job than he did
without a doubt.

Thank you, vonbrocklin, that's quite a glowing message considering I'm
not an accountant! 8-) Sincerely, hummer