[I am preparing course materials for an upcoming presentation at the 2012 CalCPA Family Law Conference (01 Nov 2012 in Los Angeles, 02 Nov 2012 in San Francisco; the San Francisco event will be webcast) on the international tax aspects of divorce. This is a piece of what I am working on. It is a draft version, so please forgive mistakes. People who attend the live show will get the final version of this, along with the other topics I will cover.]
Alimony payments to nonresidents can be tricky. The tax rules are similar enough to purely domestic situations to encourage complacency, but with withholding, paperwork, and penalty risks for the complacent.
Is it alimony?
The familiar rules that make the IRS treat a payment as alimony ((Section 71(b).)) will apply:
- The payment is made in cash; ((Section 71(b)(1).))
- The payment is received by (or on behalf of) a spouse under a divorce or written separation instrument; ((Section 71(b)(1)(A).))
- If the spouses are divorced or legally separated, they reside in separate households when the payment is made; ((Section 71(b)(1)(C).))
- The payments to a third party on behalf of the recipient are documented with a timely executed document; ((Regs. Section 1.71-1T(B), Q & A 6, 7.))
- The payor’s liability to make payments ends when the recipient dies; ((Section 71(b)(1)(D).))
- The parties do not file a joint tax return; ((Section 71(e).)) and
- The divorce or separation instrument does not designate non-alimony treatment. ((Section 71(b)(1)(B).))
I will assume that all of these requirements are satisfied, and look at the payment of alimony across borders, from a U.S.-resident payor to a nonresident alien recipient.
Who is a nonresident alien?
The different rules apply only if the alimony recipient is a nonresident alien. This means he or she is not a U.S. citizen, and also is not a U.S. resident for income tax purposes. ((Section 7701(b)(1)(B).))
Citizenship is easy to ascertain. A person either is or is not a U.S. citizen. Only occasionally will a person be unaware of his or her status as a U.S. citizen. Holding additional citizenships will not change U.S. citizen status.
Resident status is not as simple to determine. For income tax purposes, a resident is someone who holds a green card visa, ((Section 7701(b)(1)(A)(i).)) or who spends a sufficient number of days in the United States every year. ((Section 7701(b)(1)(A)(ii).)) For more information on the rules, see IRS Publication 519, U.S. Tax Guide for Aliens.
For the purposes of this article, let us assume that you have done the necessary due diligence and have confirmed that the recipient is neither a citizen nor a resident of the United States for U.S. income tax purposes.
How alimony is taxed–the normal rules
When the alimony recipient is a U.S. citizen or resident, the rule is easy to understand: amounts received are included in the recipient’s income, ((Sections 61(a)(8), 71(a).)) and the payor deducts the alimony from his or her income. ((Section 215(a).))
Paperwork is minimal. The recipient gives the payor his or her social security number ((Section 215(c)(1).)) and the payor reports the payment amount and recipient’s social security number on his or her tax return. ((Section 215(c)(2); Temp. Regs. Section 1.215-1T, Q-1. The Internal Revenue Code does not limit the reporting requirement to the first year of alimony payments, but the Temporary Regulations (temporarily in place since 1984!) state that it is a one-time reporting requirement. The information is provided at Form 1040, Lines 31a and 31b, and requires the recipient’s social security number each year. Prudence suggests that the recipient’s social security number be provided annually on Form 1040.))
Penalties are minimal. There is a $50 penalty on either party for failure to comply with these reporting requirements, which may be abated. ((Sections 6723 and 6724(d)(3)(C).)) The IRS cannot deny a deduction for the alimony payment made just because the payor omitted the recipient’s social security number. ((CCA 200251004.))
How alimony is taxed–nonresident alien recipient
Things are different when the recipient is a nonresident alien:
- The tax rate applied to the alimony income will be different;
- The paperwork requirements for both parties will be different; and
- Penalty opportunities exist for the payor.
Nonresident alien taxation generally
A person who is neither a citizen nor a resident of the United States is generally subjected to U.S. income tax only on income derived from U.S. sources.
Once you have decided that you have U.S.-source income, you have to know how it is taxed. A nonresident alien’s U.S.-source income will be subject to U.S. tax in one of two ways:
- just like a resident’s income (income minus allowable deductions, then apply the graduated tax rates), or
- it will be taxed at a flat 30% of gross income.
Both of these tax methods can be overridden by income tax treaties.
Alimony is U.S. source
The source of alimony income is the residence of the person who makes the payments. ((See, e.g., Manning v. Commissioner, 38 T.C.M. 646 (1979), aff’d, 614 F.2d 815 (1st Cir. 1980) (alimony paid by U.S. resident to resident of Puerto Rico was U.S. source), and Housden v. Commissioner, T.C. Memo 1992-91.)) Thus, alimony received from a U.S.-resident spouse or ex-spouse will be U.S.-source income to the recipient.
Alimony is taxed at 30%
U.S. income tax is imposed on U.S.-source alimony at a flat 30% of the gross amount paid to the nonresident recipient. ((Section 871(a)(1).)) This is the default U.S. income tax treatment that a nonresident alien recipient of alimony from a U.S. spouse or ex-spouse should expect.
This result, however, can be altered by claiming benefits under a relevant income tax treaty.
Alimony taxed at 0% using a tax treaty
The United States has many income treaties. A treaty might apply to eliminate the U.S. tax liability on the recipient of alimony–instead of paying 30% U.S. income tax on the alimony received from a U.S.-resident spouse or ex-spouse, the recipient might pay zero U.S. income tax.
The U.S. Model Treaty language gives you an idea of how this works:
Alimony paid by a resident of a Contracting State to a resident of the other Contracting State shall be taxable only in that other State. The term “alimony” as used in this paragraph means periodic payments made pursuant to a written separation agreement or a decree of divorce, separate maintenance, or compulsory support, which payments are taxable to the recipient under the laws of the State of which he is a resident. ((2006 U.S. Model Treaty, Article 17, Paragraph 4.))
The Model Treaty is the U.S. government’s opening position for how they negotiate income tax treaties. It demonstrates that in the abstract alimony should be taxable to the recipient in the recipient’s home country.
The real world is messier. Some treaties have no special rules for alimony. ((U.S.-Bermuda Income Tax Treaty; U.S.-China Income Tax Treaty; U.S.-France Income Tax Treaty; U.S.-Greece Income Tax Treaty; U.S.-Hungary Income Tax Treaty; U.S.-Luxembourg Income Tax Treaty; U.S.-New Zealand Income Tax Treaty; U.S.-Pakistan Income Tax Treaty; U.S.-Poland Income Tax Treaty; U.S.-Russian Federation Income Tax Treaty; U.S.-Sri Lanka Income Tax Treaty; U.S.-Ukraine Income Tax Treaty; U.S.-U.S.S.R. Income Tax Treaty (still applies to some former U.S.S.R. member republics).)) A few treaties give the payor’s country the right to tax alimony. ((U.S.-Australia Income Tax Treaty, Article 18, Section 6; U.S.-Austria Income Tax Treaty, Sections 3, 4; U.S.-Indonesia Income Tax Treaty, Article 21, Section 3; U.S.-Mexico Income Tax Treaty, Article 19, Section 3.)) Many, however, follow the general principles of the Model Treaty.
A survey of the many dozens of income tax treaties is beyond the scope of this article. The tax advisor for an alimony recipient should make a careful review of an applicable treaty to determine whether U.S. income tax obligations can be eliminated by invoking the protection of the treaty. ((The method for reducing U.S. tax liability by invoking the treaty provisions is discussed below.))
The recipient’s paperwork
Having decided that the recipient will pay U.S. income tax on alimony received at either 30% or the treaty rate of 0%, the next thing to do is deal with the paperwork.
Claiming treaty benefits on Form 8833
If you have determined that the recipient can use the income tax treaty between the United States and his or her home country to eliminate U.S. income taxation of alimony received, it is necessary to notify the IRS of the treaty election. This is done on Form 8833. ((T. Regs. Section 1.301.6114-1(a)(1)(i).))
The important elements of preparing Form 8833 are:
- The recipient’s name and address are self-explanatory.
- A U.S. taxpayer identification number is needed. If the recipient does not have a social security number, it will be necessary to apply for an Individual Taxpayer Identification Number using Form W-7.
- Check the box that says the “taxpayer is disclosing a treaty-based return position as required by section 6114.”
- Identify the treaty country at Line 1a. This will be the recipient’s country of domicile.
- Identify the specific Article of the treaty that makes the alimony nontaxable in the United States and taxable only in the home country of the recipient. ((For instance, under the U.S.-Italy Income Tax Treaty, the relevant provision is Article 18(5).)) This is entered on Line 1b.
- The Internal Revenue Code provisions overruled or modified are Sections 71(a) and 871(a). This goes on Line 2.
- Line 3 contains the identifying information for the payor of alimony.
- Line 4 references a provision of the income tax treaty called the “Limitation of Benefits” article. Most treaties have this provision. Treaties are intended for use only by true residents of the two countries that are parties to the treaty. Find the relevant article in the treaty that applies to the recipient. Make sure that the recipient is eligible for benefits under the treaty. Fill in the appropriate information. ((For instance, the 2006 U.S. Model Treaty, Article 22(2)(a) says that an individual resident of a contracting State is entitled to all treaty benefits. If the alimony recipient lives in a country for which the income tax treaty follows the Model Treaty, you would write “Article 22(2)(a)” on Line 4.))
- Line 5 is the essay answer. Here it is sufficient to report the gross amount of alimony received, and note that the payments properly qualify as alimony as provided in Internal Revenue Code Section 71.
Form 8833 is attached to Form 1040NR. Instructions for the preparation of the latter form are beyond the topic at hand.
Payments of U.S.-source income (like alimony payments from a U.S. resident) are subjected to reporting requirements and tax withholding requirements. The IRS wants to know about money leaving the country, and it wants to know that any required income tax is withheld from the payment before the money leaves the United States.
The IRS enforces this by imposing penalty risks on the payor. Therefore, the recipient will need to satisfy the paperwork requirements of the payor. If the recipient does not, then the default 30% tax will be imposed, and the payor will (or should) withhold the 30% amount from each payment remitted to the nonresident alien recipient.
The payor needs to know two things:
- the recipient’s nonresident alien status, and
- the appropriate tax withholding rate to apply to the alimony payments.
The recipient satisfies both needs by giving Form W-8BEN to the payor. Part I certifies that the recipient is a nonresident alien. If applicable, the right to claim treaty benefits is provided in Part II.
To properly fill in Part II to claim that alimony is exempt from U.S. income taxation by virtue of a provision in an income tax treaty, Part II of Form W-8BEN would be completed as follows:
- Check the box at Line 9a, and fill in the name of the recipient’s country of residence.
- Lines 9b through 9e do not apply.
- Line 10 asks that you fill in the Article number from the treaty that exempts alimony from U.S. taxation and allows the recipient’s country of residence the sole right to tax it. This is the same information you used in Form 8833. The applicable rate of tax is zero. The essay answer can say “The recipient’s country of residence, and not the United States, imposes income tax on alimony received.”
If the recipient provides this form without a U.S. taxpayer identification number, it expires at the end of the third year following the year it was provided to the payor. ((See, Instructions to Form W-8BEN (Rev. February 2006), page 2.)) For example, if the Form W-8BEN is given to the payor in mid-2012, the form will expire on December 31, 2015.
This form is given to the payor. It is not given to the IRS.
The recipient’s obligation to file tax returns with the Internal Revenue Service will vary. There may or may not be a need to file an income tax return. Assuming that there is no other reason to file a U.S. income tax return other than the alimony we are discussing, the nonresident alien recipient of U.S.-source alimony will fall into one of these categories:
- The required withholding was 30%, and it was fully satisfied by tax withheld by the payor. No U.S. income tax return is required to be filed.
- The required withholding was 0% due to a claim of benefits under an income tax treaty. File Form 1040NR, and attach Form 8833 to render the alimony received exempt from U.S. income tax.
- The required withholding rate was 30% but the payor did not withhold enough tax to satisfy the tax liability. File Form 1040NR and pay the extra tax liability that is due.
- The required withholding rate was 0% or 30%, and too much money was withheld from the alimony payments. File Form 1040NR to claim the appropriate refund. File Form 8833 if you are making the election under an income tax treaty to exempt the alimony received from U.S. income taxation.
How the payor is taxed
Alimony deducted from income
The payor’s right to deduct the alimony payments from income ((Section 215(a).)) remains unchanged, even if the recipient is a nonresident alien and the income is tax-free to the recipient. ((CCA 200251004; Rev. Rul. 56-585, 1956-2 C.B. 166.))
The payor will reduce his or her adjustable gross income by the alimony payments by reporting the information required on Form 1040, Line 31.
A U.S. person making payments abroad is a “withholding agent.” ((Regs. Section 1.1441-7(a)(1).)) A withholding agent must withhold 30% of any payment of an amount subject to withholding that is made to a foreign person, unless the withholding agent has documentation to prove the foreign person is entitled to a reduced rate of withholding. ((Regs. Section 1.1441-1(b)(1).))
The withholding agent may not blindly rely on documentation. The withholding agent must “reliably associate” the documentation with the payment to the foreign person. This means:
- The withholding agent must physically have the required documentation in hand;
- The withholding agent must be able to reliably connect the documentation to the payment and know whether it is going to the recipient or an intermediary; and
- Have no actual knowledge or reason to know that any of the information in the documentation is false. ((Regs. Section 1.1441-1(b)(2)(vii)(A).))
The documentation required in our situation is Form W-8BEN. ((Regs. Section 1.1441-1(c)(16).)) But that will not be enough in some cases. If the alimony payment to a nonresident alien is being paid to a U.S. address or account, the documentation is deemed unreliable. ((Regs. Section 1.1441-7(b)(8)(iii).)) The payor must get a “written reasonable explanation” from the recipient to support status as a foreign person and prove the holder of the U.S. account is a foreign person. ((Regs. Section 1.1441-7(b)(8)(iii).))
Alimony is an amount subject to withholding. ((Amounts subject to tax under Section 871 are in turn subject to withholding requirements under Section 1441. Alimony is subject to tax under Section 871(a)(1).)) This means that the person paying alimony to a nonresident alien spouse or ex-spouse must obtain the necessary documentation to justify zero withholding, or must withhold 30% of the payments made. Failure to do this will expose the payor to liability for the tax required to be withheld. ((Regs. Section 1.1441-7(b)(7)(i).)) Documentation failure will cause the same result. Civil and criminal penalties are also possible. There are some opportunities to mitigate this exposure.
Accordingly, the alimony payor should insist on having Form W-8BEN and any necessary additional documentation needed to meet the three requirements listed above.
The payor keeps the documentation on file and does not provide it to the IRS unless requested. If the recipient provides a U.S. taxpayer identification number, Form W-8BEN will be valid and the payor may rely on it until there is a change in circumstances making the information incorrect. ((See, Instructions to Form W-8BEN (Rev. February 2006), page 2.)) For example, if the payor discovers that the recipient has moved from one country to another, this would give the payor “reason to know that the information contained in the documentation is false.” The payor should insist on an updated Form W-8BEN or, in the alternative, commence withholding tax at 30%.
If the recipient does not provide a U.S. taxpayer identification number, the Form W-8BEN expires at the end of the third year that commences after it was signed. For example, a Form W-8BEN signed in mid-2012, the Form W-8BEN would expire on December 31, 2015. Any payments made after that should have 30% withholding imposed, or a new Form W-8BEN should be obtained.
Form 1042 and Form 1042-S
The payor needs to tell the IRS about the payments and the tax withheld, if any. This is done on Forms 1042 and 1042-S. These are the international equivalents to Form 1099, which is used for domestic payments.
Form 1042 is required for every withholding agent (like our U.S. payor of alimony) who pays “fixed or determinable periodic income.” ((Form 1042, page 2.)) Alimony is fixed or determinable periodic income. ((Section 871(a)(1).))
The filing requirement exists even if no tax is withheld. ((Regs. Section 1.1461-1(b)(1).))
In addition to Form 1042, a withholding agent must file Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. ((Regs. Section 1.1461-1(c)(1).)) If tax is withheld, it is paid with Form 1042. Payment may be due monthly, quarterly, or annually depending on the amount of tax withheld. See the Instructions to Form 1042 to determine when you must deposit the withheld taxes.
A variety of penalties apply to withholding agents who do not correctly withhold and remit withheld tax and file Forms 1042 and 1042-S. ((Regs. Section 1.1461-1(h). These include penalties under Sections 6651, 6662, 6663, 6721, 6722, and 6723. Even criminal penalties are possible.))
Alimony payments to a nonresident alien spouse or ex-spouse take extra care.
In addition to the normal documentation required to make the payment qualify as alimony for income tax purposes, the “after the fact” tax and paperwork burdens need to be considered and monitored carefully.
The additional tax compliance (and risk) burden on the payor should be professionally handled in order to ensure that the payor’s obligations as a withholding agent are handled properly.