Archive for 'Divorce'

Property Transfers Between Spouses: Gift Tax

I will be speaking on November 1, 2012 (Los Angeles) and November 2, 2012 (San Francisco and simulcast on the internet) at the 2012 Family Law Conference of the California Society of Certified Public Accountants.

Here, for your reading pleasure, is a portion of the presentation materials. This is the fifth and final installment in this series. Like the others, this version of the handout has all of the footnotes stripped out of it. Sorry. You’ll have to show up in person to get the handout in all of its PDF glory.

Property Transfers Between Spouses: Gift Tax

Summary

Section 1041(b) generally makes transfers to nonresident spouses subject to income tax gain or loss recognition.  That is not the only problem that applies to transfer between spouses or former spouses when the international tax rules start to apply.

The normal rules that everyone expects to see for transfers between spouses and former spouses are benign.  Assume a typical divorce where both spouses are U.S. citizens.

A transfer within the scope of Section 1041 is treated as a gift for income tax purposes. That is how the income tax rules cause such a transfer to escape gain or loss recognition, and to cause the recipient to have the giver’s basis.

The Normal Gift Tax Rules

At the same time, Section 2501(a)(1) imposes a tax on transfers of property by gift.  It is sufficiently broad that it would apply to transfers between spouses and former spouses.  However, there are a number of exceptions that can be used to reduce or eliminate the gift tax on interspousal transfers, either while the couple is married or incident to a divorce.

The biggest one–and easiest to rely on in the purely domestic context–is the unlimited gift tax marital deduction.  Look at your total gifts for the year.  Deduct from that any transfers to your spouse.  What remains will be your taxable gifts.  For married couples this rule means that there is no gift tax, ever, on interspousal transfers.

This is true even in the divorce context.  Transfers of property and payments of cash between divorcing or divorced spouses will be exempt from gift tax if made pursuant to a written settlement agreement and made within a defined time period.

Coupled with Section 1041(a), which causes such transfers to be nonrecognition events for income tax purposes, spouses and former spouses have the assurance that asset transfers between themselves will always be tax-free.  Income tax and gift tax?  Both eliminated.

Income tax (resident aliens) vs. gift tax (citizens)

Whether gain or loss is recognized in interspousal transfers–during marriage or as part of a divorce–depends on the recipient’s status as a resident alien.  If the recipient is a resident alien, no gain or loss is recognized on the property transfer; if the recipient is a nonresident alien, gain or loss will be recognized.

Citizenship does not enter into the picture for income tax purposes.  If the recipient spouse is a U.S. citizen, then the property transfer will be a nonrecognition event, no matter where the recipient lives on the planet.

The gift tax problem, however, revolves around citizenship.  The recipient can be a resident alien, and gift tax will still apply to the property transfers.  This means a green card holder or a person who is a resident alien because of the substantial presence test (too many days in the USA) cannot receive property transfers from his or her spouse (during marriage or incident to a divorce) without triggering a possible gift tax liability for the donor.

Gift tax when the recipient is a noncitizen

When the recipient spouse is not a U.S. citizen, the unlimited federal gift tax marital deduction does not apply.  Instead of the unlimited marital deduction, gifts to noncitizen spouses have a large annual exclusion.  The amount is indexed annually for inflation.  For 2012, the amount that can be given to a noncitizen spouse tax-free is $139,000.

This means that every property settlement where the transferee is a noncitizen must be scrutinized for potential gift tax liability for the donor.

But more important, this same rule applies even to a couple that never gets divorced.  If the recipient is not a U.S. citizen, the unlimited marital deduction does not exist.

Example

Husband is a U.S. citizen and Wife is a green card holder.  They live in the United States.  Husband gives Wife 50% of a piece of real estate that he owns.  The value of the interest in real estate is $500,000.

Husband has made a taxable gift to his wife.  The first $139,000 of the gift is exempt from gift tax.  The remainder ($361,000) is subject to gift tax.

Income tax or gift tax?

Property settlements between spouses may trigger gain recognition if the transfer is a “sale or exchange”.  Alternatively, they may trigger gift tax if the transfer is a gift.  It won’t be both.  A gift is a gratuitous transfer, with nothing received in return.  Property transfers where he gets this asset and she gets that asset will be a sale or exchange.

Recipient is a U.S. taxpayer

If the recipient of a property transfer that is treated as a gift is a U.S. taxpayer (a citizen or resident alien), he or she must report the gift from a nonresident alien on Form 3520 if the value is over $100,000.

Example

Husband is a nonresident alien.  Wife is a U.S. citizen.  Husband makes a property transfer to Wife of $500,000 cash.  Wife must report the receipt of that gift on Form 3520.

Income taxation of property transfers between spouses

I will be speaking on November 1, 2012 (Los Angeles) and November 2, 2012 (San Francisco and simulcast on the internet) at the 2012 Family Law Conference of the California Society of Certified Public Accountants.

Here, for your reading pleasure, is a portion of the presentation materials. This is installment four in a series of five. Like the others, this version of the handout has all of the footnotes stripped out of it. Sorry. You’ll have to show up in person to get the handout in all of its PDF glory.

Property Transfers Between Spouses: Income Tax

Summary

Property transfers to nonresident alien spouses or former spouses will trigger recognition of gain or loss. The normal “no income tax, no problem” approach toward property settlements will not work.

Any property transfer involving a noncitizen spouse or former spouse must also run the gauntlet of the gift tax rules. Transfers to noncitizen spouses are not afforded the full exemption from gift tax that citizen spouses expect. Just avoiding the tax pitfalls discussed in this chapter will not be enough. Look at the gift tax chapter as well.

The Normal Income Tax Rules

Everyone knows what to expect for property settlements in a divorce, even cocktail party tax advisors: no gain or loss is recognized in a transfer of property between spouses. Similarly, no gain or loss is recognized for a transfer of property between former spouses, if the transfer is incident to divorce.

As long as the technical rules are satisfied (mostly related to that magic phrase “incident to divorce”), the person making the transfer does not create a taxable gain or loss, and the person receiving the property takes the adjusted basis of the transferor.

Transferee is a nonresident alien

The normal rules do not apply if the spouse (or former spouse) receiving the property is a nonresident alien. The explicit nonrecognition provision of Section 1041(a) does not apply, in other words, to transfers to a person who is a “nonresident alien.”

First-Year Election

Someone who was a nonresident alien (i.e., not a resident and not a citizen of the United States) last year and who commences living in the United States in the current year can elect to be treated as a resident alien starting on January 1 of that first year of residency. This is done by making an election.

It would be a truly exceptional divorce that would involve property transfers incident to a divorce occurring in the first year that the recipient became a resident of the United States. However, for normal transfers between married couples, this happens more commonly. A married couple that immigrates to the United States should time interspousal transfers carefully–especially for appreciated property. Transfers that occur while both are nonresidents are obviously safe. The IRS cannot touch transactions between nonresidents involving non-U.S. property. But transfers of U.S. property, or transfers that involve one resident and one nonresident spouse, may be tripped up inadvertently by the application (or not) of the nonrecognition rules of Section 1041(a).

Transfer to Green Card Holder

If the transferee spouse holds a green card, it does not matter where in the world he or she lives. A transfer of property incident to divorce will be covered under the normal rules of Section 1041(a). No gain or loss is recognized.

This result occurs because Section 1041(d) says that transfers to nonresident aliens are not covered by the normal nonrecognition rules that apply to transfers between spouses and former spouses. Note, however, that the transferor may not be up-to-date on a former spouse’s actions with respect to green card status. The normal rules apply if the recipient still has a green card. But if the recipient has terminated green card status without notifying the transferor, painful income tax results might apply: the transfer will trigger gain or loss, because Section 1041(d) will now override the normal rules of Section 1041(a).

Check the recipient’s visa status before making the property transfer.

Transfer to Resident under Substantial Presence Test

The substantial presence test is a year-by-year test. Each tax year the days of presence in the United States will be checked for the current year and the two prior years. The appropriate arithmetic is done, and the result will make the taxpayer a resident or nonresident of the United States.

For the transferor, this creates a risk that is not within his or her control. A transfer to a spouse or former spouse who is a nonresident under the “count the days” methodology of the substantial presence test will be treated as a taxable event.

If the recipient spouse or former spouse is a noncitizen and does not hold a green card visa, the transferor would be wise to make property transfers only in tax years where the recipient is a resident alien under the substantial presence test rules. This makes the transfer qualify for nonrecognition under the normal rules of Section 1041(a).

On the other hand, it might be useful to cause a property transfer to be treated as a taxable event. Perhaps it is useful, for instance, to recognize a capital loss. In that case the property transfer would not be treated as qualifying for the nonrecognition treatment of the normal rule at Section 1041(a). It would be taxable for income tax purposes.

Alimony in international divorces

I will be speaking on November 1, 2012 (Los Angeles) and November 2, 2012 (San Francisco and simulcast on the internet) at the 2012 Family Law Conference of the California Society of Certified Public Accountants.

Here, for your reading pleasure, is a portion of the presentation materials. This is installment three of five episodes. Like the others, this version of the handout has all of the footnotes stripped out of it. Sorry. You’ll have to show up in person to get the handout in all of its PDF glory.

Alimony

Introduction

Alimony payments to nonresidents can be tricky. The international tax rules for alimony are similar enough to purely domestic rules to encourage complacency. But there are special withholding and paperwork requirements to consider.

Is it alimony?

The familiar rules that tell us a payment is characterized as alimony will apply:

  • The payment is made in cash;
  • The payment is received by (or behalf of) a spouse under a divorce or written separation instrument;
  • If the spouses are divorced or legally separated, they reside in separate households when the payment is made;
  • The payments to a third party on behalf off the recipient are documented with a timely executed document;
  • The payor’s liability to make payments ends when the recipient dies;
  • The parties do not file a joint tax return; and
  • The divorce or separation instrument does not designate non-alimony treatment.

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.

When both spouses are U.S. taxpayers

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, and the payor deducts the alimony from his or her income.

Paperwork is minimal. The recipient gives the payor his or her social security number and the payor reports the payment amount and recipient’s social security number on his or her tax return.

Penalties are minimal. There is a $50 penalty on either party for failure to comply with these reporting requirements, which may be abated. The IRS cannot deny a deduction for the alimony payment made just because the payor omitted the recipient’s social security number.

How alimony is taxed to a nonresident recipient

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. The alimony recipient’s U.S. income tax liability will therefore either be the rate mandated by the treaty (i.e., zero), or it will be 30%.

Alimony is U.S. source income

The source of alimony income is the residence of the person who makes the payments. Alimony received by a nonresident alien from his or her U.S.-resident spouse or ex-spouse will be U.S.-source income to the recipient.

Alimony is taxed at 30% by default

U.S. income tax is imposed on U.S.-source alimony at a flat 30% of the gross amount paid to the nonresident recipient. 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.

Or alimony is taxed at 0% because a treaty says so

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.

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. A few treaties give the payor’s country the right to tax alimony. 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.

How the payor is taxed

The payor’s right to deduct the alimony payments from income remains unchanged, even if the recipient is a nonresident alien and the income is tax-free to the recipient.

Alimony paperwork for the payor

Here is what the paying spouse should be doing in the paperwork department.

Form 1040

The payor will reduce his or her adjustable gross income by the alimony payments by reporting the information required on Form 1040, Line 31.

Withhold 30% or get Form W-8BEN

A U.S. person making payments of U.S. source income to a nonresident alien is a “withholding agent.”

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.

Alimony is an amount subject to withholding. The documentation required from the recipient in order to reduce the amount of tax withheld by the payor is Form W-8BEN.

Risk to payor for withholding failures

The withholding agent may not blindly rely on the nonresident alien’s say-so, even if the paperwork is technically correct. 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.

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. 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. This means that the person paying alimony to a nonresident alien spouse or ex-spouse must obtain the necessary documentation or withhold 30% of the payments made. Failure to do this will expose the payor to liability for the tax required to be withheld. Documentation failure will cause the same result. 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. 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.” Alimony is fixed or determinable periodic income.

The filing requirement exists even if no tax is withheld.

In addition to Form 1042, a withholding agent must file Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. 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.

Alimony paperwork for the recipient

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. This is not a stand-alone form, so it filed attached to a Form 1040NR.

The important elements of preparing Form 8833 are:

    • The recipient’s name and address is 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.”
Identifying the treaty country at Line 1a. This will be the recipient’s country of domicile.
Identifying 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. 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 reference 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.
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 Form 1040NR are beyond the topic at hand.

Form W-8BEN

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. For example, if the Form W-8BEN is given to the payor in mid-2012, the form will expire on December 31, 2015.

Form W-8BEN is given to the payor. It is not given to the IRS.

Form 1040NR

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.

Conclusion

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.

Who is a nonresident alien?

I will be speaking on November 1, 2012 (Los Angeles) and November 2, 2012 (San Francisco and simulcast on the internet) at the 2012 Family Law Conference of the California Society of Certified Public Accountants.

Here, for your reading pleasure, is a portion of the presentation materials. This is installment two of five, and has all of the footnotes stripped out of it. Sorry. You’ll have to show up in person to get the handout in all of its PDF glory.

Who is a nonresident alien?

One of the critical things we need to know is the status of the individuals involved. Are they U.S. citizens? If both are citizens, then there is no reason to read any more. The default divorce tax rules apply to them. If one is not, then we have work to do in order to figure out the tax results that apply.

If one or both are not citizens, are they residents of the United States for income tax purposes–a “resident alien”? If both are resident aliens, again the default divorce tax rules apply.

This section gives an overview of the rules to determine whether an individual is a “resident alien” or a “nonresident alien” for income tax purposes. This status is relevant to the proper tax treatment of alimony payments and property transfers between spouses and ex-spouses.

For more information on the rules, see IRS Publication 519, U.S. Tax Guide for Aliens.

Warning: status as a “resident alien” or “nonresident alien” matters for alimony and property transfer purposes. It does not matter for gift tax purposes. In the section covering property transfers between spouses, we will see that transfers to noncitizen spouses can trigger gift tax. Only citizenship matters for that purpose, not residence.

Nonresident alien defined

A “nonresident alien” is a person who is not a resident of the United States for income tax purposes, and who is not a citizen of the United States (that’s the “alien” part).

A nonresident alien is a person who is not a “resident” of the United States and is also not a citizen of the United States. Let’s assume the recipient of the property transfer is a noncitizen of the United States. The “alien” part is covered. Is the recipient a “nonresident” of the United States? The IRS tells us what it means to be a “resident.” If a person is not a resident, he or she will therefore be a nonresident.

Three types of residents

A resident is someone who:

  • has been admitted to the United States as a lawful permanent resident alien15 (i.e., holds a green card); or
  • meets the substantial presence test for the year16 (i.e., has been in the United States for too many days); or
  • made an election to be treated as a U.S. resident for income tax purposes in the first year he or she lived in the United States.

A nonresident alien, therefore, is someone who does not satisfy any one of those three requirements.

Green card test

The first way an individual becomes a resident alien for income tax purposes is by holding a green card. If the individual has a green card at any time during the tax year, he or she is a resident alien. The starting date for this status is the first day that the person is physically present in the United States while holding a valid green card visa.

Once a person is a resident alien under the green card test, that status continues until:

  • visa status is formally revoked or rescinded administratively; or
  • the individual abandons green card status voluntarily; or
  • an election is made under the terms of an income tax treaty by the individual to be treated as a resident of another country and a nonresident of the United States for income tax purposes.

Even if the individual remains outside the United States for the full tax year, he or she will continue to be a resident alien for income tax purposes simply because he or she holds the green card visa. Days of presence in the United States will not be relevant.

Substantial presence test (“too many days”)

The substantial presence test involves counting days. We look at a person’s physical presence in the United States in the current year and the two prior calendar years. We do a little bit of arithmetic, and the result will be a determination that the individual is (or is not) a resident alien. The determination is just for the current tax year. Each tax year stands alone, so a person might be a resident alien in one year but not the next.

The arithmetic involves adding the number of days of presence in the United States in the current year to one-third of the days of presence in the preceding year and one-sixth of the days of presence in the year before that. If the total is 183 or more, the person is a resident for the current year. If the total is 182 or less, then then person is a nonresident.

Example 1

We want to know whether the person is a resident alien for calendar year 2011.

YearDays of PresenceDivide ByResult
20111201120
2010120340
2009120620
Total180

Since the total for 2009 through 2011 is 180, the person is a nonresident of the United States in 2011.

Example 2

By contrast, let’s look at someone who is physically present in the United States for 150 days in each of the years in question. Again, we want to know whether the person will be a resident alien for calendar year 2011.

YearsDays of PresenceDivide byResult
20111501150
2010150350
2009150625
Total225

Now the result of the arithmetic is a total of 225. This person is a resident alien for income tax purposes in 2011.

Resident alien status: counterstrikes

Someone who is treated as a resident of the United States has some options to nevertheless opt out of that status. Opting out may cause unanticipated problems.

Election by nonresident alien to file joint return

A nonresident alien can become a resident alien for much (but not all) of the Internal Revenue Code. A nonresident alien may make a special election and thereby file joint income tax return with a U.S. taxpayer spouse.

Making this election causes the person to be a resident for purposes of Subtitle A, Chapter 1 of the Internal Revenue Code. Chapter 1 contains the income tax rules. Critically, Section 1041 is part of Chapter 1. Thus, making the election to be treated as a resident under Section 6013(g) will cause the individual to be a resident alien for purposes of Section 1041(a), thus making property transfers between spouses subject to the nonrecognition rule.

The election has a downside, of course. It causes the nonresident alien spouse to be taxable on worldwide income, rather than merely on U.S.-source income. The election also causes the nonresident alien spouse to be subject to wage withholding under Chapter 24 of Subtitle A of the Internal Revenue Code.

This election, once made, continues indefinitely until terminated.

One method of termination is the legal separation of the couple under the terms of a decree of divorce or separate maintenance.

For the practitioner playing in divorce tax land, the key take-away is to watch out for a couple where this election has been made. Where a couple has previously filed jointly because of an election under Section 6013(g) and they separate or divorce, the effective date of the loss of resident status for the nonresident alien spouse is the first day of the tax year. This can cause some trouble.

Example

Husband is a nonresident alien, and wife is a U.S. citizen. They make an election under Section 6013(g) to file joint U.S. income tax returns. Husband does not hold a green card, and has not been in the United States for enough days during 2012 to be treated as a resident of the United States under the substantial presence test.

In September, 2012 they divorce. During 2012, in the run-up to finalizing the divorce, they made a number of property transfers.

If they lose the ability to file a joint tax return because of the election under Section 6013(g), Husband will no longer treated as a resident alien effective January 1, 2012 for U.S. income tax purposes.

Therefore, all of the property transfer from Wife to Husband in 2012 were transfers to a nonresident alien. They are subject to the exception of Section 1041(d), so gain or loss will be recognized on these property transfers. If alimony payments were made, the special tax, withholding, and paperwork requirements will apply.

The point of this example is to see that something done in late 2012 can torpedo otherwise innocent events happening in early 2012.

Treaty Election

A taxpayer who is not a citizen of the United States can take advantage of this strategy. A spouse or former spouse who holds a green card and lives in another country is a prime candidate for this election. So is someone who lives in another country but spent too many days in the United States in the tax year, becoming a resident by the substantial presence test.

If the individual’s country of residence has an income tax treaty with the United States, then he or she can make an election for U.S. tax purposes under the tie-breaker rules that are typically found in Article 4 of the treaty. Both countries can claim the individual as a resident taxpayer for income tax purposes, so the tie-breaker rules are a method for definitively causing the taxpayer to be a resident of one but not both countries.

The election is made using Form 8833. The election is effective as of January 1.

Example

Husband is a green card holder living outside the United States. Wife is a U.S. citizen. During 2012 the couple makes property transfers in anticipation of finalizing their divorce. Spousal support payments go from Wife to Husband. On December 31, 2012 they are still married.

Sometime in early 2013, while preparing his U.S. income tax return, Husband decides to elect to be a nonresident of the United States for income tax purposes. He files his Married Filing Separate tax return with Form 8833 attached making the appropriate election to be treated as a resident of his home country for income tax purposes, and be treated as a nonresident of the United States for income tax purposes.

Those property transfers and alimony payments from Wife to Husband are now fully outside the scope of the default divorce tax rules. Property transfers trigger gain recognition. Alimony payments should have had withholding tax imposed.

Hilarity ensues.

There are other risks involved with making the election under a treaty to be a nonresident of the United States. This can trigger a deemed expatriation by the individual, potentially causing application of the exit tax.

But the election has another “gotcha” waiting for the ill-advised. Electing under the treaty to be taxed as a nonresident causes the individual to calculate income tax liability as a nonresident alien only. For all other purposes, the person remains a resident alien. This means that the individual faces the full panoply of international tax reporting and compliance requirements: Form 5471 if he or she owns shares of a foreign corporation, Form 8938 for foreign financial assets, the notorious FBAR (Form TD F 90-22.1), and any other reporting requirement generally applicable to U.S. citizens or resident aliens.

Closer connection exemption

Because the treaty election is an incomplete way for a nonresident alien to remove himself or herself from the U.S. income tax requirements, a second counterstrike methodology might prove more palatable.

This exception applies only to a nonresident alien who is treated as a resident alien in the United States under the substantial presence test, and who has been in the United States in the current year for fewer than 183 days. A green card holder cannot use this method.

Someone who has a “tax home” in another country, has a “closer connection” to that country than to the United States, and does not take steps to get a green card during the current year is eligible to claim the closer connection exemption to the substantial presence test. Doing the correct paperwork–Form 8840–is a requirement to claiming the exemption.

If this exemption works for the taxpayer, then he or she is a nonresident alien for all purposes of the Internal Revenue Code. They pay income tax on only their U.S. source income, and are not subjected to the ever-expanding disclosure requirements facing U.S. taxpayers.

Claiming the closer connection exception can wreak havoc in property settlements and alimony payments.

Example

Husband is a resident alien in the United States in 2012 because he spent sufficient days in the United States to make him a resident alien under the substantial presence test. However, he did not spend 183 days in the United States in 2012. He does not have a green card.

In February, 2012, as a run-up to the divorce, Wife transfers property to Husband, fully expecting this to be a nonrecognition event. No gain or loss will be recognized on the transfer under Section 1041(a) because, she thinks, Husband is a resident alien.

In March, 2013, Husband prepares his 2012 income tax returns, and makes the Closer Connection Exemption claim, filing Form 8840 with his tax return. He is a nonresident alien effective as of January 1, 2012. The property transfer that Wife made in February, 2012 is not eligible for nonrecognition under Section 1041(a).

The moral of the story

The moral of this story is that resident alien status matters. If the two parties work together the tax results will be predictable. If they do not, there may be a small and unexpected tax-caused crater in someone’s finances.

Child support and international divorce

I will be speaking on November 1, 2012 (Los Angeles) and November 2, 2012 (San Francisco and on the interweb) at the 2012 Family Law Conference of the California Society of Certified Public Accountants.

Here, for your reading pleasure, is a portion of the presentation materials — installment one of five episodes. This version of the handout has all of the footnotes stripped out of it. Sorry. This is what happens when something moves from Pages to HTML while you’re flying above the Indian Ocean en route from Mumbai to Dubai and you can’t log into WordPress and download a handy-dandy footnote plug-in. Hypothetically speaking, of course.

Child Support

Summary

The taxation of child support in an international divorce should be the same as in a purely domestic divorce: no income tax deduction is allowed for the paying parent, and the recipient is not treated as receiving taxable income. There are no reporting requirements, either.

Where you run into problems, of course, is in the edge cases. If something is labeled as child support but in fact it is not, we have to decide what it is and how it is taxed. The payment could be a property settlement payment to the spouse or former spouse. Or it could be a gift to the gift or former spouse, or to the child. These questions are explored here. Better, of course, to not play too close to the edge.

Income taxation of child support

The rules for income taxation of child support are the same for international divorces as they are in the purely domestic context:

  • payments are not tax-deductible by the payor, and
  • are not taxable income for the recipient.

No tax deduction to the payor

The parent making the child support payment does not receive an income tax deduction. If the parent is a U.S. citizen or a U.S. resident alien, the default rules of the Internal Revenue Code apply: no deduction is allowed.

If the parent making the child support payments is neither a U.S. citizen nor a resident alien, then he or she is exposed to the U.S. income tax system only for U.S.-source income. There, the only possible tax deductible items will be expenses associated with the conduct of a U.S. business. Child support is self-evidently not a business expense.

No taxable income for the recipient

The recipient of child support payments will have no taxable income in the United States. If the recipient is a U.S. citizen or resident alien, the Code hands us that result. If the recipient is neither, then the payments received are irrelevant for U.S. income tax purposes. A nonresident alien cares only about his or her home country income tax.

Income tax treaties and child support

Whenever you are dealing with a cross-border divorce, it is wise to determine whether an income tax treaty exists between the countries of residence of the two ex-spouses. An income tax treaty may be able to trump unsatisfactory tax results in the other country.

Typically, if an income tax treaty exists there will be a provision that deals explicitly with the taxation of alimony and child support. The United States has a model treaty that it uses as a starting point for its negotiations with other countries. It refers to child support, making it tax-exempt in both countries.

Periodic payments . . . for the support of a child made pursuant to a written separation agreement or a decree of divorce, separate maintenance, or compulsory support, paid by a resident of a Contracting State to a resident of the other Contracting State, shall be exempt from tax in both Contracting States.

The relevant provision is usually found in Article 18 of older treaties, and may or may not follow the precise language quoted from the Model.

The Canadian treaty, as an example, exempts child support from income taxation in a round-about way:

. . . [C]hild support payments . . . arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable only in that other State, but the amount included in income for the purposes of taxation in that other State shall not exceed the amount that would be included in income in the first-mentioned State if the recipient were a resident thereof.

Let’s translate that into simple language. Assume a payment of child support from a U.S. citizen parent to a non-U.S. citizen minor child living in Canada. Is that child (or the custodial parent, for that matter) taxable in Canada on the child support payments received? The provision would read as follows:

. . . [C]hild support payments . . . arising in the United States and paid to a resident of Canada shall be taxable only in Canada, but the amount included in income for the purposes of taxation in Canada shall not exceed the amount that would be included in income in the United States if the recipient were a resident thereof.

Since the United States does not impose income tax on the recipient of child support, Canada may not, either. This demonstrates one possible use of the income tax treaties: if you can prove that the payment would be nontaxable child support in the United States, a nonresident alien custodial parent abroad may use the income tax treaty between his or her home country and the United States to trump a home country rule that would make the child support taxable.

Paperwork

Paperwork requirements are always a concern when money crosses the border, or one of the parties involved is a nonresident. The Service is fond of obscure reporting requirements and big penalties for late, incomplete, or missing pieces of paper. In tax work, there is a constant nagging doubt: “Is there something lurking out there that I forgot?” In order to dispel fear, we will now prove a negative–there is no extra paperwork required by the IRS for child support payments across borders.

Outbound child support payments

If the payment of child support is outbound–from a U.S. citizen or U.S. resident parent to a minor child living outside the United States, there is only one possible reporting form that could apply: Form 1042 and Form 1042-S. These forms are used to report the payment of U.S.-source fixed, determinable, annual or periodic income to a nonresident alien.

The payment of child support is made to satisfy a parent’s legal obligation to support a minor child. It is not a payment of “income” earned by the child. The reporting obligation applies only to “income”, and therefore child support is not a reportable payment.

This is true under the Internal Revenue Code. In addition, if the recipient lives in a country that maintains an income tax treaty with the United States, it is almost certainly true that the treaty characterizes the payment as nontaxable as well.

Inbound child support payments

For child support payments received by a U.S.-citizen or U.S.-resident child from a nonresident-nonresident parent, there are similarly no applicable IRS reporting requirements.
The only reporting rules that could theoretically apply to inbound payments are the rules requiring U.S. recipients of gifts or bequests from nonresident aliens to declare amounts received in excess of $100,000 per year. This requirement is implemented in Part IV of Form 3520. Only gifts and bequests must be reported.

Child support payments made according to a written agreement are not gifts.

A gift as “any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed.” A gratuitous transfer is one where you give more than you get back. When you get something back, you receive “consideration”, in legal jargon. If the value of what you get back is equal to what you gave, there is no gift. Thus, if you make a voluntary transfer and receive nothing back in return, you have made a gift.

The Regulations extends the definition of a gift to “dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor.” Where a husband and wife enter into a written agreement in connection with a divorce, a reasonable allowance for support of minor children is deemed in full and adequate consideration in money or money’s worth.
Since the money received as child support is not a gift under gift tax principles, it is not required to be reported on Form 3520 as such.