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