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.
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.
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.
A resident is someone who:
A nonresident alien, therefore, is someone who does not satisfy any one of those three requirements.
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:
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.
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.
We want to know whether the person is a resident alien for calendar year 2011.
[table id=1 /]
Since the total for 2009 through 2011 is 180, the person is a nonresident of the United States in 2011.
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.
[table id=2 /]
Now the result of the arithmetic is a total of 225. This person is a resident alien for income tax purposes in 2011.
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.
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.
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.
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.
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.
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.
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.
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 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.