A nonresident alien individual (NRA) is generally subject to US income tax on two types of income categories:
Income that is “effectively connected” with a trade or business in the United States (so-called “ECI”); Income from US sources that is “fixed, determinable, annual or periodical” (so-called “FDAP” income)
ECI versus FDAP
When income is “effectively connected” with a US trade or business, the income is taxed at graduated rates. These are the same rates that apply to US citizens and residents (the highest marginal rate is 39.6%). Such “effectively connected income” ECI, is to be reported on page one of Form 1040NR, U.S. Nonresident Alien Income Tax Return.
The performance of personal services in the US generally constitutes a US trade or business. Other indications that a trade or business is being conducted in the US are as follows – maintaining a fixed office with employees; storing goods for sale to US purchasers; soliciting orders through a dependent agent; providing logistics support for an export business; management of a US real estate business.
With respect to FDAP income, income is considered “fixed” when it is paid in amounts known ahead of time. Income is “determinable” whenever there is a basis for figuring the amount to be paid. Income can be “periodic” if it is paid from time to time. It does not have to be paid annually or at regular intervals. Income can be determinable or periodic, even if the length of time during which the payments are made is increased or decreased.
FDAP income generally consists of passive investment income, such as interest or dividends. It can include almost any sort of income, such as scholarship and fellowship grants, awards, prizes, boxing purses paid for fights held in the US, even commissions for a single transaction. FDAP income is taxed at a flat 30 percent rate on a gross basis. A lower treaty rate may possibly apply. No deductions are allowed against such income. FDAP income should be reported on page four of Form 1040NR.
Determining Source of Income
Determining the source of income depends on the type of income in question as well as other factors. See IRS Publication 519 Typical types of income and the factors used to determine the “source” are set out in the IRS Publication. For example, determining the source of salaries, wages or other compensation depends on where the services are performed; determining the source of interest depends on the residence of the payor of the interest income; determining the source of a royalty, patent or copyright depends on where the intellectual property is used.
A payment of cash from one spouse to the other under the terms of a divorce or separation agreement, regardless of how it may be labeled in that agreement, will be characterized for US income tax purposes as “alimony” if the payment meets the criteria listed in Internal Revenue Code (IRC) § 71(a). If treated as “alimony,” the payment will be tax deductible for the payor, and will be taxable income to the payee.
When paid to a NRA, the IRS treats alimony income as FDAP. This means that payments of alimony income to an NRA are taxable and will be subject to gross withholding at source if the alimony is derived from “US sources”. This is significant because the US payor will have withholding duties. If he fails to meet them he can become personally liable for the tax. Payments of US-source income (such as alimony payments that are considered to have a US source) are also subject to reporting requirements. The payor of the alimony should obtain a Form W8-BEN from the NRA recipient. Part I of the Form contains a certification that the recipient is a NRA and Part II will cover the right to claim treaty benefits, that can reduce or eliminate withholding, if any such treaty benefits exist. The Form W8-BEN is retained by the payor; it is not sent to the IRS. If the alimony is from US sources, withholding will be required by the payor at the 30% (or lower treaty rate).
What is the “Source” of Alimony Income?
The source of alimony income is the residence of the payor and not the location of the court that issued the divorce decree (e.g., a US or foreign court). This was made clear in the case of Elinor Manning versus the Commissioner Thus, if the paying spouse is a US resident (regardless of his or her citizenship), the alimony will be treated as having a US source and reporting and withholding obligations must be met when paying the NRA recipient. On the other hand, if the paying spouse is resident overseas (even if a US citizen), then the alimony will not have a US source and it should not be taxable in the hands of the NRA recipient. Reporting and withholding should not be required on the part of the paying spouse. Surprisingly, it appears the IRS will permit the US payor to deduct the alimony on his or her tax return even though the recipient does not include it in income. See Chief Counsel Advice 200251004 12/20/2002
Property transfers at divorce carry their own US tax consequences. The tax issues become more complicated when a NRA-spouse is in the picture. You can learn more about this topic on my earlier blog post here.
IRS May More Closely Scrutinize Alimony Payments
The Treasury Inspector General for Tax Administration (TIGTA) recently reported (TIGTA Rep’t No. 2014-40-022 (3/31/14)) that there is a huge discrepancy in the amount of alimony income reported by recipient-taxpayers and alimony deductions claimed by the alimony paying-taxpayers. The TIGTA report claims there was $2.3 billion in excess deductions claimed in 2010. It does not take much imagination to realize that this kind of report may trigger an increase in IRS scrutiny in the alimony area. Those who should be withholding had best do the necessary or suffer the consequences.
Original Post By: Virginia La Torre Jeker, J.D.
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