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Are Settlement Payments to Nonresident Aliens in Civil Litigation “U.S. Source Income” ?

brokenbank-300x262One of the top questions that arises for U.S. defendants making settlement payments to nonresident aliens or foreign noncitizens is how the settlement payment should be taxed and whether any amounts should be withehld from it. Every day defendants settle cases without withholding any amounts from the settlement payments.

Defendants generally do not withhold amounts from settlement checks except when the funds being paid are sourced to a type of income for which the defendant has an obligation to withhold, such as employment cases in which the settlement constitutes the payment of back wages.  (26 U.S.C. §§ 3102(a), 3402(a)(1);  Maxfield v. United States Postal Service (9th Cir. 1984) 752 F.2d 433, 434).

Defendants do not withhold amounts from settlement proceeds, even when they do know whether the plaintiff will withhold those amounts properly, pay the taxes that are owed, or not, and how much is actually taxable to the plaintiff or not.    Indeed, it is irrelevant to a defendant’s position as to whether a plaintiff pays taxes on a non-physical injury litigation settlement or not, as it is not defendants’ obligation to withhold.

Nonresident Aliens Subject to Taxation for U.S. Source Income

A nonresident alien usually not subject to U.S. income tax, except to the extent such income is considered  U.S. source income.  (26 U.S.C. §861; IRS Publication 519, Chapter  2 <> last accessed August 22, 2016.)  The concept of “sourcing” income serves the purpose of determining whether income of non-resident aliens may be taxed by U.S.  taxing authorities.

The word “source” does not refer to monies originating from U.S. accounts or U.S. businesses.  Rather, the concept of U.S. source income refers to the types of income specifically enumerated in 26 U.S.C. 861(a).    The U.S. only taxes thirty percent (30) of income of nonresident aliens for “U.S. source income,” not all income. (I.R.C. 871(a)).

The general rules for determining source of income and whether income constitutes “U.S. source income” are contained in sections 861 through 865 of the Code.  Section 861(a) enumerates certain items of gross income that “shall be treated as income from sources within the United States,” specifically certain interest, dividends, personal services income, rents, royalties, gains from real estate and inventory property, insurance underwriting income and social security benefits. Section 862 enumerates items of income that are treated as not being U.S. source income.  With respect to types of income not enumerated in Sections 861 through 865, section 863(a) provides that “mixed” types of income shall be allocated and apportioned between the two.

When the nature of the income is identified, there are additional factors that are assessed to determine whether it is U.S. source income or not. For example, if the income is considered “interest,” the factor determining its source is the “residence of the payer.” For example, if the residence of the payer is in the U.S., and if the nature of the payment is “interest,” then it is considered U.S. source income.

On the other hand, if the income is considered “other compensation,” and the location of the recipient is “not in the U.S.,” it is not considered “U.S. source income.”

Below is a reproduction of the IRS’  chart that summarizes the factors governing each type of income:

Item of Income Factor Determining Source
Salaries, wages, and Other compensation Where services performed
Business income:
Personal services
Where services performed
Business income:
Sale of inventory -purchased
Where sold
Business income:
Sale of inventory -produced
Where produced (Allocation may be necessary)
Interest Residence of payer
Dividends Whether a U.S. or foreign corporation*
Rents Location of property
Natural resources
Location of property
Patents, copyrights, etc.
Where property is used
Sale of real property Location of property
Sale of personal property Seller’s tax home (but see Personal Property, in Chapter 2 of Publication 519, for exceptions)
Pensions Where services were performed that earned the pension
Scholarships – Fellowships Generally, the residence of the payer
Sale of natural resources Allocation based on fair market value of product at export terminal. For more information, see IRC section 1.863–1(b) of the regulations.
*Exceptions include:
a) Part of a dividend paid by a foreign corporation is U.S. source if at least 25% of the corporation’s gross income is effectively connected with a U.S. trade or business for the 3 tax years before the year in which the dividends are declared.

Taxation of Settlement Payments to Nonresident Aliens

 The category of the money being paid to a plaintiff during the course of litigation is generally a “settlement payment,” amounts paid to settle civil claims in ongoing litigation.

Although “settlement payments” are not enumerated specifically in 26 U.S.C. 861-865, the IRS has issued letter rulings that specify how settlement payments are to be categorized and sourced, when determining whether they are comprised of U.S. source income or not:

With regard to the taxation of a settlement payment made to a nonresident alien individual, the IRS has held that the nature of the item for which the settlement payment is substituted controls the characterization of the payment. (Private Letter Ruling August 11, 2005 (PLR-150182-05) (citing U.S. v. Gilmore, 372 U.S. 39 (1963).)

Essentially, the source of the item for which a settlement payment is substituted controls the source of the payment. Rev. Rul. 83-177, 1983-2 C.B. 112.

This means that the IRS expects the  underlying claims to be evaluated to determine how they fit into the enumerated categories, to determine whether the income is considered U.S. source income or not.

Accordingly, it is important to analyze the nature of the claims made by a plaintiff.

For example, if a settlement payment is considered “other compensation” for services performed, with the categorization of the settlement payment ascertained, turning back to the IRC to determine the factors that are assessed to determine whether such income is U.S. source income, pursuant to the IRC, income considered “Salaries, Wages, and Other Compensation” is assessed to determine whether it is U.S. source income based on “where the services are performed” (26 U.S.C. 862(a)(3) and whether the services were performed “within” the U.S. or outside of the U.S.

There are special rules governing the sourcing of income by nonresident aliens that partially perform services in the U.S. and partially elsewhere, and these rules require “apportionment” on  “time basis” i.e., the amount of time spent by the individual in the U.S. Treas. Reg. sec. 1-861-4(b).

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