Tax Questions Are Everywhere:
A reader asks:
[W]hen are US bounties, such as the kind on Abu Musab al-Zarqawi, subject to US income tax?
I love the question, a perfect example of the lawyer's gift for finding important legal issues in the unlikeliest contexts. I have no idea what the answer is, but I'm sure some of our commenters do.
Whether you are in the business of collecting bounties would affect whether you could deduct your expenses, not whether it was income, though I suppose one could make a colorable argument that such expenses were in the pursuit of profit.
Nunzio, it probably would be considered compensation for services and therefore subject to payroll taxes.
I think this is better characterized as an example of the carpenter who attempts surgery, using a hammer.
Since a bounty paid by the U.S. government is "U.S. source income," if the recipient is a foreign national, then the payment would be subject to U.S. withholding tax (not employment tax withholding, but withholding tax nonetheless) at the rate of 30% unless the rate is reduced by treaty. U.S. tax treaties with most of our trading partners would allow a reduced withholding rate. But we don't have a tax treaty with Iraq right now, so technically it's subject to 30% withholding. If the $25 million bounty is paid and the recipient is an Iraqi, I wonder if he or she will complain when the check is only $17.5 million?
Firstly, we consider the situation of the earner and earnings. The US income tax applies to all worldwide income earned by US citizens, US residents (including part year residents and possibly to those with a right to residence who do not reside in the US), and entities doing any business in the US or territories. If the income is not in one of those categories it isn't subject to US income tax.
FICA taxes apply to wages paid by any US entity to any US citizen or resident and to wages paid to nonresidents for any work done wholly or partially in the US. FICA taxes also apply as self employment taxes to any non-wage income earned by any US citizen or resident while working anywhere in the world. US citizens and residents who wish not to pay FICA taxes for work done wholly outside the US should incorporate their businesses in a foreign country; there are many countires with sunny beaches that provide this service.
For this purpose, whether a bounty is subject to tax by the United States will largely depend on how a bounty is characterized for tax purposes, because that will dictate how the source of the bounty is determined. There is one revenue ruling from 1970 (Rev. Rul. 70-576) that characterizes a reward paid by the United States to a Canadian informant as personal service income. The source of personal service income is generally the place where the services were performed. IRC Secs. 861(a)(3) &862(a)(3). If the informing in this situation was done in Iraq, then the bounty would be foreign source income paid to a nonresident alien, which renders it generally non-taxable by the United States. (In the revenue ruling, the informing appears to have been done in the United States, which would make the reward U.S. source income; however, the IRS found that the informant was nonetheless exempt from tax under the commercial traveler exception in the U.S.-Canada income tax treaty---the US currently has no treaty with Iraq, but we do have a statutory commercial traveler exception---IRC Sec. 861(a)(3), but that exception likely would not apply here given the size of these bounties).
If the informant were in the business of informing, then that would open a whole other can of worms.
I don't know why I think this is so funny, maybe I have killed one too many brain cells studying for the bar...but the idea of the federal government taking taxes out of its own reward bounty paid to an Iraqi who lives and works in Iraq sounds hilarious. Basically, what you're saying is that the federal government gets to pay itself for receiving a tip about a criminal the federal government wanted to catch/kill.
That's not to say that the BIA or the IJ in the case won't see it your way for political purposes (the government wants to encourage Iraqi informants, of course), and then there would of course be no appeal to a higher court.
More likely, if said person wants to come to the US, it will be under the special exemption powers accorded the Attorney General.
As several above suggest, the character question seems decided, if notstraightforward--the reward would be treated as income from personal services. Note that a couple of years back, the Tax Court (in Roco) held that a payment to a qui tam relator was taxable, using 1.61-2(a), which deals with wages and other remuneration. Query whether this reward is directly analogous, but it seems to me like it is.
As several above also suggest, the source question is harder. (If the tipster is a US resident for tax purposes, the source only matters for foreign tax credits and other minutiae.)
Richard Riley--is there a per se rule that a payment from the US government is US source income? Could be, I just don't know. Otherwise, I'd second Anthony Infanti's suggestion that the "place of performance" rule applies. Then query whether the IRS would assert that certain parts of Iraq (embassies/consulates, military bases, the Green Zone) are US territory. There may be easy answers to these also, I just don't know. Didn't other parts of the administration try to stretch "US territory" for certain purposes in the national security context?
Any source experts out there?
From the Army Field Manual 27-10, Law of Land Warfare there is this quote in paragraph 31:
Are bounties even legal in a war?
You ask. But leaglity of income has no bearing on its taxability for income tax purposes.
Note that what you describe is a reward for capturing or killing an enemy. This is a reward for information; you'll notice that it was the U.S. military that actually did the killing.
As far as "privilege" goes, there is a specific statute (IRC 6103) that prescribes the situations in which the IRS is permitted to disclose tax return information.
Says the "Dog"
P.S., isn't there a specific statute that exempts nobel prize winnings from taxation? I think the tax lawyers here have staked out the issues pretty well. Its not wages because the tipster isn't an employee. If it isn't wages then it isn't subject to FICA and medicare. Some here have analyzed the payment as though it is for sure some type independent contractor gross income, which I guess in a sense it is. If the USA hires a foreign only based service provider (like a law firm or advertising agency) to provide a service in that foreign country, when the US government pays on the contract would such payments be subject to any kind of USA income tax or withholding? I don't think it would, absent the payment being effectively connected with a USA based trade or business carried on by the foreign person/entity providing the foreign service.
Finally, the coup de gras argument would be that the reward contract between the tipster and the USA was for a net payment to be received by the tipster of $25 million and if the USA fails to deliver $25 million net to the tipster then the USA has breached the contract (i.e., if tax is owed the promise by the USA impliedly contained the agreement that such taxes would either be waived or paid by the USA itself or at worst paid by the tipster AFTER first having received the full $25 million).
I mean suppose you are a salesman whose contract specifies that you will be paid such and such amount per *proof* of sale when this proof is handed over (say a reciept from the customer's order form). It seems quite strange to suggest that a salesman who did all his selling in the US (or not in the US) could play games with the income tax he owes by handing over the proof of sales in another country.
Anyway the real reason I wanted to post was just to ask whether CIA operatives and other US government employees paid to uncover Osama or similar terrorists can collect on these rewards. If you are reporting the tip to the US goernment as part of your normal employment can you still recieve the reward? If not could you quit your job as soon as you learn the info and then turn it over and collect the reward?
Does this apply to terrorists, or only to legitimate combatants as defined by Geneva? It seems that terrorists come under the purview of criminal, not military, law. Spies behind enemy lines, e.g., do not merit the protections of the Geneva Conventions.
Was I a tax cheat? I didn't think so, and I don't think publication 519 calls me a tax cheat for it. The section on personal services and employment income describes the source of the income keying on the location the service is provided; and not the location of the payer.
If I wasn't, why would a foreign-national Iraq resident tipster be fine paying only Iraqi tax?
I'd like to hear more about why a payment by the US government to a foreign national who is a foreign resident is US source income.
If the recipient is a non-resident alien, the bounty is taxable only if it is considered U.S. sourced income. The bounty is most likely income from personal services, and as such is U.S. source if the personal service sare performed in the United States. 26 USC s. 861(a)(3).
The question thus becomes: "where did the recipient of the bounty perform the services?" If the information was obtained in Iraq, and delivered to United States officials in Iraq, then it seems that the recipient has a very strong argument that the income is not US source, and thus not subject to United States income tax.
I suppose there are other possible characterizations of the income (e.g., the sale of intangible property), but the source outcome would not change. See 26 USC s. 865(a), (d).
There is no blanket rule that payments by the US government are US source. Indeed, s. 861(a)(6) specifically lists social security benefits as a type of income that is US source. It stands to reason that if US government payments were ipso facto US source, s. 861(a)(6) becomes "mere surplusage," a result that diligent construers of statutes like to avoid.
It might make a neice exam question next time I teach International Tax.
If the coalition or the Iraqi government makes the payment, and if the U.S. merely provides a grant to these tax exempt entities to fund the bounty, then the income is no longer U.S. source income. To the extent the income is paid to a non-U.S. citizen who is not a permanent resident of the U.S. (quite likely), it would be tax free since it concerns services outside the United States.
Also, practically speaking, the I.R.S. reports to the President, and U.S. always has discretion to not pursue rights that it has to collect taxes, something it does routinely in domestic cases for less weighty reasons like expense or a lack of a desire to disturb common practice.
Thus, if a tax was due, the only way it would likely be enforced is through a qui tam action, and the person who gets the bounty may very well prefer anonymity, so establishing a qui tam case might be difficult and also might be legitimately barred by the state secrets privilege, even though the exercise of that privilege in many other cases is far more questionable.