Several tax rules specifically affect members of the U.S. Armed Forces and their families. Many of these rules provide substantial tax benefits to military families but navigating the eligibility and compliance rules can be complicated, especially for military families serving overseas. This article explores some of these issues, including recent rule changes that negatively impact military families. Given the inherent difficulties military families face, quick resolution of these issues is vital.
A recent U.S. Citizenship and Immigration Services policy update changes how children of certain U.S. government employees and members of the U.S. armed forces who are employed or stationed outside the United States can obtain U.S. citizenship. Previously, such children of citizens born outside the United States were considered “residing in” the United States and thus were automatically considered U.S. citizens at birth.
The policy update, effective October 29, 2019, alters this treatment and provides that children who are living abroad with a parent who is a U.S. government employee or U.S. service member are no longer considered as “residing in the United States” for purposes of acquiring citizenship automatically at birth. Parents of such children will be required to file certain forms to obtain U.S. citizenship for these children.
Failure or delay in obtaining U.S. citizenship for a dependent child may affect the parent’s ability to claim certain tax benefits. For example, individual taxpayers can claim a $2,000 child tax credit for each “qualifying child.” Section 24(c)(2) of the Internal Revenue Code provides that an individual is not a qualifying child unless he or she is a U.S. citizen, a U.S. national, or a U.S. resident alien for the tax year in which the taxpayer seeks to claim the credit. Failure or delay in satisfying the definition of a qualifying child may significantly impact these families’ ability to claim the child tax credit.
Communicating this change and assisting military families navigate these rules is key to avoiding adverse tax consequences for these families.
In other news affecting military families, legislation has been proposed to fix drafting errors in the 2017 Tax Cuts and Jobs Act (“TCJA”) that resulted in higher taxes on death-related benefits paid to military families.
Currently, Department of Defense survivor benefits paid to surviving children are taxed at rates of up to 37% because under the TCJA the income is taxed at rates applicable to a trust or estate. Prior to enactment of the TCJA, these payments were subjected to “kiddie tax” rules that taxed a child’s unearned income at the higher of the child’s or the parent’s marginal tax rate.
Not surprisingly, the marginal tax rate for many military families is well below the 37% rate that typically applies to trusts and estates and individuals in the highest marginal tax bracket. This change from the TCJA has resulted in increased tax liabilities of thousands of additional dollars for many military families. Various legislative fixes have been proposed, but to date, no new legislation has been enacted to address this issue.
Congress must move quickly to fix this legislative error to avoid future, adverse impacts to our gold star families.
Under long-standing tax rules, some items of earned income paid to U.S. military members may not be subject to U.S. income tax. These include Basic Allowance for Housing and Basic Allowance for Subsistence payments. In addition, otherwise taxable pay related to service in a combat zone is generally excluded from gross income. Death gratuity payments to eligible survivors and payments for burial services may also be excluded from gross income.
In addition to the above income exclusions, several procedural rules benefit U.S. service members.
For example, service members can choose to suspend the five-year test period for ownership and use of a home during periods of “qualified official extended duty” for purposes of excluding gain on the sale of a home under I.R.C. § 121(d)(9). Qualified official extended duty includes service at a duty station at least 50 miles from the taxpayer’s main home or residence in government quarters under military orders. Military families may also benefit from extensions to the deadline for filing tax returns and making payments if serving in a combat zone or if stationed overseas.
Notwithstanding the tax benefits described above, several U.S. income tax reporting and disclosure rules may apply to military families stationed abroad. For example, all U.S. persons must report income from sources outside the United States. Thus, wages a military spouse earns from employment in a foreign country and income from non-U.S. investments are subject to current reporting and taxation. Some of this income may be excluded under the foreign earned income exclusion of I.R.C. § 911, and foreign tax credits under I.R.C. § 901 may further reduce U.S. income tax. Notwithstanding these exclusions and credits, military families must still report all foreign source income and navigate the complex international tax compliance rules.
In addition, a U.S. person must file the Report of Foreign Bank and Financial Accounts (“FBAR”) if she has a financial interest in or signature authority over any financial account(s) outside of the United States and the aggregate maximum value of all such accounts exceeds $10,000 at any time during the calendar year. For purposes of the FBAR reporting rule, “foreign financial account” is broadly defined to include non-U.S. bank and securities accounts, foreign pension plan accounts and cash value life insurance policies established outside the United States. Steep penalties apply to failures to file the FBAR. The compliance rates for the FBAR have been historically low and the IRS has in recent years aggressively moved to increase compliance.
While awareness of the FBAR rules has increased, it’s fair to assume many military families may still be unaware of these rules.
The rules for reporting foreign income and assets are complex and can significantly increase the compliance burden for military members. Some may opt to engage a professional tax return preparer to ensure income and assets are correctly reported. Military members, including retirees, may be eligible to receive free tax consultation and return preparation assistance through Volunteer Income Tax Assistance (“VITA”) locations. Military OneSource, an agency within the Department of Defense, provides links to local VITA locations and makes tax preparation software available at no charge to eligible service members.
Providing the necessary support to military families so they don’t run afoul of tax rules is essential and will allow these hardworking families to better serve our country.
Doug Andre, a U.S. Navy veteran, is a partner at Ivins, Phillips & Barker in Washington, DC, where he practices estate and gift tax law for high net worth individuals, specializing in the international tax obligations of U.S. citizens living abroad and non-U.S. persons residing or investing in the U.S.
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