A researcher gets a grant award direct from an institution or university. The grant is not paid as wages, but is paid as a stipend or maybe as a scholarship. The payment might not be subject to income tax.
Compare that to a grant is awarded to an institution and the institution pays a researcher wages to perform the work. The researcher is indirectly receiving grant funds, but they are being paid to the researcher as wages.
The appeals court considered this later fact pattern in Baturin v. Commissioner, No. 20-1648 (4th Cir. 2022), in the context of a U.S. Tax Treaty. The question was whether wages paid to the researcher were exempt from tax as a grant or taxable as wages.
Facts & Procedural History
This is an international tax case. The taxpayer in this case was a Russian citizen who was in the U.S. under a J-1 exchange visitor visa. The J-1 visa is usually issued to those involved in teaching, studying or doing research in the U.S.
The case involves his work as a physicist at a U.S. government research laboratory. He was employed to perform research. He received a Form W-2 that reported his pay for this work as wages.
The taxpayer filed Forms 1040NR, non-resident returns. The tax returns claimed an exemption under the U.S.-Russian Tax Treaty for the wages he was paid.
The IRS concluded that the wages were not exempt. Litigation in the U.S. Tax Court ensued. The court was tasked with interpreting the tax treaty. The U.S. Tax Court found that the wages were exempt as a grant. So wages could be a grant under the applicable tax treaty. The IRS appealed, which resulted in the present court opinion.
About U.S. Tax Treaties
The United States has entered into tax treaties with about 70 foreign countries. These treaties are the governing tax law for transactions involving citizens or residents of these countries.
U.S. Tax Treaties provide for reduced tax rates and allocate income to one country or the other.
The U.S. Tax Treaties are similar, but not identical. The terms and language differ. Thus, one has to actually read the relevant treaty to confirm what rule applies when analyzing a foreign transaction involving a treaty country. This is particularly true about tax exemption rules that exempt income from taxation in the United States.
The IRS’s Industry Practice Group paper for Examining Treaty Exemptions touches on this:
Many Income tax treaties include articles, commonly referred to as the Students/Trainees article and the Teachers/Researchers article, which allow students, trainees, teachers and researchers to exempt some or all of their income from U.S. tax. The Students/Trainees article typically applies to trainees or business apprentices, as well as students. The Teachers/Researchers article typically applies to teachers, professors, researchers, and visiting scholars. The extent of the benefits provided, and the conditions for being eligible for those benefits differ from one treaty to another, so it is important to review the applicable treaty provisions and Treasury Department Technical Explanations accompanying such provisions.
Taxable Wages v. Non-Taxable Grant
The appeals court started by noting that the treaty does not define wages or grants, but it says that one is taxable and one is not.
Given the distinction, the appeals court looked to U.S. law to determine what the terms mean. It considered a court case that addressed the distinction between wages and a scholarship or grant. The scholarship or grant was paid “as relatively disinterested, ‘no-strings’ educational grants, with no requirement of any substantial quid pro quo from the recipients.”
The appeals court went on to note that the regulations for scholarships addresses de minimis services: “the recipient is required to furnish reports of his progress to the grantor, nor the fact that the results of his studies or research may be of some incidental benefits to the grantor shall, of itself, be considered to destroy the essential character of such amount as a scholarship or fellowship grant.”
Given the foregoing, the appeals court concluded that the payments to the taxpayer in this case were for services, which are taxable wages and not a non-taxable grant.
While it is not the law (and not addressed in this court case), the IRS’s IPG on Treaty Exemptions sets out several factors that can be considered in evaluating this issue:
- Whether the payment in question was to further the education and training of the recipient or whether it was a payment for services which directly benefited the payer.
- Whether the individual’s services were directly related to the fulfillment of a contractual commitment to a specifically sponsored project.
- Whether the individual’s work was subject to supervision, time schedules, and reporting requirements.
- Whether the university reported amounts paid on a Form W-2 or provided health and other employee benefits.
- Whether the amounts received by the individual was unusually large compared with less generous amounts normally awarded for fellowships.
The IRS’s IPG also instructs IRS auditors to review the following information in making this determination:
Examiner should review relevant documents to determine whether the amounts received by an individual is a scholarship, a grant, or is compensation for personal services.
Taxpayers should review this documentation themselves in light of the applicable U.S. Tax Treaty before filing their tax returns.
This case was decided by the Fourth Circuit Court of Appeals. The Fourth Circuit includes Maryland, North Carolina, South Carolina, Virginia and West Virginia. Foreign researchers here on J-1 visas who work in these states should follow this court opinion. Wages should be reported as taxable as long as there are some strings attached to receiving the wages that go beyond providing progress reports.
Alternatively, those receiving wages might consider structuring their assignments so that the payments are more like grants than wages. This may include securing concessions in writing from the employer. These taxpayers will have to report the treaty-based tax position on their tax returns (which is usually done using a Form 8833), which may increase the risk of an IRS audit.
There are other implications of this decision. For example, the wages may qualify for the research tax credit.