A Canadian tax resident, Student, attends art school in the United States. During the program, the school holds an exhibition of Student’s creations. Artworks are sold, the proceeds of which were credited against Student’s tuition. What are the federal tax consequences to Student?
Question 1 – Is a reduction in tuition income?
Barring specific exclusion, realized and readily measurable economic benefits are taxable. Accordingly, the reduction in tuition could be assimilated to either a payment in kind for the artworks, or the surrender of property in satisfaction of a debt, depending on whether the tuition had yet to become due, both of which are clearly taxable transactions.
Had Student been an employee of the school, the situation would have potentially been addressed by IRC 117(d), which shields from tax reductions in tuition benefiting people treated as employees. However, it would be precarious to take the position that Student was acting in the quality of an employee when the artworks were produced.
Another perspective on the matter would be qualification under IRC 117(a), which provides for an exclusion from gross income of amounts received to pay for qualified tuition and related expenses. As we already associated a reduction in tuition to a payment, maybe there would be ground to argue that the reduction in tuition is equivalent to the payment of a grant to cover tuition, and thus falls within the scope of IRC 117(a).
It is not the case, however, since amounts excluded under 117(a) must be handed out gratuitously, based on needs, not as quid pro quo. Cases such as Meehan v. Comm. (66 TC 794) were decided on whether compensation paid to students employed by a school were excludible under IRC 117(a). Regulations have since settled the issue by making clear that only compensation for services that are required as condition to being granted the degree is excludible from gross income under IRC 117(a).
Since participation in the public exhibition, and subsequent sale of the artworks, was not a requirement to award the degree, it appears that the transaction does represent income to Student.
Question 2 – Is Student resident for US tax purposes?
The determination of whether a student, teacher, or researcher is classified as US tax resident for tax purposes is similar to any other non-citizen and non-green-card holders. It follows the substantial presence and closer connection tests of IRC 7701(b)(3), with one significant distinction. Under IRC 7701(b)(5), days spent in the US as an exempt individual, a category that includes foreign government employees, teachers, trainees, students, and professional athletes, do not count toward the substantial presence test threshold. Generally, to be eligible to the exempt individual characterization, an individual must be temporarily present in the US under an F, M, J or Q visa.
All the days Student spent in the US were under a qualifying visa. Consequently, Student would be considered a US nonresident for tax purposes.
Question 3 – Is the exempt individual status mandatory?
Regulations under IRC 7701(b)(5) leave little room to avoid the status of exempt individual. Although professional athletes and individuals with a medical condition preventing them from leaving the US may potentially scuttle their exempt individual status by not timely filing form 8843, students are carved out of this eventuality. At any rate, the authorities retain the option of disregarding the failure to file form 8843 and enforce an exempt individual status.
It thus appears that Student has no choice but to file as nonresident.
Question 4 – Where is income sourced?
The sourcing of income from creating artworks is not explicitly considered in the code. That being said, we can extrapolate from international taxation cases a rough outline of how courts perceive such income. In Tobey v. Commissioner (1973) and subsequent rulings, the courts likened the creation of paintings to personal service income, reasoning that in all cases, it was income earned from the application of personal skills, and not a return on property.
A earlier ruling, Roerich v. Commissioner (1938), instead found that that the sale of paintings created in Asia but sold in the US gave rise to US income from the sale of personal property.
The works having been created and sold within the US, both lines of argument point toward a US situs for the US income.
Question 5 – Is there a deduction available to Student?
Tuition for technical training, as is generally any other business expense, would be available under IRC 162 to a taxpayer already engaged in a trade, as long as it represents an ordinary and necessary expense to further this trade. This would prevent a deduction for tuition for training required to merely meet the minimum requirements of a trade, including a new domain of activity pursued by the taxpayer.
Since Student had already established an enviable reputation as a painter before registering in the program of our concern, and that the program was reasonably considered an opportunity to maintain and improve on existing skills and knowledge, it would appear that the net amount of tuition ultimately paid would be available to offset the tuition reduction income assessed.
No tax or legal advice intended: The discussions regarding tax laws and regulations are for informational purposes only and should not and may not be taken as advice on any particular set of facts or circumstances. Contact your tax adviser for advice adapted to your personal circumstances.