The U.S. tax system is very complicated. Everything is interrelated. It's like playing a game of chess.
Without a strategy or plan the U.S. tax system can bury you in compliance, taxes and substantial penalties. Foreign non-residents with U.S. investments, or foreigners who spend too much time in the U.S. can easily fall into the U.S. tax trap. The information provided below will give non-resident aliens and non-permanent resident aliens practical areas of consideration in regards to U.S. taxation.
- How you structure U.S. investments is critical to minimize U.S. tax exposure and liability!
- Watching the amount of time spent in the U.S. is critical!
Resident Alien VS Non-Resident Alien (NRA): What is the Definition?
According to U.S. tax rules, a non-resident alien is a person who does not have U.S. citizenship by birth or naturalization and does not have U.S. permanent resident status (a U.S. “Green Card”).
- If you have a U.S. passport you are not an NRA for U.S. tax purposes but rather a U.S. resident –regardless if you reside outside the U.S.
- You can be considered a U.S. resident by spending too much time in the U.S.
A person who spends more than 183 days during a calendar year or has spent more than an average of 121 days a year for three consecutive years in the U.S. is treated as a U.S. income tax resident. This is known as the “substantial presence test”.
One must be very careful about how many days they are present on U.S. soil in a given year. A day of presence counts regardless of the amount of time spent during a day in the U.S., unless is strictly a stopping point to your final destination outside the U.S. If your final destination is somewhere other than the U.S. or its territories but you decide to stay for a short visit before continuing on, those days will count towards the 183 or 121 days in the U.S. So, if you come through the U.S. often only to continue to a destination outside the U.S., make sure you keep track of your days or else you could find yourself inadvertently being treated as a U.S. income tax resident.
- You should also know that if you come to the U.S. for medical treatment and spend too much time in the U.S. you will be deemed to be a U.S. income tax resident even though that was not your intention.
U.S. tax residents are subject to taxation and reporting on their worldwide income and assets regardless if they reside in the U.S. or abroad. This also includes the possibility of taxation of distributions received from trusts (domestic and foreign) and or civil law wealth transfer structures such as stiftungs (civil law foundations), usufructs and similar structures which are generally treated as foreign trusts for U.S. tax purposes.
Of course, the U.S. has exceptions. The U.S. and some of the U.S. income tax treaties provide for what is commonly referred to as a closer connection test.
- If you can meet the closer connection test you may be able to argue you are not a U.S. income tax resident.
In order to make such claim you will need to file a U.S. tax form and this form will be subject to audit by the U.S. federal tax authorities (AKA the Internal Revenue Service) for three years after it has been filed.
It should be noted that the individual States of the U.S. have similar income tax resident rules and they are not required, as ruled by the U.S. Supreme Court, to abide by the rules of Income Tax Treaties the U.S. has with other countries.
- This means that though a person may be able to make a successful claim of NRA status at the federal tax level, it does not mean said person won’t be treated as a tax resident of a particular U.S. State!
Exceptions to the Rules: Non-Resident Alien Tax Exemptions
There are some exceptions to the residency test rules. Students and teachers, including any family members, who have entered the U.S. under a student, teacher or trainee visa are exempt from the substantial presence test with some limitations.
There are special limitations for students. Students are only allowed exemption from the U.S. substantial presence test for five calendar years. A calendar year is January to December. The first calendar year begins upon the arrival of the student even if that date is after January. This will mean that most students will not have five full years of exemption. At the end of the fifth calendar year, if the student continues to stay in the U.S. their days in the U.S. will count towards the residency test. It should also be noted that under the U.S. Treasury Regulations, a student must be enrolled in a full-time educational program accredited by the U.S. Department of Education.
Some other exceptions are Athletes. Athletes can be exempt if they enter the U.S. to play in a charitable event.
What is U.S. Source Income?
Before we can discuss some of the structures for U.S. tax planning, you need to know about certain rules that were enacted by the U.S. congress and are enforced by the IRS. Unlike other countries, the U.S. tax authorities can’t make laws. They are only enforcers of the law. Nevertheless, it’s good to understand what the IRS considers to be U.S.-based/sourced income, because it can be a difficult situation if you are in disagreement with their legal definitions.
There are several general types of U.S.-source income:
- Capital gains: While capital gains are generally excluded from U.S. tax for non-resident aliens, the net gains from sales of U.S. real property not exempt.
- Dividends from U.S. companies: Dividends are subject to 30 percent withholding.
- Interest from bank accounts: Generally treated as portfolio interest, interest from bank accounts is excluded from U.S. income tax for NRAs.
- Interest from bonds or debt obligations: With some limited exceptions, these gains are generally covered under the portfolio exception and not subject to tax.
- Capital gains from real estate sales: As noted above these gains are subject to tax under FIRPTA rules.
- Rental income: If income is generated from U.S. real estate, that income is subject to a 30 percent withholding.
- Mutual funds: Exclusions on mutual fund income expired in 2013—though long-term capital gain distributions are excluded.
- FDAP: Income that is considered “Fixed, Determinable, Annual or Periodical,” (FDAP) generally consists of passive investment income. However, in theory, it could consist of almost any sort of income. FDAP income is taxed at a flat 30 percent (or lower treaty rate, if applicable) and no deductions are allowed against such income. Note: FDAP also includes U.S. capital gains which are generally exempt from taxation by NRA.
- ECI: Income that the law deems Effectively Connected (ECI), meaning income that is connected to a trade or business in the United States. What qualifies as ECI? Generally, income derived from a taxpayer’s engagement in a U.S. trade or business when they perform personal services in the United States.
Financial Planning Techniques and Tax Strategies for Non-Resident Aliens
In general, the purpose of being strategic in your tax planning is to reduce tax. NRAs who may end up categorized as a U.S. tax resident whether unintentionally or intentionally, should proactively consider speaking with a professional U.S. tax advisor about how to structure their financial affairs and arrangements for U.S. tax purposes.
The following are a few strategies for your consideration, with the caveat that these strategies must also be reviewed by your home country tax advisor. This ensures such plans will not cause any undue tax bills at home.
U.S. tax as well as home country tax implications must be considered to ensure a global tax minimization strategy and maintain primary financial planning objectives.
IWTA suggests clients review the following strategies along with home country implications and objectives, in context of being either a permanent U.S. tax resident or a temporary U.S. tax resident:
- Recognize gains: To reduce the potential U.S. tax burden before immigration, many NRAs may want to sell or transfer assets to family members. This is done to step up basis, which an NRA can do by offloading assets for their full value.
- Accelerate income: As an NRA, non-U.S. income is not subject to taxation prior to moving to the U.S. As a result, many NRAs will accelerate deferred income prior to residency. This might, for instance, include recognizing income from assets with significant deferred income before residency. There are many ways to go about accelerating income, and a tax advisor can advise you appropriately.
- Defer losses: Another tactic is to defer assets that have significantly declined in value. After residency, these losses can be used to offset some income and capital gains.
- Transfer to foreign trust: As we’ve established, there are significant regulations affecting foreign trusts. But for many NRAs, transferring assets to a foreign trust prior to residency (domicile) is an important way to reduce significant gift and estate tax. Taxpayers may also want to add a U.S. domestic trust for pre-immigration planning and for the U.S. beneficiaries of the children of NRAs.
The bottom line? There are a lot of steps to consider before establishing U.S. residency—intentionally or unintentionally, and many tactics that can be considered.
New Regulations on Foreign-Owned U.S. LLCs (Non-Resident Alien LLC Tax)
NRAs should be aware of new rules governing the reporting of foreign-owned U.S. limited liability companies (LLCs).
What’s New: As of December 2016, the Treasury Department and IRS mandated that foreign-owned LLCs must annually file Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.
What it Does: Form 5472 collects a lot of different information, including a client LLC’s total assets, the direct and indirect 25 percent foreign owners of the entity, and any related party transactions (which are defined very broadly). In addition to Form 5472, you must also follow the record maintenance requirements of IRS Code Section 6038A that covers party transactions.
What’s at Risk: Failure to file Form 5472 in a timely fashion can result in significant penalties, including a $10,000 penalty for each violation—meaning it can quickly escalate.
Navigating Real Estate Tax Structures for Non-Resident Aliens
Keeping all the previous information in mind, when it comes to tax structures, there are three very basic structures NRAs should know before investing in U.S. real estate.
These three structures are designed to help non-resident aliens minimize their income, capital gains, and non-resident alien estate tax burdens. However, before considering any of these, NRAs should ensure the investment is large enough to warrant both the cost and the complexity.
- Individual Ownership or Pass-Through Entity: This is the best structure for income tax purposes but not estate tax purposes. It results in having to file a U.S. tax return and will likely subject taxpayers to estate taxes on their real property.
- Foreign Corporate Ownership: If an NRA is investing in passive real estate and their goal is to avoid estate taxes, they can use a single foreign corporation to own real estate (and remain anonymous). The new GILTI and FDII provisions of the recent tax law changes will be important to consider here. Note: In the end, capital gains from the sale of property may be much higher if a taxpayer’s holding is structured as a foreign corporate ownership. But, if there is no annual income from passive real estate, taxpayers can avoid the branch profits tax, which the U.S. tax law defines as a “provision under IRC Section 884(a) [that] treats a U.S. branch of a foreign corporation as if it were a U.S. subsidiary of a foreign corporation for purposes of taxing profit repatriations.” So, be mindful.
- Real Estate Holding Companies: By forming a real estate holding company, an NRA can avoid the branch tax and the estate tax. But it’s also the most complex and costly method to set up. If you are heavily involved in the active real estate business (i.e. you have income from properties and developments) this may be the route for you. NRAs that go this route must form a holding company, and that company is considered the owner of a domestic corporation. Technically, they don’t own the property; the corporation does. Since the direct investor will now be a domestic corporation, you or your client no longer need to pay the branch tax—and, since the NRA only owns shares in the foreign corporation, there is no need to pay estate taxes.
Got all that? It’s a lot to take in and it’s OK to feel confused. Cross-border tax planning is complex! There are many aspects to consider. Among the many conditions clients and/or their advisors need to understand are:
- A taxpayer’s tax status
- The distinction between ECI and FDAP income sources
- Pre-immigration planning for income tax
- Estate/gift taxes, and issues related thereto
- Real estate investment planning
- Aspects of general tax planning structures unique to nonresident alien tax planning
We hope this information has been useful. For a more in-depth analysis and strategy for entering or exiting the U.S. tax system, contact IWTA’s founder, Jack Brister.
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