U.S. Tax & Legal Consequences for Foreign Investors and Potential Residents
- The cost of doing business, investing or spending significant time in the U.S. is being subject to some level of taxation and other legal obligations
- The tax law is extremely complex and everyone’s situation is different
- Advance legal planning can avoid legal exposure and reduce the amount of tax that must be paid
- The following is a brief outline of some of the issues foreigners can expect to discuss as they prepare their own plan
- Foreigners Who Are Not Tax Residents
- Consequences of Tax residency
- Planning For (and Against) Tax Residency
- Planning Methodology
- Some Critical Non-Tax Legal Issues
- Common Pitfalls
Foreigners Who Are Not Tax Residents
- Only taxed on income defined in the tax law coming from a “U.S. Source”; not on income that is considered “Foreign Source”
- However, some U.S. Source income is still exempt from tax (e.g. capital gains on the sale of U.S. stock, certain loans to U.S. person, etc.)
- U.S. Source income is usually taxed at a flat 30% rate without taking any deductions, unless reduced by a treaty
- The person paying the foreigner is normally required to withhold the tax
- Sometimes deductions are allowed when the U.S. Source income relates to certain business activities
Income Taxation of Tax Residents
- Taxed on worldwide income, both U.S. Source and Foreign Source
- A Tax Resident’s taxable Foreign Source income can include, for example:
- dividends and interest generated by non-U.S. investments
- gains from the sale of foreign real estate or businesses
- commissions or fees earned for the performance of personal services outside the U.S.
- gains from the exchange of foreign currency, etc.
- A “Foreign Tax Credit” can usually be taken for the amount of income tax on the same income that was actually paid to another country
Tax Residents Must Also Report Information Regarding:
- Foreign bank and financial accounts in which they have a direct or indirect financial interest or signature authority;
- Foreign financial assets;
- Direct and indirect ownership in and economic activity of, certain foreign companies and partnerships;
- Transfers to and from certain foreign trusts;
- Receipt of gifts and inheritances from foreigners; and
- Virtually anything else that a U.S. citizen must report.
The Inbound Journey
- Passive Investment/Vacation
- Opening business/ relocating family
- Securing long-term visa/ permanent status
- Preparing for long-term U.S. residency
- Discontinuing social and economic ties to home country
- The decisions you make regarding when and how you take these steps will have tax and legal consequences
At what point along the inbound journey do you become a Tax Resident ?
- It could happen before or after obtaining permanent residence.
- It could happen at different times for purposes of income tax than for purposes of estate and gift taxes.
- This presentation focuses on income taxes.
Who is a Tax Resident?
- U.S. Citizens and Permanent residents (i.e. “green card” holders), even if they have another nationality or have never been to U.S., unless qualified to elect non residency pursuant to a tax treaty
- Persons with a “substantial presence” in the U.S., unless qualified to elect non residency pursuant to the “closer connection” exception or pursuant to a tax treaty
- Note: Tax Residency does NOT depend on immigration status, although that is relevant
What is Substantial Presence?
- The Substantial Presence Test is one measure of Tax Residency for Income Tax purposes (not used for Estate & Gift tax purposes)
- Basic formula counts all days present in the U.S. in the current year, one-third of the days present during the prior year and one-sixth of the days present the year before that
- Some days are excluded from the calculation, for example
- Days present in the U.S. holding some visas
- Days present in the U.S. while unable to leave due to a medical condition
- Other exceptions
- A foreigner has a substantial presence in the U.S. if the three year formula yields 183 days or more without counting the days subject to any of the exceptions.
Closer Connection Exception to Substantial Presence
- Allows a foreigner to avoid being treated as a Tax Resident, even if they meet the substantial presence test
- Must be present less than 183 days in any one year, after subtracting days present subject to any exception
- Must file a statement with the IRS to claim this exception
- The foreigner’s personal circumstances must meet the legal criteria to prove a “closer connection” to another country
Treaty Exception to Substantial Presence or Permanent Residence
- Allows a foreigner to avoid being treated as a Tax Resident
- Can be present in the U.S. any number of days
- Foreigner must have a “tax home” in a country that has a treaty with the U.S.
- Only western hemisphere treaty countries are Canada, Mexico, & Venezuela
- The foreigner’s personal circumstances must meet the legal criteria set forth in the treaty
- Must file a U.S. tax return and report all worldwide income, but not required to pay tax on Foreign Source income
Planning Methodology Regarding Establishment of Tax Residency
- First, determine if Tax Residency has already been established under the general formula
- Review the personal circumstances to determine whether any days present in the U.S. can be excluded from the computation under one of the various exceptions
- If necessary, review whether the facts and circumstances support an election under the Closer Connection exception or a tax treaty, if available
- If Tax Residency has been irrevocably established, what tax returns and reports are required and have they been filed?
- If there is non-compliance determine how to comply with minimal taxes, civil penalties, and criminal exposure
Estate & Gift Tax Residency is Measured Differently
- A completely different set of rules determines when a foreigner becomes a Tax Resident for purposes of the Estate & Gift Tax (“Transfer Taxes”).
- The consequences are that transfers of their worldwide assets become taxable both during life and upon death.
- Pre immigration Transfer Tax planning can reduce or eliminate a multinational family’s current and future transfer taxation for generations.
Critical, Related, Non-Tax, Legal Issues
A good tax lawyer will understand that tax planning does not occur in a vacuum and be capable of multidimensional legal analyses, including:
- Planning for the possibility of death and incapacity while residing in the U.S.
- Minimizing personal liability for U.S. business or investment activity
- Protecting U.S. assets from unforeseen personal legal judgments
- Structuring U.S. business entities and legal agreements with third parties to provide maximum legal advantage
- Working effectively with your U.S. accountant and investment advisor