Navigating the U.S. Tax Landscape: A Guide for Foreigners Moving to America
Relocating to the United States can bring about a multitude of new experiences, but it also carries its share of legal obligations. Among these, understanding the U.S. tax system can seem like an intimidating task. This article delves into key elements of the U.S. tax structure: worldwide income taxation, the concept of tax residency, the dilemma of double taxation, the requirement of foreign assets reporting, and the intricacies of estate and gift tax rules.
Worldwide Income Taxation: A Core Principle of the U.S. Tax System
The United States operates on a system of worldwide income taxation. Unlike a territorial system, which only taxes income earned within the country's borders, the U.S. system taxes U.S. citizens and residents on their global income, regardless of where it is earned (IRC §61). Consequently, foreigners who become U.S. residents for tax purposes may find themselves liable for U.S. taxes on their worldwide income.
Residency for Tax Purposes: The Substantial Presence Test
One of the often-misunderstood aspects of the U.S. tax system is the determination of residency for tax purposes. In the U.S., this is governed by the Substantial Presence Test, as defined by IRC §7701(b)(3). According to this test, an individual is considered a U.S. resident for tax purposes if they meet the following criteria:
1. They must be present in the U.S. for at least 31 days during the current year.
2. They must be present in the U.S. for an aggregate of 183 days during a three-year period that includes the current year and the two preceding years. Days of presence are calculated as all the days present in the current year, one-third of the days in the first preceding year, and one-sixth of the days in the second preceding year.
There are exceptions to the Substantial Presence Test. For instance, days on which the individual falls under exempt categories such as a foreign diplomat, teacher, student, or professional athlete temporarily in the U.S. for a charitable event, are not counted towards the test.
The Dilemma of Double Taxation and The Role of Tax Treaties
Double taxation - the possibility of being taxed on the same income in both the U.S. and one's home country - is a major concern for foreigners in the U.S. To alleviate this issue, the U.S. has established tax treaties with numerous countries, which provide guidelines on where taxes should be paid.
Tax treaties primarily aim to prevent double taxation and tax evasion. They define the taxing rights between countries on different types of income, often providing for reduced rates or exemptions from tax for certain types of income (IRC §894(a)).
The details vary from treaty to treaty, but generally, they follow the Model Tax Convention of the Organization for Economic Co-operation and Development (OECD). The U.S. has its model known as the U.S. Model Income Tax Convention. Provisions generally cover categories of income such as business profits, personal service income, passive income, government payments, and pension income.
While these treaties provide relief from double taxation, they also contain anti-abuse provisions to prevent tax evasion. An example of such provision is the Limitation on Benefits (LoB) clause, which ensures treaty benefits are only available to bona fide residents of the contracting states.
The U.S. also provides unilateral relief from double taxation through mechanisms like the Foreign Tax Credit (IRC §901) and the Foreign Earned Income Exclusion (IRC §911). These mechanisms allow U.S. taxpayers to offset taxes paid to foreign countries against their U.S. tax liabilities or exclude a certain amount of foreign-earned income from U.S. taxation.
The specific provisions of each treaty can vary, but they typically cover the following categories of income:
1. Business Profits: The treaties usually stipulate that business profits are taxable in the country where the business is located unless the business operates in the other country through a permanent establishment like an office or a factory.
2. Personal Service Income: Income from personal services (like wages and self-employment income) is typically taxable in the country where the services are performed.
3. Passive Income: Investment income such as dividends, interest, and royalties are often taxable in the country where the recipient resides, although there may be a reduced tax rate in the source country.
4. Government Payments: Payments made by a government to a citizen of that country may only be taxed by that country.
5. Pension Income: Pensions and other retirement benefits are typically taxed in the country of residence.
Additionally, the U.S. provides two methods to alleviate double taxation for its taxpayers - the Foreign Tax Credit and the Foreign Earned Income Exclusion.
The United States tax system provides certain measures to mitigate the effects of double taxation on its taxpayers. These include the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE), both of which can be claimed by U.S. taxpayers on their annual federal tax returns.
1. Foreign Tax Credit (FTC): The Foreign Tax Credit, as outlined in IRC §901, is a non-refundable tax credit for income taxes paid to a foreign country as a result of foreign income tax withholdings. The FTC directly reduces the tax liability on foreign-sourced income dollar for dollar. This credit is particularly beneficial for individuals who reside in the U.S. but work in a foreign country and are therefore subject to tax in both jurisdictions.
The FTC can be complex to calculate, particularly when the taxpayer has income from multiple foreign sources, each with different tax rates. In these cases, the taxpayer must calculate the FTC separately for each source of income. If the total foreign tax paid is more than the U.S. tax liability on the foreign income, you may be able to carry forward or carry back the unused part of the FTC.
2. Foreign Earned Income Exclusion (FEIE): The Foreign Earned Income Exclusion, as detailed in IRC §911, allows U.S. taxpayers living and working abroad to exclude a certain amount of their foreign-earned income from their U.S. federal income taxes. As of my knowledge cutoff in September 2021, the maximum exclusion amount was $107,600 for the 2020 tax year, but this figure is adjusted annually for inflation.
To qualify for the FEIE, a taxpayer must meet two criteria. They must have foreign-earned income, and they must meet either the Bona Fide Residence Test (showing they've been a resident of a foreign country for an entire tax year) or the Physical Presence Test (showing they've been physically present in a foreign country for at least 330 full days during a consecutive 12-month period).
It's important to note that even if a taxpayer elects to exclude foreign earnings under FEIE, they must still file a U.S. tax return. Additionally, the FEIE doesn't exclude the income from self-employment tax, so individuals who are self-employed may still owe U.S. Social Security and Medicare taxes on their earnings.
Both the Foreign Tax Credit and the Foreign Earned Income Exclusion are elective and come with certain trade-offs and limitations, so taxpayers should carefully consider their individual tax situations and potentially seek advice from tax professionals when deciding whether and how to claim these benefits.
Passive Income and the U.S. Tax System
Passive income is relevant to the taxation of newly arrived foreigners in the United States as it can significantly impact their overall U.S. tax liability. Passive income refers to earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved. Examples of passive income include interest, dividends, royalties, rent, and gains on the sale of property. Passive income for tax purposes is generally categorized as either "Fixed, Determinable, Annual, or Periodical" (FDAP) income or "Effectively Connected Income" (ECI).
1. Taxation Based on Source of Income and Residency Status
In the U.S., the source of income and an individual's tax residency status are crucial determinants of how income is taxed. As a general rule:
U.S. citizens and resident aliens (those who pass the Green Card test or the Substantial Presence Test) are subject to U.S. taxation on their worldwide income, including passive income from foreign and domestic sources.
Nonresident aliens are typically taxed only on U.S.-sourced income, which can include passive income originating from the U.S.
2. Withholding Tax on U.S.-Sourced Passive Income
Passive income of nonresident aliens from U.S. sources, such as interest, dividends, annuities, and certain types of rents and royalties, is usually subject to a flat 30% withholding tax (unless a lower treaty rate applies). This withholding tax is typically deducted at the source by the payer.
3. Impact of Tax Treaties
Tax treaties between the U.S. and other countries can affect how passive income is taxed. These treaties often provide for reduced tax rates or exemptions on certain types of passive income. For example, the treaty might reduce the rate of withholding tax on interest or dividends paid to residents of the treaty country.
4. Reporting Passive Income
Foreigners with passive income from foreign financial accounts may have additional reporting requirements under the Foreign Bank Account Report (FBAR) and the Foreign Account Tax Compliance Act (FATCA). Both FBAR and FATCA aim to combat tax evasion by U.S. taxpayers hiding money in offshore accounts.
· Fixed, Determinable, Annual, or Periodical (FDAP) Income: FDAP income is passive income such as interest, dividends, royalties or rents that are paid periodically. Nonresident aliens are subject to a 30% tax on U.S. source FDAP income (IRC §871(a)(1)(A)). However, this rate may be reduced under a tax treaty between the U.S. and the foreign person's country of residence.
· Effectively Connected Income (ECI): If the foreign person's passive income is "effectively connected" with a U.S. trade or business, it is taxed at graduated rates just like a U.S. person's income (IRC §871(b)(1)). This means the income, after allowable deductions, is taxed at rates ranging from 10% to 37%, depending on the amount of taxable income. The determination of whether passive income is "effectively connected" with a U.S. trade or business is a complex issue and often requires professional advice.
Let's take an example: if a resident of Canada (a country with which the U.S. has a tax treaty) receives dividend income from a U.S. corporation, the default 30% FDAP withholding tax can be reduced to 15% under the U.S.-Canada tax treaty.
It's also worth mentioning that nonresident aliens are generally not subject to U.S. tax on capital gains unless the gains are effectively connected with a U.S. trade or business, or the nonresident alien is present in the U.S. for 183 days or more during the tax year (IRC §871(a)(2)).
Tax Reporting Obligations: Foreign Assets and Accounts
The U.S. mandates residents to report foreign financial assets if they exceed specified thresholds. This includes foreign bank accounts, which must be reported through the Report of Foreign Bank and Financial Accounts (FBAR) as per the Bank Secrecy Act (BSA).
The Foreign Account Tax Compliance Act (FATCA), enacted in 2010, imposes a requirement for U.S. taxpayers who hold certain foreign financial assets with an aggregate value exceeding $50,000 to report information about those assets on Form 8938, which must be attached to the taxpayer's annual income tax return.
U.S. Estate and Gift Taxes
Foreigners moving to the U.S. should also be aware of U.S. estate and gift tax rules. These rules can affect foreigners differently based on their classification as resident or non-resident aliens. Under IRC §2101, a non-resident alien's estate is subject to U.S. estate tax on U.S.-situs assets. Resident aliens, on the other hand, are subject to U.S. estate and gift taxes on their worldwide assets, similar to U.S. citizens (IRC §2001, 2010, and 2501).
Case Law and Statutes
Understanding the U.S. tax system often involves a deep dive into the extensive body of tax law. Notable court cases have clarified certain issues related to the taxation of foreigners in the U.S.
1. Cook v. Tait (265 U.S. 47, 1924): This U.S. Supreme Court case upheld the constitutionality of taxing U.S. citizens' worldwide income, setting the precedent for the worldwide taxation system.
2. Piedras Negras Broadcasting Co. v. Commissioner (43 B.T.A. 297, 1941): This case highlighted the role of source rules in the taxation of income and set the precedent for the taxation of business income in the U.S.
3. Commissioner v. Gaston Estate (1987): In this case, the Supreme Court held that the step-up in basis rules applied to non-resident aliens who owned U.S. real property, clarifying the law in a significant area of non-resident alien estate taxation.
Key statutes in the U.S. tax code (IRC) include:
1. IRC §61, which defines gross income as income from whatever source derived, establishing the principle of worldwide taxation.
2. IRC §7701(b), which defines the rules for who is considered a U.S. resident for tax purposes.
3. IRC §901 and §911, which provide relief from double taxation through the Foreign Tax Credit and the Foreign Earned Income Exclusion, respectively.
4. IRC §894(a), which codifies the role of tax treaties in U.S. tax law.
Understanding U.S. tax obligations can be a daunting task, especially for foreigners moving to the U.S. However, by familiarizing oneself with concepts like the Substantial Presence Test, double taxation, and taxation of passive income, you can be better prepared to navigate the U.S. tax system. The U.S. tax system is complex and multifaceted. For individuals unfamiliar with the system, understanding the intricacies can be challenging. Therefore, consulting with tax professionals or attorneys well-versed in U.S. tax laws is highly recommended. The team of legal professionals at VAdam Law is dedicated to offering customized counsel tailored to your unique circumstances to ensure adherence to all regulatory obligations, and clear and comprehensive advise.
If you would like to learn more about VAdam Law and schedule a free consultation, visit our online scheduling portal or call 24 hours a day at (954) 451-0792.