What are the tax implications for foreigners living and working in the United States?
Residents and non residents are taxed differently in the United States. Foreigners should be aware that the definition of a “resident alien” under the Internal Revenue Code is not the same as the definition used for purposes of immigration. Section 7701(b) of the IRC defines a resident alien under two tests, known as the “green card test” and the “substantial presence test”. The green card test identifies a resident alien as an individual who is a permanent resident of the United States under immigration laws.
The substantial presence test identifies foreign individuals who spend substantial periods of time within the United States as resident aliens. This test is met if the foreign individual was present within the U.S. at least 31 days during the current year and 183 days during the 3 year period that includes the current year and the 2 preceding years, determined as follows:
- all days present in the current year
- 1/3 of the days present in the first preceding year
- 1/6 of the days present in the second preceding year
It is quite common for foreign individuals traveling to the United States for work or other purposes to be unaware of the substantial presence test. The only exemptions provided under the substantial presence test for the purpose of counting days of presence are individuals temporarily present in the U.S. on behalf of foreign governments, teachers and trainees under J or Q visas, students under F, J, M or Q visas, professional athletes competing in charitable sports events, and certain individuals with medical conditions.
Foreign individuals who travel frequently to the United States and do not file U.S. tax returns should be aware of the substantial presence test and be sure to keep track of their travel records. Individuals who travel to the United States on a regular basis frequently for professional or recreational purposes find themselves unwittingly falling within the definition of U.S. resident under the Tax Code.
Aliens deemed U.S. residents under the substantial presence test may still be treated as nonresidents by establishing a closer connection to a foreign country. The closer connection test is met if the individual is present in the U.S. for less than 183 days out of the year, maintains a tax home in a foreign country during the year, and can demonstrate a closer connection to that foreign country via the location of residence designated by the individual on forms and documents, permanent home, family, business activities, etc.
It is important to note that the closer connection test may only be met by filing a U.S. tax return and making a closer connection exception claim.
Source Rules: Income of Nonresident Aliens
U.S. residents are taxed on their worldwide income. This includes interest, dividends, wages or other compensation, royalties and rental income from both within and outside the United States. Nonresidents, however, are generally taxed only on U.S. source income. Income is generally considered U.S. source if the location of the activity or the sale of property for which the payment is being made is in the United States. This may include interest, dividends, rents and royalties, employment income, compensation for personal services and sale of real and personal property.
U.S. source rules for nonresident aliens can be complex. Heavily nuanced rules exist to address many issues involving the nature of the income-generating activity, the amount of time the nonresident alien has spent in the U.S. and the type of income received. These rules address numerous matters such as the sale of intellectual property, interest income, scholarships and grants, inventory and so forth. Nonresident individuals who work both within and outside the United States will need to prorate their compensation to figure out how much is U.S. source.
Foreign Persons: U.S. Trade or Business Income
When a foreign person engages in a U.S. trade or business, all U.S. source income connected with the activity of the trade or business is considered Effectively Connected Income (ECI). ECI is taxed at the same graduated rates applicable to U.S. citizens and resident aliens (or lesser rate if permitted by treaty). Deductions are permitted against ECI.
Foreign Persons: Nonbusiness U.S. Source Income
Most of the forms of U.S. source income received by foreign persons that are not ECI are subject to a flat withholding tax of 30 percent (or lower treaty rate). These types of income are referred to as Fixed, Determinable, Annual, or Periodical (FDAP) income and includes interest, dividends, rents, salaries, wages, fixed or determinable annual or periodical gains, profits and income. The obligation is imposed on the payor to withhold the tax in order so as to ensure its collection. Deductions are not permitted against FDAP income. If FDAP income is also classified as ECI in a given situation, however, it will be subject to the ECI rules explained above.
Certain types of investments such as the sale or exchange of capital assets or real property are subject to special rules
TL: What do foreign companies need to know when doing business in the United States, particularly in terms of taxation and other regulations?
KY: The income sourcing rules discussed above are extremely important for foreign companies to understand. Foreign companies should also be aware that the United States has a number of different taxing jurisdictions. Taxes are levied on the federal level as well as by states, counties, cities, towns and villages.
Foreign companies should also be aware of the various entity classifications in the United States. Foreign companies may register a branch office in the United States or a subsidiary company.
A branch is part of a company and not a separate legal entity in the United States. A foreign company may establish a U.S. branch. Choosing to open a U.S. branch requires careful consideration on both the state and federal level and an awareness of special tax considerations such as the Branch Profits Tax.
A subsidiary is a wholly separate legal entity owned by a foreign parent company and may be formed as one of several different types of entities. A corporation, for example, is a separate legal entity created under state law. Although basic laws governing corporations are similar, differences exist between states that may influence a foreign entity in choosing where to form and operate. Furthermore, a corporation that conducts business outside its state of incorporation may also be required to register to do business in other states. Registration generally subjects a corporation to taxation in that state.
A partnership is an association of two or more persons formed to carry on a business for profit as co-owners. A partnership is any type of unincorporated organization by which business is conducted and which is not a corporation, trust or estate. Each state has its own laws governing partnerships. Partnerships are generally subject to pass-through taxation. Each partner recognizes a proportionate share of profit and loss regardless of whether it is distributed to the partners. Partnership law can allow for flexibility in the allocation of profits and losses, as well as distributions, as long as it meets certain standards dictated by the IRS regulations.
The limited liability company (LLC) is a structure that provides limited liability for its owners (similar to a corporation) while maintaining a single level of tax (as in a partnership).
Each type of entity has its own benefits and drawbacks. Foreign businesses should consult carefully with an attorney in the United States who is familiar with both taxation and corporate law in order to form the optimal structure.
TL: What would be a good international tax planning strategy for European-based companies and/or families seeking to purchase commercial and residential units in the United States?
KY: It depends on the investor’s goals and priorities. Individual ownership or the use of an LLC generally provides the best income tax results as they allow for pass through taxation and the investor will enjoy the benefit of the long term capital gains rate. There are two issues here, however.
The first big drawback is that conduct of a real estate business through anything other than a corporation will not permit a foreign investor to maintain anonymity. Ownership individually or via a pass through entity such as an LLC or partnership requires the foreign investor to file a U.S. tax return.
The second problem is that a nonresident alien’s individual or pass through ownership of U.S. real property may subject the nonresident alien to a substantial U.S. estate tax on the equity value of the real property.
The drawback of corporate ownership is that the ordinary income rates and capital gain rates of a corporation are the same rate. Corporations are also taxed twice-first at the company level and subsequently on distributions to shareholders. Furthermore, payment of dividends by a corporation to its nonresident shareholder might be subject to an additional US withholding tax.
Various methods exist to create tax planning strategies for foreigners interested in purchasing U.S. real estate. Depending on the foreign investor’s needs, it may be advisable to own property outright; to establish one or multiple U.S. entities to own and manage real estate; to establish a foreign corporation to own a U.S. real estate holding company or U.S. property outright; and to even set up a trust to manage the foreign corporation. One important planning tool to keep in mind when developing a strategy is any tax treaty that may exist between the U.S. and the foreign investor’s home country. Such a tax treaty may prevent double taxation, reduce or eliminate the U.S. branch profits tax and reduce U.S. taxes on a foreign investor’s interest, dividends and business income earned from within the U.S.