Ten Key U.S. Tax Issues for Non-U.S. Citizens

1. The Migration of Individual Financial Plans
   
   

   Worldwide more and more individuals are utilizing the services of professional advisors to help plan for the accumulation, management and disposition of their personal wealth.  Where the business, family or investment interests of such individuals move beyond the borders of their home country, problems frequently arise, especially when exposed to the US.  Almost without exception, the “home-country” based financial planning of an individual cannot translate free of issues into the US tax and financial system.  Such home-country planning utilizes tax and investment strategies that are best suited to the individual’s home country needs and objectives based on local income and inheritance tax laws and employing investment vehicles that make sense in his or her home country.    Effective financial planning for the international client must consider the unique issues, dangers and opportunities presented when two or more tax and financial systems collide at the individual level.

2. Residency and Worldwide Taxation by the US
   
   

   The US taxes its citizens and residents on their worldwide income and transfers of assets regardless of where located.  The determination of residency status is different for income and transfer tax purposes.  The income tax rules provide objective standards for assessing residency status.  A foreign national becomes a US resident for income tax purposes if he or she holds a green card, satisfies a numerical day counting test known as the “substantial presence test” or, in certain limited circumstances, makes a special election to be taxed as a resident of the US.

   For US estate and gift tax purposes (herein referred to as, “transfer taxes”), residency is based on a subjective standard of domicile.  Under these rules, a foreign national is a US resident if he or she is present in the US with the intention of making the US his or her home and with no present intention of ever leaving.

   In certain circumstances, income and transfer tax residency in the US may be overridden through the application of a tax treaty.

3. Green Cards and the US Expatriation Taxes When Leaving the US
   
   

   A key consideration for a foreign national seeking to become a US lawful permanent resident or “green card holder” is the potential impact of the recently enacted exit tax.  While these rules have no impact at the time a green card is issued, they are a factor if at a later point in time a green card holder expects to leave the US indefinitely (e.g., retirement back to one’s home country) or for an extended period of time (e.g., taking a job outside of the US).

   The exit tax rules apply to “long-term residents” (“LTR”) who forfeit their green card, whether voluntarily or involuntarily, and satisfy one of three criteria.  Generally, a LTR is one who has held a green card during any part of 8 of the last 15 tax years.  The three criteria include:

   • The individual’s average annual net income tax looking back over the 5 tax years immediately preceding expatriation exceeds $147,000 (2011), indexed annually for inflation,
   • The individual’s worldwide net worth equals or exceeds $2,000,000,
   • The individual fails to file Form 8854 to certify compliance with federal tax laws for the preceding 5 years.

   Generally, those subject to the exit tax rules are taxed in the year of expatriation on the previously untaxed appreciation in their worldwide assets and on untaxed income, including pensions, deferred compensation, IRAs, and other tax deferred assets.

4. Nonresident (Non-domiciliary) Estate Tax—$60,000 Threshold to Taxation
   
   

   The top US estate tax rate for 2011 is 35%.  Under current law, effective January 1, 2013, the top US estate tax rate will be 55%.

   Generally, foreign citizens who either live abroad or live in the US but are not domiciled there are subject to US estate tax to the extent their US assets exceed $60,000.  US assets for this purpose include (but are not limited to) US real estate, personal property located in the US, interests in US qualified pension and 401(k) plans, benefits payable by US companies under nonqualified deferred compensation plans and stock option agreements, and investments in certain US securities such as stock issued by US publicly traded corporations.  For those who qualify, relief may be available from one of the few currently in force estate tax treaties. 

5. Non-US Citizen Spouse and Taxation of Marital Transfers
   
   

   For married US citizens, all of the assets of the first spouse to die can be left estate tax free to the surviving US citizen spouse, with a few exceptions.  Further, during lifetime one spouse can make unlimited gifts to the other and place property into joint name without fear of owing a gift tax.  But, where the surviving (estate tax) or donee (gift tax) spouse is not a US citizen, there is generally no unlimited marital deduction.

   For most gifts to a noncitizen spouse, there is an annual exclusion of $136,000 (2011), indexed annually for inflation.  For estate tax, there is no marital deduction.  Thus, a real liquidity crisis may result at the death of the first spouse, forcing the surviving spouse to liquidate assets to pay estate tax leaving the family with less to live on.  Fortunately, with proper planning a deferral of the estate tax is possible if assets are placed into a “qualified domestic trust.”  However, these trusts are expensive to maintain and, generally, only the income of the trust can be used by the survivor without exposure to estate tax.  A distribution of the assets placed into the trust by the decedent’s estate likely will incur an estate tax. 

   Practically, where the survivor is the non-working spouse living in the US, he or she is likely to return to his or her home country and the family support network.  In such cases, leaving assets in a US trust becomes more burdensome.  As an alternative, life insurance is often used to provide the needed liquidity to pay any estate taxes due.

6. Foreign Trusts: Adverse Income Taxation, Severe Penalties, Burdensome Compliance
   
   

   The US has a very complex set of income tax and reporting rules applicable to foreign trusts and to US trusts that become foreign trusts.  The potential penalties and income tax ramifications can be significant.  Individuals must understand how and when they are exposed.
   
   Some of the potential tax implications include:

   • Taxation of built in gains on property contributed to a foreign trust,
   • Taxation of built in gains on trust property to the grantor of the trust upon the termination of US income tax residency of either the grantor or the US beneficiaries,
   • Taxation of US beneficiaries on distributions of income accumulated in the trust including compound interest charges on the value of tax deferrals and taxation of accumulated capital gains of the trust to the beneficiaries at ordinary income tax rates,
   • Taxation of the grantor of the trust on all trust income even where the grantor has no beneficial interest in trust property and is unable to receive a distribution from the trust to pay the associated tax.

   There are multiple tax and information return filing requirements for foreign trusts, grantors and beneficiaries.  Failure to comply may result in penalties ranging from 5% of the value of trust assets to 35% of the value of contributions to or distributions from the trust, including contributions deemed to occur under the tax regulations.

   Special note for inbound gifts and inheritances.  A US citizen or resident who receives a gift or inheritance from a nonresident alien, foreign trust or estate must report the receipt on a timely filed Form 3520, or risk a penalty of up to 25% of the value of the gift or inheritance.  For gifts from a foreign corporation or partnership, the threshold for reporting is $14,375 (2011), indexed annually for inflation.

7. Foreign Investment Portfolios
   
   

   Typically, foreign citizens who become US residents are subject to US taxation on their investment income, regardless of source, including interest, dividends and capital gains.  Even investments that are favorably taxed or not taxed at all abroad are likely subject to US taxation.  Even worse, certain investments in the foreign equivalent of a US mutual fund are exposed to taxation at ordinary income tax rates.  Further, burdensome compliance rules apply to what are referred to as “passive foreign investment companies.”

   Individuals exposing their investments to US taxation may successfully reduce the US taxation of their portfolios by restructuring their investments into asset classes that are subject to more favorable US taxation.  Advance planning is critical to limit the issues and increase the value of available opportunities.

8. Life Insurance
   
   

   For US citizens and residents, life insurance offers protection to family members and heirs from the loss of income and the financial burdens of the US estate tax.  The benefits paid under a typical life insurance policy to beneficiaries are free of income taxes.   Additionally, the growth in the cash surrender value of a whole life insurance policy, generally, is tax deferred and amounts can be borrowed from the cash surrender value of a policy without incurring current income taxes.  These benefits are only available where the life insurance policy satisfies the technical definition of life insurance under US tax rules. 

   Foreign nationals moving to the US often hold an interest in a non-US life insurance policy.  It is quite possible that such policies are not fully compliant with US law resulting in potentially significant US tax exposures.  The policies of arriving foreign nationals should be reviewed to determine the extent of any exposure to US taxation.

   US compliant annuity contracts allow a tax deferred accumulation of investment capital.  Annuities issued by foreign insurance companies may not satisfy US rules and may not provide the desired tax benefits.  As with foreign life insurance, these contracts should be reviewed to determine compliance with US law.

9. US Real Estate
   
   

   An investment in US real estate presents both income and transfer tax issues.  Generally, foreign citizens are exposed to income taxation and withholding on any income generated by US real estate and gains from the sale thereof.  A complex set of US tax rules were enacted as a part of the Foreign Investment in Real Property Tax Act (“FIRPTA”) in 1980.

   The transfer of an interest in US real property, generally, is taxable as a gift if while living, or to a decedent’s estate if at death.  Any transfer of a present or future interest in US real estate should be carefully planned to limit exposure to US transfer taxes.

   In order to limit their exposure to US transfer taxes, many informed US nonresidents hold their US real estate investments in a foreign corporation.  Properly structured and maintained, this approach may reduce the exposure to transfer taxes.  However, where such individuals later move to the US and become a US resident, multiple tax issues and reporting requirements may arise and the penalties for failure to comply with the law may be significant.

   The estate of a foreign citizen who at death was not domiciled in the US (even if living in the US as an income tax resident at the time of death) may not be able to offset the amount of an associated mortgage debt against the value of US real estate in computing the taxable estate.  While a partial deduction may be available, a significant US estate tax may result from owning leveraged real estate.  A full deduction may be available under the estate tax treaties with several countries.

10. Inbound Employee Benefits
    
    

    Foreign nationals moving to the US to work often continue to participate in pension and other benefit arrangements (e.g., stock options, deferred compensation, restricted stock) sponsored by the foreign “home country” employer.  Under US tax rules often the benefits earned and accruing under these plans are exposed to US taxation.  This may be true even where a similarly structured US based plan is not exposed to current taxation.  In light of the significant value of some of these benefit arrangements, careful planning in advance of any exposure to US taxation is recommended.  While some relief is available under some US tax treaties, the relief is often subject to specific dollar limitations and conditions. 

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    This discussion is based on authorities that are subject to change without notice.

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    Circular 230 Disclosure.  As required by the rules governing practice before the US Internal Revenue Service the following disclosure is made:

    Any U.S. federal tax advice included in this memorandum, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding US federal tax-related penalties or (ii) promoting, marketing or recommending to another party any tax-related matter addressed herein.