Introduction
As the world becomes increasingly “global,” so too does the practice of tax law. In California, Florida, and other states, clients of tax advisors are often families from outside the United States that seek to take advantage of investment opportunities and a higher living standard in the United States. While the United States may provide a number of opportunities for non-United States citizens, in order to take advantage of these opportunities, many non-United States citizens become residents of the United States. Once these individuals establish residency in the United States, they may face a host of complicated tax issues. To non-U.S. citizens, these U.S. tax issues may be foreign in every sense of the word. This is because domestic tax law has notable distinctions from taxing systems around the world and many non-U.S. citizens find these distinctions surprisingly complex. Many non-U.S. citizens are surprised to learn that upon becoming residents of the United States, they are not only subject to U.S. tax on their worldwide income, but are also faced with the consequences U.S. tax law that discourages individuals from holding offshore assets. Consequently, non-U.S. citizens and their tax advisors must tread carefully to avoid a number of tax traps built into the Internal Revenue Code and its regulations.
Tax Trap Number 1- Consequence of Taxation on Worldwide Income
The most significant tax trap facing non-U.S. citizens is the imposition of U.S. tax on their worldwide income and assets. For unsuspecting non-U.S. citizens, the imposition of worldwide U.S. taxation can present serious unanticipated tax results. For example, the sale of a non-U.S. citizen’s residence outside the United States can trigger a large income tax liability or a gift of a stock in a non-U.S. Corporation can result in a hefty U.S. gift tax liability. Below, we will discuss the different types of taxation on worldwide income.
Taxation
The United States taxes U.S. persons on their worldwide income. See IRC Section 61. U.S. persons include U.S. citizens, resident alien individuals, and domestic corporations (i.e., corporations organized under U.S. law). An alien is considered a U.S. resident if he or she meets either the green card test (i.e., lawful permanent immigrant status) or the substantial presence test. IRC Section 7701(b). As discussed above, many non-United States citizens are surprised to learn that they are subject to United States taxation on their worldwide income. Not only are many non-United States citizens surprised to learn that they are subject to taxation on their worldwide income, many are surprised to learn the complexities of worldwide taxation.
Transfer Taxation
Similar to income taxation, the transfer tax regime applies to the worldwide assets of a non-U.S. citizen. Transfer tax encompasses both estate and gift taxes. The amount of estate or gift taxes a non-U.S. citizen could be subject to is based on a number of factors, including but not limited to the residency of the individual. The test for determining residency for transfer tax purposes is not nearly as clear cut as in the case of income tax. For transfer tax purposes, the test is based on “domicile” in the U.S. rather than on an individual’s days in the U.S. or status as a green card holder. An individual “acquires domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom.” See Treas. Reg. Sections 20.0-1(b)(2) and 25.2501-1(b). There is no hard and fast rule for evaluating whether an individual has formed such intent. Prominent considerations include where the individual maintains residences, the amount of time spent at such residences, the value of such residences, the domicile of the individual’s friends and family, where the individual maintains social, professional, and religious affiliations, and the location of investments and business interests.
With proper planning, non-U.S. citizens in the U.S. can often avoid U.S. estate and gift taxes. With that said, due to the inherently nebulous concept of domicile for U.S. estate and gift tax purposes, more than one jurisdiction may claim that such individual or estate was subject to its transfer taxes based upon its own laws. For these reasons, the U.S. has entered into a series of bilateral estate and gift tax treaties. In certain cases, these treaties may minimize the impact of U.S. transfer taxes. Prior to becoming a resident of the United States, all non-U.S. citizens and their tax advisors should carefully plan for the consequence of U.S. transfer taxes.
Tax Trap Number 2- The U.S. Anti-Deferral Tax Laws
The “anti-deferral regime” is a complex set of rules designed to prevent the deferral of U.S. income tax liability through the use of non-U.S. corporations. Tax advisors advising non-U.S. citizens need to be able to identify two classifications of corporations to understand the tax consequences of the ownership in such corporations. Although such ownership is innocuous prior to moving to the U.S., non-U.S. citizens can find themselves trapped with adverse U.S. tax consequences after establishing U.S. residency.
Controlled Foreign Corporations
A non-U.S. citizen can be trapped by ownership of stock in a controlled foreign corporation. Subpart F of the Internal Revenue Code requires every person who is a U.S. shareholder (this includes shareholders that are non-U.S. citizens that can be classified as being a resident of the U.S.) of a controlled foreign corporation (or “CFC”), and who owns stock in such corporation on the last day of the CFC’s taxable year, to include in gross income a deemed dividend equal to the shareholder’s pro rata share of the CFC’s tainted earnings. See IRC Section 951(a)(1). The principal types of tainted earnings include:
(i) Subpart F income, and
(ii) Earnings invested in U.S. property.
A U.S. shareholder’s pro rata share is the amount that the shareholder would have received if, on the last day of its taxable year, the CFC had actually distributed pro rata to all of its shareholders a dividend equal to the Subpart F inclusion. A foreign corporation is a CFC if, on any day during the foreign corporation’s taxable year, the U.S. shareholder owns more than 50 percent of the combined voting power of all classes of stock, or more than 50 percent of the total value, of the foreign corporation. A U.S. shareholder is defined under Subpart F as any U.S. person owning at least 10 percent of the combined voting power of all classes of voting stock of the foreign corporation. All forms of ownership, including direct, indirect (i.e., beneficial ownership from one related party to another) are considered in applying both the 10 percent shareholder and the 50 percent aggregate ownership tests. See IRC Section 958.
Passive Foreign Investment Companies
A non-U.S. citizen can also be trapped by ownership of stock in a passive foreign investment company (“PFIC”). A PFIC is any non-U.S. corporation if 75 percent or more of the gross income of such corporation in the taxable year is passive income, or if 50 percent or more of the assets held by such corporation during the taxable year produce or are held for the production of passive income. See IRC Section 958(b). Once a corporation has been classified as a PFIC, the shareholder’s distributed dividends and/or gains will always be characterized as a PFIC.
The PFIC provisions contain three sets of rules with three different mechanisms for determining taxation of a PFIC. Under one set of rules which apply to PFICs that are “qualified electing funds” (“QEF”), the electing individual holding stock in the PFIC includes in their gross income their pro rata shares of the PFIC’s earnings. These U.S. persons may elect to defer payment of the tax, subject to an interest charge, on the portion of the PFIC’s earnings not currently received.
Under a second set of rules, if the stock of a PFIC is “marketable stock,” a person owning stock in the PFIC may elect the market value of the PFIC’s stock each year. If this election is made, the person includes in gross income the excess of the fair market value of the PFIC’s stock at the end of the year over the individual’s adjusted basis in the stock. Alternatively, if the person’s basis in the PFIC’s stock exceeds the fair market value of the stock at the end of the year, the stockholder is allowed to deduct such excess (subject to limitation). This method is known as the “Mark to Market” (“MTM”) method and it may be used to avoid harsh tax consequences. A shareholder may make a MTM election with respect to “marketable” PFIC stock and thereby subject the appreciation or devaluation of the stock to the U.S. tax law.
Under a third set of rules, which applies to PFICs that are not QEF and for which a shareholder owning stock in the PFIC cannot make a MTM election or has not made such an election, the individual holding stock in the PFIC pays tax when they receive a distribution from the PFIC or sell their shares of PFIC stock, but also must pay an interest charge attributable to the value of the tax deferral when they receive an unusually large distribution (called an “excess distribution) or have gain from the disposition of the PFIC stock. In the case of a PFIC that is not a QEF, the advantage of deferral in a PFIC is removed by requiring shareholders owning shares in the PFIC to pay U.S. tax plus an interest based on the value of the tax deferral at the time the shareholder disposes of the PFIC stock at a gain or receives an “excess distribution” from the PFIC. See IRC Section 1291(a)(1) and (2). An excess distribution includes the following:
- A gain realized on the sale of PFIC stock, and
- Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years.
The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is compared by using the highest tax rate in effect in the years the income was accumulated, plus interest. See IRC Section 1291(a)(2).
Below, please see illustration 1 which demonstrates a potential tax consequence associated with the sale of PFIC stock.
Illustration 1.
A foreign national who became a U.S. resident for income tax purposes likes to invest in mutual funds. On the advice of her broker, on January 1, 2016, she buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. Not having any knowledge of the PFIC rules, the foreign national and her accountant fail to make a QEF election. During 2016, 2017, and 2018, FORmut accumulated earnings and profits. On December 31, 2018, the foreign national sells her interest in FORmut for $300,000. Because the foreign national has never made a QEF election, she must throw the entire $300,000 gain received over the entire period that she owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, the foreign national will pay tax on the throwback gain at the highest rate in effect that year with interest.
The PFIC tax rules can be financially devastating. Any non-U.S. citizen and their tax advisors should understand these rules before the non-U.S. citizen becomes a resident of the United States and plan accordingly. Tax advisors must also understand how to timely make QEF and MTM elections.
Tax Trap Number 3- The Throwback Rules as Applied to Trusts
The so-called “throwback rules” apply to certain distributions from foreign nongrantor trusts. To constitute a foreign nongrantor trust, the trust must be foreign. The Internal Revenue Code defines a foreign trust as any trust that is not a U.S. trust. See IRC Section 7701(a)(31)(B). A trust is a U.S. trust if a U.S. court is able to exercise jurisdiction over its administration. Once a foreign trust is at issue, it is critical to determine whether distributions from the trust to the non-resident will be subject to the throwback rules. The throwback rules apply to accumulated distributions made to U.S. beneficiaries.
If the nonresident receives an accumulation distribution, the tax consequence are determined under a complex set of rules based on the concept of undistributed net income (“UNI”). A trust’s UNI for a particular year is the amount by which the trust’s distribution net income (“DNI”) exceeds the sum of the amounts distributed to beneficiaries and any taxes paid by the trust. The throwback rules work to allocate an accumulation distribution back to the years in which the trust had UNI, starting at the earliest years. See IRC Section 666. By allocating the accumulation distribution among these years, the application of the throwback rules results in an addition to tax in the year of accumulation distribution that approximates the taxes that the beneficiary would have paid had the allocable UNI actually been distributed in the tax year in which it was earned as DNI. In addition to the throwback tax, the throwback rules impose an interest charge on the throwback tax. The interest rate is compounded daily over the throw-back period. See IRC Section 668.
Any non-U.S. citizen establishing a trust or having a beneficial interest in a trust must consider the throwback rules of the Internal Revenue Code and its regulations.
Tax Trap Number 4- Gift and Estate Tax Consequences Between Spouses
Special rules apply to foreign nationals in estate planning situations. Many estate planners utilize a marital deduction to fully make use of each spouse’s unified credit for estate and gift tax purposes. The Internal Revenue Code expressly disallows the use of a marital deduction if the donor spouse is not a U.S. citizen. Rather, Internal Revenue Code permits donor spouses an annual gift of $148,000 to a non-U.S. citizen spouse gift tax-free. See IRC Section 2503(b). This nuance is of particular importance in planning to avoid the gift and estate tax. This allows the use of planning for the transfer of assets between spouses that are not U.S. citizens. Tax practitioners should should carefully consider Internal Revenue Code Section 2503(b) when drafting trusts or advising a non-U.S. citizen in estate planning situation. Otherwise, the non-U.S. citizen may needlessly be subject to gift or estate taxes.
Tax Trap Number 5- The Expatriation Tax
The most surprising of the tax traps is the application of the U.S. expatriation regime to non-U.S. citizens. To most, the term “expatriation” connotes the giving up of one’s citizenship. Thus, its application to nonresident aliens is unexpected. Nonetheless, certain nonresident aliens can come within the U.S. expatriation regime and face substantial adverse U.S. income and transfer tax consequences.
Definition of “Covered Expatriate”
The application of the current U.S. expatriation regime is dependent upon the nonresident being classified as a covered expatriate. Certain requirements must be satisfied for a nonresident alien to be a covered expatriate. The first requirement is that the nonresident is an “expatriate.” The term “expatriate” includes U.S. citizens who relinquish their citizenship. It also includes long-term residents who surrender their green cards. A long-term resident is any nonresident who has been a lawful permanent resident for at least eight of the previous 15 years. See IRC Sections 8877A(g)(5) and 877(e)(2). The second requirement is that the expatriate must meet any one of the following three requirements:
- The expatriate’s average annual net income tax liability for the five years preceding the expatriation date is greater than $165,000 (2018);
- The expatriate’s net worth as of the expatriation date is $2,000,000 or more; or
- The expatriate fails to certify under penalty of perjury that the expatriate has complied with U.S. tax obligations for the five years preceding the expatriation date. See IRC Section 877(a)(2).
Foreign nationals who are covered expatriates become subject to the expatriation exit tax upon surrendering their green cards. Generally speaking, all of the covered expatriate’s property is treated as sold for fair market value on the day before the expatriation date. Any gain or loss realized is required to be recognized. However, the covered expatriate is permitted to up to $713,000 of gross income resulting from the deemed sales. See Rev. Proc 2017-58.
The expatriation rules also technically impose taxes on the transfer of gifts. Internal Revenue Code Section 2801 imposes a special inheritance tax on any U.S. citizens or resident who receives any “covered gift or bequest.” A covered gift is any property received from a donor who is a covered expatriate. A covered bequest is any property received from a decedent who was a covered expatriate at the time of death. The recipient is subject to tax on the value of the covered gift or bequest at the highest transfer tax rate in effect when the property is received. These rules also apply to covered gifts or bequests made to U.S. trusts. In the case of a foreign trust, the covered gift or bequest is not treated as occurring until a distribution from the trust is made to a U.S. person. These rules can be particularly harsh when applied to former nonresident aliens who have returned to their countries of citizenship. A former U.S. resident who has held a green card long enough to be considered a covered expatriate upon the surrendering of the green card may subject any beneficiaries and heirs who are U.S. persons to inheritance tax.
Please see illustration 2 regarding an example how the expatriation rules could impact the transfer of a gift.
Illustration 2.
A former nonresident alien who holds a green card for nine years returns to his home country. While in the United States, the former nonresident alien has a child, who by reason of birth in the U.S. is a U.S. citizen. The former nonresident alien and child never return to the United States again. When the former nonresident alien dies, he leaves to his child a parcel of real estate not located in the United States. Under the special inheritance tax rules, this bequest will be a covered bequest, and the United States will likely attempt to assess a tax on the transfer of the property.
Conclusion
Non-U.S. citizens who come to the United States may find a number of opportunities. However, once the non-U.S. citizen establishes U.S. residency, they become subject to a host of complex tax issues. These issues must be properly addressed to avoid adverse tax results. All the tax traps discussed in this article can often be avoided through proper planning. However, this planning should and must take place before the individual establishes tax residency in the United States.
Anthony Diosdi is one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.