KPMG US

U.S. Taxation of
Foreign Citizens

 

 

Contents | Introduction | Chapter 1 | Chapter 2 | Chapter 3 | Chapter 4 | Chapter 5 | Chapter 6 | Chapter 7 | Chapter 8 | Chapter 9 | Chapter 10 | Appendixes


Chapter 2 -- Taxation of Resident Aliens

Gross Income | Compensation for Personal Services | Business Deductions and Exclusions | Capital Gains and Other Gross Income | Passive Loss Limitations | Adjustments to Gross Income | Itemized Deductions | Personal Exemptions | Rates and Filing Status | Residency Election by Married Taxpayers | Tax Credits | Alternative Minimum Tax | Minimum Tax Credit | Community Property | Taxable Year | Imputed Income from Certain Foreign Corporations | Withholding on Certain Payments by Resident Alien Individuals  | Expatriation

 

Gross Income

Gross income of a resident alien includes income from all sources and wherever earned throughout the world. Thus, a resident alien’s gross income can include: salaries; other compensation; interest and dividend income (wherever paid); net income from carrying on any trade or business (that is, gross income less expenses incurred to earn that income); capital gains or losses (subject to limitations); income (less expenses) from partnerships and rental properties; annuities; pensions; and other miscellaneous income, including reimbursed business expenses in excess of expenses reported to the employer. Gross income, however, does not include income received while the individual was a nonresident alien. (See Chapter 4.)

Certain items are excluded by statute from gross income. These items include: interest received on certain state and local obligations; gifts and inheritances; compensation for injuries or sickness; amounts received under accident and health plans; contributions by employers to accident and health plans; and qualified scholarships.

Compensation for Personal Services

In General

A resident alien is taxed on his or her worldwide compensation regardless of where or for whom the services are performed.

Compensation includes:

  • Salaries, bonuses, and commissions;
  • Fringe benefits;
  • Deferred compensation;
  • Employer stock and other property;
  • Stock-option income;
  • Pensions and other retirement income;
  • The benefit of loans with below-market interest;
  • Foreign service allowances;
  • Cost-of-living allowances;
  • Housing costs paid for by an employer;
  • The value of the use of employer-provided housing;
  • Reimbursements for U.S. or foreign taxes;
  • School tuition for an employee’s spouse and children;
  • Home-leave allowances;
  • Use of a company car for personal purposes;
  • The value of domestic help provided by an employer;
  • Reimbursement of moving expenses; and
  • The value of employer-provided tax return preparation services.

Compensation includes cash remuneration and the fair market value of property or services received. All compensation is taxable unless excluded by law.

Deferred Compensation

Generally, deferred compensation is not taxable until the compensation is received, if it is based on an unfunded and unsecured promise to pay compensation in the future for present services (a completely different rule applies to tax-exempt organizations, such as charities). Under newly-effective deferred compensation rules, if compensation has already been earned, an individual generally cannot avoid current taxation by asking to defer the receipt of the compensation. To be effective, a deferred compensation agreement must generally be made in the year before the services are to be performed. For example, if a bonus will be earned in 2007 and payable in 2008, an election to defer all or a portion of the bonus (if any is paid) may have to be made in 2006. An employee can make an election with respect to an incentive program after the period of service has started if the amount being earned is subject to a substantial performance condition. If the payment will not be made unless the performance conditions are satisfied (and the performance testing period is at least 12 months), the employee can elect to defer all or a portion of the amount at least six months before the amount would otherwise be payable (if the performance requirements are satisfied).

New rules also require that the deferral election specifically state when the distribution will be made, and limit the choices and flexibility. An employee can elect distributions on separation from service, retirement, death, disability, unforeseeable emergency, change in control, or a date stated in the original deferral election. The election must also state the method of distribution (lump sum or the number of years for periodic payments). An employee cannot generally ask for the payment any sooner than provided in the original election. Subsequent deferrals can be permitted by a plan, but an employee must elect to postpone the distribution for at least five years.

Significant tax penalties apply if the deferral does not satisfy the new rules, including a requirement that the taxpayer include the deferred amount in income in the current year (once no longer subject to any substantial risk of forfeiture) and pay an additional 20-percent income tax. As a general rule, the employer is required to withhold federal income tax on the amount included in income and the additional 20-percent tax. In addition, interest is payable from the date the income was first deferred or, if later, the date the substantial risk of forfeiture lapses.

There are exceptions from the above rules that apply to certain foreign-based deferred compensation arrangements.

Compensation earned by a foreign citizen as a resident alien in the United States, but received when a nonresident alien, will generally be taxed at the regular U.S. graduated tax rates in the year received.  However, it is suggested the treaty provisions be reviewed, if the compensation was set aside in a broad-based pension plan of the home country while the employee was a U.S. resident alien.

Employer Stock and Other Property

Compensation in the form of employer stock or other property generally is taxable when received. The amount of compensation is the excess of the fair market value of the property over the amount (if any) the recipient pays for the property. However, if such property is not freely transferable or is subject to a substantial risk of forfeiture, income is not recognized until the restrictions are removed. Property is subject to a substantial risk of forfeiture if the recipient’s rights to full enjoyment of such property (for example, the right to sell the property) are conditioned on the future performance of substantial services.

An individual who receives property that is not otherwise currently taxable as compensation may elect to treat the property as compensation in the year received. This election must be made within 30 days after the transfer. This election may be desirable if the property is expected to appreciate substantially in value. However, no deduction is allowed if the property is subsequently forfeited.

Stock Options

A stock option is the right granted to an employee or to an independent contractor (for example, company director), in consideration for the performance of services, to purchase shares in a corporate employer or related company. The option agreement usually specifies the purchase price and time period during which the option may be exercised. The taxation of stock options to an individual depends on whether the options are incentive stock options or nonqualified options.

An incentive stock option (ISO) is an option that meets certain statutory requirements, including the following:

  • The option price must be at least the fair market value of the stock at the time of the grant (or at least 110 percent of fair market value if granted to a 10-percent, or greater, shareholder);
  • The fair market value of the stock with respect to which the ISOs are exercisable for the first time by an individual cannot exceed USD 100,000 a year;
  • The option must not be exercisable more than 10 years after the date of grant (five years if granted to a 10-percent, or greater, shareholder).

An individual is not taxed on the grant or exercise of an ISO. However, the excess of the fair market value of the stock option when exercised over the actual purchase price must be added back as an adjustment to taxable income for alternative minimum tax purposes (discussed later in this chapter).

The subsequent sale of the stock obtained by exercise of an ISO will result in a capital gain or loss if sold more than two years after grant and one year after exercise and if certain employment requirements are met. In determining gain or loss, the basis in the option stock is its purchase price.

A nonqualified stock option is generally any option other than an ISO that is granted, in connection with the performance of services, to acquire employer stock. Unless the option has an ascertainable fair market value, an individual is not taxed when granted a nonqualified stock option. Upon the exercise of the stock option, the individual is treated as receiving taxable compensation measured by the excess of the fair market value of the stock received over its purchase price. The exercise of a nonqualified option does not give rise to an adjustment to taxable income for alternative minimum tax purposes. The subsequent sale of the option stock will result in a capital gain or loss. In determining gain or loss, the basis of the option stock is the purchase price plus the compensation recognized at exercise.

If an option has a readily ascertainable fair market value at the time of grant, the individual recognizes income at the time of grant instead of at the time of exercise of the option. To have a readily ascertainable fair market value, the option must be actively traded on an established securities market, or its value must be otherwise measurable with reasonable accuracy based on certain tests. It is uncommon for employee stock options to have a readily ascertainable value.

Other rules apply to stock acquired by exercise of options under employee stock purchase plans.

Pension and Other Retirement Income

Pensions and other retirement allowances received under U.S. or foreign plans generally are taxable. If the employee did not contribute to the cost of the pension, the full amount received generally is taxable. If the employee did so contribute, a portion of pension amounts received may be excluded from gross income. Special rules also apply for determining a plan participant’s basis in the pension plan. Special taxing rules apply to certain pension and other retirement benefits received as a lump-sum distribution.

Pension benefits are foreign source income to the extent that they are attributable to services performed abroad. Accordingly, the U.S. tax on these benefits can be offset in whole or in part by foreign tax credits (discussed later in this chapter).

Income tax treaties may affect the taxation of pension benefits. Many U.S. tax treaties provide that a resident of the United States may be taxed on pension benefits only by the United States.

Foreign nationals on international assignment in the United States who continue to participate in a pension plan in their home country may be taxed on their employer’s contribution (and the employee’s contribution may not be deductible) while on assignment.

The tax on contributions to and income accrued in pension plans that are qualified under U.S. tax rules is usually deferred until distribution. A foreign national, resident or nonresident, who is assigned to the United States, may be taxed on the income accruals in his or her non-U.S. pension under U.S. tax rules applicable to nonqualified plans, if he or she continues to participate in a foreign pension plan. This occurs because foreign pension plans do not enjoy the benefit of U.S. tax qualifications. Foreign plan benefits will be subject to U.S. tax provided: (1) the plan is funded for U.S. tax purposes and (2) the foreign national’s interest in the plan is vested in whole or in part. However, certain income tax treaties may provide relief from U.S. taxation on contributions to, and the accrual of benefits in, foreign country pension plans.

Loans with Below-Market Interest

Compensation includes imputed interest on loans from an employer with no interest payable or with interest payable at below-market rates.

Loans subject to interest imputation include any below-market interest loan that is (l) a compensation-related loan between an employer and an employee, (2) a corporation-shareholder loan, or (3) a loan with tax avoidance as one of its principal purposes. The tax consequences of a below-market demand loan focus on the amount of “foregone interest.” This is the excess of the amount of interest that would be payable on the loan during the taxable year, if accrued at the applicable federal rate, over the amount actually payable during the taxable period. The amount of foregone interest is treated as transferred from the lender to the borrower and characterized as compensation, dividend, or other payment, depending on the relation between the lender and borrower. In addition, the amount is treated as re-transferred from the borrower to the lender and treated as interest income to the lender and interest expense to the borrower. This imputed interest expense of an individual could be subject to the limitations on the deduction of personal interest (discussed in the Itemized Deductions section below).

The treatment of a below-market term loan is slightly different. With respect to a non-gift term loan, the lender is treated as transferring and the borrower is treated as receiving the excess of the actual loan amount over the present value of all payments required to be made under the terms of the loan. The excess is then treated in accordance with the relationship of the lender and borrower. In addition, the excess is considered to be original issue discount such that the lender has income and the borrower has interest expense in an amount tied to the imputed daily discount.

There are a number of exceptions with regard to below-market interest loans, the most important being the USD 10,000 minimum exception that applies in certain circumstances. For any day in which the total loan between lender and borrower is less than USD 10,000, interest income and expense generally will not be imputed. Furthermore, there is an exception from the imputed-interest requirements for below-market loans where both the lender and borrower are foreign persons or where the lender is a foreign person and the borrower is a U.S. person (other than a compensation-related loan), unless the interest income imputed to the lender would be effectively connected with a U.S. trade or business and not exempt under a tax treaty. A resident alien is a U.S. person for purposes of this exemption.

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Business Deductions and Exclusions

In General

Ordinary and necessary business expenses generally are deductible from gross income. However, employee business expenses are fully deductible only to the extent they are reimbursed by an employer. Such expenses and reimbursements need not be reported on an employee’s tax return if he or she fully accounts to the employer for such expenses under a reimbursement or other expense allowance arrangement. (See Chapter 5.) Unreimbursed employee business expenses are deductible as miscellaneous itemized deductions, which are deductible only to the extent that miscellaneous itemized deductions in total exceed 2 percent of adjusted gross income.

Travel Expenses

If an individual is in the United States for a temporary assignment, certain U.S. away-from-home expenses such as travel, meals, and lodging may be deductible (or if reimbursed by the employer, the reimbursements may not be includible in income). The individual must be temporarily away from his or her foreign principal place of employment (that is, tax home), and the stay in the United States must not be indefinite. No away-from-home living expenses paid or incurred are deductible if the individual’s period away from his or her tax home is expected to be more than one year at a single location. The deductibility of expenses for assignments of one year or less depends on the facts and circumstances of each case; however, the expenses would generally be deductible.

If employer-furnished accommodations are provided on the employer’s business premises for the convenience of the employer, and the employee is required to accept them as a condition of employment, the value of such lodging may be excluded from the taxable income of the employee. Similarly, the value of meals provided by the employer is not taxable if the meals are provided on the employer’s business premises and for the convenience of the employer.

Comment:

1.

Employers must adequately document not only an employee’s assignment that is initially expected to last one year or less, but also when the assignment is extended beyond one year.

2.

Where possible, assignments should be scheduled with a projected period of employment for as close to one year as possible, but not over one year.

 

 

Example

(a) If an assignment is scheduled to last six months, but after four months it is determined that the assignment will last 14 months, the maximum deduction for away-from-home travel expenses would be limited to those expenses incurred during the four months prior to rescheduling.
(b) Assume the assignment discussed in example (a) is originally scheduled to last 12 months, but due to various delays it in fact lasts 14 months. In this situation, the maximum deduction for away-from-home expenses would be limited to those expenses incurred during the first 12 months.

Foreign Earned Income Exclusion

A lawful permanent resident (i.e., greencard holder) who has his or her tax home in a foreign country and who is physically present in a foreign country or several foreign countries for at least 330 full days during any period of 12 consecutive months may qualify to exclude up to USD 85,700 (for 2007, adjusted for inflation annually) of foreign earned income from his or her gross income. In addition to (or in lieu of) the foreign earned income exclusion, qualifying resident aliens may elect to exclude from income, or in some cases to deduct from income, a housing cost amount based on the individual’s actual housing expenses in the foreign country but limited to USD 11,998 (for 2007; adjusted for inflation annually – higher limitations apply for specified high-cost locations). A resident alien may also qualify for these foreign exclusions if he or she is a bona fide resident of a foreign country and if he or she is a citizen or national of a country with which the United States has an income tax treaty.

A resident alien who is a lawful permanent resident of the United States and who elects these foreign exclusions should consider consulting a U.S. immigration attorney with respect to the impact of the elections on his or her U.S. immigration status.

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Capital Gains and Other Gross Income

Capital gains include gains from the sale of investment assets, personal assets, and certain business assets. Short-term capital gains are taxed at the taxpayer’s marginal tax rate based on his or her income and filing status up to a maximum rate of 35 percent.  Short-term capital gains arise from assets held less than one year. Long-term capital gains are taxed at a maximum rate of 15 percent. To qualify for long-term capital gains rates, assets must have been held for more than 12 months before disposition. See Appendix D for tax rates. Net capital losses may be deducted against ordinary income up to USD 3,000 annually. Unused losses can be carried over indefinitely and used in later years until exhausted.

Gain of USD 250,000 (USD 500,000 in the case of a married couple filing jointly) on the sale or exchange of a principal residence can be excluded if certain requirements are met. (See “Sale of a Principal Residence,” Chapter 5).

Gross income of a resident alien can also include his or her share of the undistributed income of certain foreign corporations. These corporations are controlled foreign corporations with tax haven (subpart F) income, and certain passive foreign investment companies. This topic is discussed at the end of the chapter.

Passive Loss Limitations

A passive activity includes the conduct of any trade or business in which the taxpayer does not materially participate throughout the year and, generally, any rental activity, regardless of whether the taxpayer materially participates. A limited partnership interest is generally treated as intrinsically passive. A taxpayer will most likely be considered to participate materially in an activity if the activity is the taxpayer’s principal business.

Deductions from passive trade or business activities, to the extent that they exceed income from all such passive activities (exclusive of portfolio income), generally may not be deducted against other income such as salary, interest, dividends, and active business income. Credits from passive activities generally will be limited to the tax allocable to the passive activities.

Losses arising from a passive activity generally will be deductible only against income from that passive activity or other passive activities. Unusable passive activity losses will be carried forward indefinitely (but not carried back), generally to be applied against passive activity income in subsequent years.

An individual is allowed annually to offset up to USD 25,000 of non-passive income with losses and credits from rental real estate activities with respect to which the individual actively participates. The USD 25,000 amount is phased out for taxpayers above certain income levels. The active participation standard requires less involvement than the material participation standard and generally will not require regular, continuous, and substantial involvement in operations.

Working interests in oil and gas property held in a manner that does not limit liability are exempted from the passive-loss rules, regardless of the level of a taxpayer’s participation. In general, a working interest is an interest with respect to an oil and gas property that is burdened with the cost of development and operation of the property.

Rental of Former Residence

Foreign nationals often prefer not to sell their former foreign residence and therefore rent the property during the U.S. assignment. In such case, the resident may be taxed on the rental income less applicable deductions such as mortgage interest, property taxes, insurance, agency commissions, and other ongoing operating expenses of the property. Depreciation may also be permitted on the building cost (excluding the portion attributable to land) and improvements and furnishings left in the house. Depreciation must be calculated according to U.S. rules. Additionally, qualified residence interest payments can be deducted in full. Interest payments on a principal residence are excluded from the passive activity determination and are not subject to the passive loss limitations.

If the principal residence is rented for less than 15 days during the year, the rental income and associated deductions, other than interest and taxes, are ignored in determining taxable income.

Special rules also apply to limit deductible losses if property is used by the taxpayer for personal purposes during the year. No loss deduction is allowed if the taxpayer used the property for personal purposes for more than the greater of 14 days or 10 percent of the number of days the house was actually rented during the tax year. “Personal use” of a property includes occupancy by friends or relatives. If personal use does not exceed this limitation, a deductible loss is allowed that is proportionately based on the rental percentage. It should also be noted that losses from rental of a property to a family member may not be deducted, unless an arm’s-length rent is paid.

Foreign nationals who elect to rent their former foreign residences may have to compute net gain or loss from the property in the foreign functional currency as a qualified business unit (“QBU”). The annual income or loss would be translated into U.S. dollars at the average exchange rate for the year, rather than on the dates of receipt of income or payment of expenses by the taxpayer.

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Adjustments to Gross Income

Certain expenses are deductible even if the flat standard deduction (discussed below) is claimed. These deductions are subtractions from gross income to compute adjusted gross income. The following are some of the deductions available:

·          Employee business expenses to the extent reimbursed by an employer;

·          Trade or business expenses other than employee business expenses;

·         Individual retirement account (IRA) contributions up to the lesser of USD 4,000 in 2007 (USD 8,000 for a spousal IRA) or compensation included in income (the maximum deduction, however, is phased out where adjusted gross income exceeds certain limitations). For taxpayers over 50, the amounts for 2007 are USD 5,000 and USD 10,000 respectively;

·          Health savings account deduction;

·          Unreimbursed qualified moving expenses;

·          One-half of self-employment tax paid, for certain self-employed individuals;

·          Certain self-employed health insurance payments for certain self-employed individuals;

·         Keogh and certain other retirement plan contributions, within limitations, for self-employed individuals;

·          Forfeited interest penalty on early withdrawal of savings from time deposits;

·          Alimony paid;

·          Qualified student loan interest.

The concept of adjusted gross income (AGI) is important because several limitations on deductions and credits are calculated by reference to AGI.

Itemized Deductions

After computing adjusted gross income, resident aliens may elect to claim the same non-business deductions as a U.S. citizen. The non-business deductions include, but are not limited to, the following:

  • Medical expenses, including insulin and prescription drugs, to the extent that such expenses exceed 7.5 percent of adjusted gross income.
  • State and local taxes on income, real property, and personal property; foreign real property taxes; and foreign income taxes, provided that foreign income taxes are not claimed as a credit. (State and local general sales taxes are deductible for tax year 2007 in lieu of state and local income taxes, at the taxpayer’s election.)
  • Contributions to qualified U.S. charities (with limitations).
  • Interest on home mortgages and certain other interest on debt secured by a principal or a second residence. However, the deduction is generally limited to interest amounts paid on the first USD 1 million of debt incurred to acquire, construct, or substantially improve the residence and up to USD 100,000 of other debt that is secured by the residence. Any interest paid in excess of the limits is treated as personal interest and is not deductible. For debt that was incurred and secured by the residence on or before October 13, 1987, the terms of which has not been altered since that date, the USD 1 million limitation is inapplicable.
  • Personal casualty and theft losses to the extent each loss exceeds USD 100 and the total combined losses in any year exceed 10 percent of adjusted gross income.
  • Certain miscellaneous deductions for union dues, casualty losses related to income-producing property (within limits), tax return preparation fees, unreimbursed employee business expenses, and others, to the extent that these deductions in total exceed 2 percent of adjusted gross income.

A deduction for investment interest expense is limited to net investment income, that is, gross investment income less expenses incurred to earn such income, such as the cost of investment advice and consulting fees. Investment interest expense includes interest incurred to earn investment income (for example, dividends, portfolio interest, capital gains, and so forth). It does not include any interest that is taken into account in computing income or loss from a passive activity. Amounts disallowed under this provision may be carried forward indefinitely and deducted in future years, subject to the annual limitation.

A deduction for personal interest is not allowed. Personal interest includes interest paid on automobile loans, credit card interest incurred for personal purposes, and interest paid on tax deficiencies.

An individual whose adjusted gross income exceeds a threshold amount is required to reduce the amount of allowable itemized deductions by 3 percent of the excess over the threshold amount. (See Appendix D for 2007 threshold amounts) The reduction, however, may never be more than 80 percent of allowable deductions, and deductions for medical expenses; investment interest; and casualty, theft, or wagering losses are not subject to the reduction. The limitation is applied after any disallowance of miscellaneous itemized deductions subject to the 2-percent floor (discussed above) has been taken into account. In addition, this reduction in allowable itemized deductions is being phased out. After calculating the reduction, only 2/3 of the reduction is taken in 2006 and 2007. In 2008 and 2009, only one-third (1/3) of the reduction will be applicable, and in 2010, the reduction will be repealed.

In lieu of the aforementioned itemized deductions, an individual who has been a resident alien for the entire taxable year (or who has elected to be treated as a resident for the entire taxable year) may claim the flat standard deduction.  (See Appendix D for the 2007 standard deduction amounts.)

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Personal Exemptions

In addition to the foregoing deductions, a resident alien may claim a personal exemption of $3,400 (in 2007). On a joint return, exemptions for both spouses are allowed. If a joint return is not filed, a spouse may be claimed as an exemption if the spouse had no gross income for U.S. tax purposes and was not a dependent of another taxpayer. The exemption may be claimed even if the spouse was not a resident alien for a full tax year or is an alien who has not come to the United States. In addition, an exemption can be claimed for each person who qualifies as a dependent according to the rules for U.S. citizens. To qualify as a dependent, an individual must be a citizen, national, or resident of the United States, or a resident of Canada or Mexico, at some time during the calendar year in which the year of the taxpayer begins. The dependent must also receive more than half of his or her support from the taxpayer and be either related to the taxpayer or a member of his or her household.

The deduction for personal exemptions may be reduced or eliminated for high-income taxpayers whose adjusted gross income exceeds certain threshold amounts, based on filing status. The deduction for exemptions is reduced by 2 percent for each USD 2,500 (USD 1,250 for a married person filing separately) or fraction thereof by which adjusted gross income exceeds the threshold amount. However, as is the case with the reduction for itemized deductions discussed above, this reduction is being phased. After calculating the reduction, only two-thirds (2/3) of the reduction is in 2006 and 2007. In 2008 and 2009, only one-third (1/3) of the reduction will be applicable, and in 2010, the reduction will be repealed. (See Appendix D for 2007 threshold amounts.)

Rates and Filing Status

The United States has a graduated income tax rate structure; the income tax rates increase as taxable income rises, with a maximum tax rate of 35 percent. Tax rate schedules for 2007 are set forth in Appendix D.

The United States has six basic tax-rate brackets applicable to individual taxpayers: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent. The phase-outs of personal exemptions and itemized deductions for high income taxpayers are additional adjustments which increase the effective tax rate, apart from the graduated tax rate structure.

The tax liability of a resident alien is computed by first determining taxable income and then using the applicable tax rate schedule and subtracting allowable credits. Taxable income is gross income less deductions and exemptions. The United States has the following four basic tax rate schedules for individuals:

  • Married individuals (and certain surviving spouses) filing joint returns;
  • Heads of households;
  • Single individuals; and
  • Married individuals filing separate returns.

It is crucial to know which schedule should be used, since the tax burden increases from the first to the last listed schedule. Depending on their marital status, resident aliens use one of the rate schedules listed above. A resident alien may file a joint tax return only if both spouses were residents of the United States for the entire taxable year or if they both elect to be treated as resident aliens for the entire taxable year.

If married foreign citizens are not treated as residents for the entire taxable year, the couple cannot file a joint income tax return and generally must use the rates applicable to married individuals filing separate returns (usually the least desirable status).

The head-of-household rates are applicable to an unmarried alien who maintains as his or her home a household that constitutes the principal place of abode for a related dependent. In addition, a married resident alien may qualify for the head-of-household rates if he or she maintains a household for a relative other than his or her spouse (for example, for a child) if the spouse is a nonresident alien at any time during the year. The taxpayer, generally, cannot use the head-of-household rates if he or she is a nonresident alien at any time during the year.

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Residency Election by Married Taxpayers

Two elections are available to married individuals that permit them to file a joint return and qualify for the preferential “married filing jointly” tax rates. See Chapter 4 for a discussion of these elections.

Tax Credits

A credit against U.S. income tax liability for foreign income taxes paid by a resident alien is allowed, subject to limitations. Such credit is limited to the U.S. income tax on foreign source taxable income.

Limitations on the amount of the credit are computed separately after separating income into two categories, passive income (for example, dividends, certain interest, rents, and so forth), and other income (compensation, etc.). The credit cannot be claimed if foreign income taxes are claimed as an itemized deduction. Foreign income taxes that cannot be claimed as a credit due to the limitation may be carried back one year and carried forward 10 years to offset the U.S. income tax on foreign source taxable income for such years, subject to the limitations that apply to those years.

Additional credits are available, with limitations, for child and disabled dependent care expenses, tuition paid for post-secondary education, and various other items.

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Alternative Minimum Tax

The United States also imposes an alternative minimum tax (AMT), which was devised to ensure that at least a minimum amount of income tax is paid by high-income taxpayers. The AMT functions as a recapture mechanism, reclaiming some of the tax breaks that were originally primarily available to high-income taxpayers, and represents an attempt to maintain tax equity.

The tax law provides for preferential treatment for certain income and allows special deductions and credits for certain expenses. Taxpayers who take advantage of these tax incentives may have to pay AMT. The AMT, a separate tax computation from regular income tax, eliminates some of the preferential tax breaks available under the regular tax regime, thereby increasing the U.S. tax liability of an individual who would otherwise pay little or no regular U.S. tax.

Technically, AMT is the amount by which a taxpayer’s tentative minimum tax exceeds his or her regular tax liability. The tentative minimum tax is imposed on the portion of the taxpayer’s alternative minimum taxable income (AMTI) in excess of the AMT exemption amount. The AMT rate is equal to 26 percent, with a second 28-percent bracket starting at $175,000, on AMTI in excess of the exemption (see Appendix D for the 2007 exemption amounts).

The tax base subject to AMT, or AMTI, is taxable income (before personal exemptions) re-computed to take into account certain adjustments and tax preference items. The AMT adjustments and tax preference items include, in part, certain itemized deductions (such as deductions for state and local income tax (or sales tax) and property taxes), taxable state and local tax refunds, accelerated depreciation of certain property, certain tax exempt interest, the difference between AMT and regular tax gain or loss on the sale of property, and the treatment of incentive stock options.

The foreign tax credit, with limitations re-calculated applying AMT rules, may be used to reduce the AMT.

Minimum Tax Credit

A minimum tax credit (MTC) may be allowed for a taxable year in which AMT is not due but AMT was paid in prior years. The MTC is allowed only against the excess of the regular tax over the “tentative” minimum tax for the taxable year. The tentative minimum tax is 26 percent of alternative minimum taxable income over the exemption amount (28 percent to the extent that alternative minimum taxable income is greater than USD 175,000) reduced by the amount of foreign tax credit allowable against AMT.

The MTC is equal to the aggregate of the AMT paid in prior years over the AMT that would have been paid in each prior year had the AMT been computed taking into account only a limited number of the adjustments and tax preference items.

The MTC generally is reduced as it is offset against regular tax. Any excess MTC may be carried forward indefinitely as a credit against regular tax liability.

Community Property

In the case of a married couple, one or both of whom are nonresident aliens, who are domiciled in a country with community property laws, any community property income will be taxed as follows:

  • Earned income is treated as the income of the spouse whose services produced the income, and all of it must be reported on that individual’s separate return;
  • Trade or business income is treated as income of the husband unless the wife exercises substantially all of the management and control over the business;
  • Partnership income is treated as the income of the partner;
  • Income from the separate property of one spouse is treated as the income of the spouse owning the property as determined by the community property laws;
  • All other community income is treated as the income of the spouse who has a vested interest in the income under the community property laws.

These rules apply whether domestic or foreign community property laws are in effect. However, these rules are not relevant when a joint return is filed, since incomes of the spouses are combined.

Certain community property laws are disregarded if both spouses are nonresident aliens, or if one spouse is a nonresident alien and the other is a U.S. citizen or resident, and they do not choose to be treated as U.S. residents. In these cases, each spouse cannot report one-half of the types of community income on separate returns. Instead, any community property income will be taxed as outlined above.

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Taxable Year

A foreign citizen must use the calendar year as his or her U.S. taxable year unless another fiscal year had been established as the taxable year before the individual became subject to U.S. taxation as a resident or a nonresident. A calendar year is 12 consecutive months ending on December 31.

Imputed Income from Certain Foreign Corporations

A resident alien may be subject to current taxation on his or her share of some or all of the income of certain closely-held foreign corporations, even though such income has not been distributed to shareholders. These corporations include controlled foreign corporations with tax haven (subpart F) income.  A corporation generally is a controlled foreign corporation if more than 50 percent of its voting power or value is owned by U.S. persons (including resident aliens) that each own at least 10 percent of that voting power. Constructive ownership rules apply.

In addition, a foreign citizen who invests in a passive foreign investment company (PFIC) must pay an interest charge, in addition to the tax, on any gain derived from the disposition of the investment or on an excess distribution from the PFIC while he or she is a resident alien. Alternatively, the resident alien can elect to be taxed currently on his or her share of the annual earnings of a PFIC by treating the PFIC as a qualified electing fund. A foreign corporation generally is treated as a PFIC if at least 75 percent of its gross income consists of passive income or if at least 50 percent of its assets produce, or are held for the production of, passive income. Proposed IRS regulations would treat the termination of U.S. residency as a disposition of stock in a PFIC. Therefore, the individual would be subject to the interest charge in addition to the tax on the entire amount of gain, not just gain attributable to residency years.

The information reporting requirements with respect to foreign corporations are discussed in Chapter 9.

Withholding on Certain Payments by Resident Alien Individuals

It may be necessary for U.S. resident aliens to withhold U.S. tax on certain payments to foreign persons. If a U.S. resident alien pays alimony to a nonresident alien, the alimony payments may be subject to withholding requirements, and the U.S. resident payor would be expected to act as the withholding agent. The same rule applies to certain mortgage interest payments made to a foreign lender by a resident alien. Any such payments would be subject to a 30-percent withholding tax (or a lower treaty rate). Treaty relief may be available to a foreign lender if the mortgage loan was not made by a U.S. branch (permanent establishment) of the foreign lender. Penalties could apply for noncompliance with the withholding requirements.

Expatriation

An individual who relinquishes U.S. citizenship or ceases to be a long-term resident of the U.S. on or after June 17, 2008, may be subject to a special exit tax.

 

An individual who is subject to the exit tax (a “covered expatriate”) is treated as if he or she had sold all of his or her property at fair market value on the day before the date of his or her expatriation. If the resulting gain is in excess of USD 600,000 (this amount will be indexed for inflation after 2008), the excess is subject to U.S. income tax. For the purposes of calculating this deemed gain, property that was owned by a covered expatriate when the individual first became a U.S. resident is treated as if it had been acquired at its fair market value on the date that he or she became a U.S. resident. Special rules apply to items of deferred compensation, certain tax-deferred accounts, and any interest in a nongrantor trust. Any election is available to postpone payment of the exit tax on a given asset until that asset is sold, by posting adequate security and paying interest. 

 

In addition, a U.S. citizen or resident who receives a gift or bequest from a covered expatriate is subject to a transfer tax on the fair market value of the property received at the highest U.S. gift or estate tax rate then in effect (currently 45 percent). The transfer tax does not apply if the property was included in a timely filed U.S. gift or estate tax return filed by the covered expatriate.

 

In general, a “long-term resident” is a foreign citizen who had been a lawful permanent resident of the United States (i.e., a greencard holder) “in” at least eight of the 15 taxable years ending with the year of expatriation. For the purpose of these rules, “expatriation” means ceasing to be a lawful permanent U.S. resident or commencing to be treated as a resident of a foreign country under a treaty residence rule.

 

The exit tax applies to any U.S. citizen or long-term resident whose expatriation date is on or after June 17, 2008, and:

 

·         Whose average annual net income tax liability over the five years ending before expatriation is greater than USD 139,000 (this 2008 amount is indexed for inflation);

·         Whose net worth is USD 2 million or more on the date of expatriation (not indexed for inflation); or

·         Who fails to certify compliance with the U.S. tax laws for the five preceding tax years or who fails to submit such evidence of compliance as the IRS requires.

 

Narrow exceptions apply to certain U.S. citizens with dual nationality.

 

An individual who would be subject to the rules above but whose expatriation date is on or after June 3, 2004, but before June 17, 2008, is subject to tax on an expanded definition of U.S. source income at graduated rates applicable to U.S. citizens, rather than rates applicable to other nonresidents, and is required to recognize gain in what would otherwise be a tax-free exchange, for a 10-year period after expatriation. This special tax is known as the expatriation tax and is due if it is higher than the regular tax imposed on nonresidents.

Stringent reporting requirements are imposed on those subject to the expatriation tax during the 10-year period following expatriation. In addition, there are restrictions on the number of days an individual subject to the expatriation tax can return to the United States without becoming subject to U.S. taxation as a resident. To partially offset some or all of the additional tax imposed, special foreign tax credits may be available. Tax treaties conflicting with these rules were expressly overridden until August 2006.

Due to the complexity of this area of the law, it is strongly recommended that professional advice be sought before an individual revokes U.S. citizenship or surrenders his or her greencard, to avoid or mitigate the many pitfalls and to take advantage of planning opportunities. Immigration counsel should be consulted as there are non-tax issues which need to be considered as well. Individuals who expatriated before June 4, 2004, should contact their U.S. tax advisers regarding the applicable law. 

 

 

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