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 8 -- Other Taxes

Social Security Tax and Benefits | Estate and Gift Taxation | Foreign Trust/Gift Reporting Requirements | State and Local Taxes

 

 

Social Security Tax and Benefits

The U.S. social security system provides a wide array of benefits to eligible individuals. The system provides old age and disability benefits to workers, benefits to dependents and survivors of retired and disabled workers, and medical benefits to the elderly. In addition, unemployment insurance is provided by the states to compensate workers for loss of income during periods of unemployment. Workers’ compensation programs provide payments for employment-related injuries or death and are generally funded through insurance maintained by employers.

There are no citizenship or residency requirements imposed for an individual to receive social security retirement, survivor, or dependency benefits. However, benefits paid to an alien, including a dependent or survivor of a covered employee, will be suspended when the alien has been outside the United States for six consecutive months except where the relationship upon which the benefit is based lasted at least five years.

The social security tax is imposed on employers and employees under the Federal Insurance Contribution Act (FICA). The so-called FICA tax is based on wages with respect to employment, generally including all remuneration from employment. Remuneration in excess of an annually-adjusted earnings ceiling, and certain non-cash and indirect payments, are excluded from the definition of wages. Employment means services of any type performed by an employee for his or her employer, regardless of the citizenship of either, performed within the United States, performed on an American-registered vessel under specified circumstances, or performed outside the United States by a U.S. citizen or resident as an employee of a U.S. employer. Some exceptions to the definition of employment are provided in the Internal Revenue Code.

The FICA tax is imposed at the same rate on both the employee and the employer. As of December 31, 2007, the combined rate is 7.65 percent, which consists of 6.2 percent for old-age, survivors, and disability insurance (OASDI), and 1.45 percent for hospital insurance (Medicare). The OASDI rate of 6.2 percent applies to wages within the OASDI wage base, which is USD 97,500 for 2007 (USD 102,000 for 2008). However, there is no ceiling on wages subject to the 1.45 percent Medicare tax. The employer is required to collect the employee’s portion of the FICA tax by means of a payroll deduction and to remit this amount along with the employer’s portion of the tax to the government.

The social security tax is imposed on self-employed individuals under the Self Employment Contribution Act (SECA). This tax is paid as an addition to the income tax, and is due together with quarterly estimated tax payments, when applicable (see discussion in Chapter 7). The self-employment tax is not imposed on nonresident aliens. This self-employment tax is imposed on the self-employment income of individuals if such earnings exceed USD 400 for the taxable year. Earnings subject to the tax are limited by the same annual earnings ceiling that limits the FICA tax. Net earnings from self-employment include gross income derived from a trade or business, less trade or business expenses (excluding the net operating loss deduction), plus the individual’s distributive share of income or loss from a business carried on as a partnership. Certain items are specifically excluded from self-employment income: interest, dividends, capital gains, and rentals (and associated deductions) from real property and personal property leased with real estate unless they are received by the individual in the course of his or her business as a real estate dealer.

For 2007, the rate of self-employment tax is 15.3 percent on net earnings of up to the base amount of USD 97,500 (USD 102,000 for 2008), and 2.9 percent on earnings in excess of the base. A self-employed person may deduct one-half of the self-employment tax for the year as a business expense in arriving at adjusted gross income.

If an individual is temporarily sent to work in another country, his or her compensation may be subject to social security taxes in both the home and host countries. The United States has concluded social security totalization agreements with a number of countries in order to eliminate double taxation and to provide integrated benefit coverage (see Appendix C for list of countries). Generally, under these agreements, an individual will be subject to social security taxes in the country in which the individual is working; but each agreement must be reviewed to determine which country has the right to impose social security tax. Without such an agreement in place, an individual’s pay could be subject to social security taxes in both countries. The totalization agreement may provide that the individual can remain covered only by the social security system of the country from which he or she was sent. To establish that the compensation of a non-U.S. individual on assignment in the United States is subject only to home country social security taxes and is exempt from U.S. social security taxes (including the Medicare tax) as a result of a totalization agreement, the individual or his or her employer should request a statement (certificate of coverage) from the appropriate agency of the his or her home country.

The agreements also provide for totalized benefits where coverage under both systems is combined, so that an individual could qualify for benefits under one or both systems. Under U.S. law, an alien may not elect totalized U.S. benefits unless the alien has six quarters of actual coverage under the U.S. social security system. U.S. totalization agreements do not apply to Medicare benefits. U.S. citizens or residents are prohibited from taking a credit or deduction for foreign social security taxes paid if a totalization agreement is in effect with the other country.

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Estate and Gift Taxation

The United States has a unified gift and estate tax system that applies to taxable gifts of property made by an individual during life and taxable bequests made at death. In addition, some states impose an estate tax or inheritance tax upon the death of an individual.

One system of estate and gift taxation applies to U.S. citizens and to foreign citizens domiciled in the United States. A separate system applies to foreign citizens who are not domiciled in the United States. An individual is domiciled in the United States if he or she actually resides here and has the intention to remain in the United States indefinitely. Domicile is different from residency for income tax purposes. Whereas a foreign national with a greencard generally is regarded as domiciled in the United States for estate tax purposes, a foreign national who is a U.S. resident for income tax purposes under the substantial presence test may not necessarily be regarded as domiciled in the United States for estate tax purposes.

The United States has negotiated a number of treaties with respect to estate and gift taxes. Their provisions should be reviewed to obtain any available benefits.

U.S. Citizens and U.S. Domiciled Foreign Citizens

A U.S. citizen or U.S.-domiciled foreign citizen is subject to gift tax on the fair market value of all gifts made during life unless an exclusion exists. Most notably, a donor is permitted to make tax-free gifts of up to USD 12,000 annually to each donee. Married couples generally can treat such gifts as if each spouse made half of the gift, thereby doubling the amount that can pass tax-free annually to any one donee. The ability to split the gifts is available only if both spouses are U.S. citizens or U.S.-domiciled foreign citizens. Gifts to the individual’s spouse qualify for special treatment. All gifts made to a spouse who is a U.S. citizen are exempt from gift tax. In contrast, for 2008, annual gifts of up to USD 128,000 to a spouse who is not a U.S. citizen are exempt from gift tax.

Upon the death of a U.S. citizen or U.S.-domiciled foreign individual, his or her taxable estate is subject to estate tax. The taxable estate includes the fair market value of all of a decedent’s assets, wherever located, less certain deductions. Deductions are permitted for funeral and administration expenses, creditors’ claims, charitable bequests, casualty losses, and other expenses.

During the individual’s lifetime, current taxable gifts are added to all prior taxable gifts and a tentative tax is computed using the gift and estate tax rate table. The tentative tax is then reduced by any prior gift taxes paid and by the applicable credit amount.  At death, the taxable estate is added to all prior taxable gifts and the same tax calculation method is applied. The highest tax rate in 2008 is 45 percent on taxable transfers in excess of USD 2,000,000. The applicable credit amount excludes the equivalent of USD 1,000,000 of taxable gifts from gift tax. Upon death, the applicable credit amount for 2006-2008 excludes USD 2,000,000 from estate taxes. To the extent a decedent has made no taxable gifts, the entire applicable credit amount will be available to reduce the estate tax. Even if the decedent has used the USD 1,000,000 applicable credit amount against gift taxes, an additional USD 1,000,000 will be available for a decedent who dies in 2006-2008.

The most important estate tax deduction is the marital deduction, which generally permits all transfers of property to the decedent’s spouse to be excluded from taxation, but only if the spouse is a U.S. citizen. Generally, no marital deduction is allowable for property passing outright to a spouse who is not a U.S. citizen. Relief, however, may be available under certain estate tax treaties. In addition, if the surviving spouse becomes a U.S. citizen before the federal estate tax return of the decedent is filed, property passing to the spouse can qualify for the marital deduction if the spouse was a U.S. resident at all times after the decedent’s death and before becoming a U.S. citizen.

The marital deduction, however, is available for property passing to a qualified domestic trust (QDOT) for the benefit of a spouse who is not a U.S. citizen.

A QDOT must satisfy the following conditions:

  • The trust instrument must require that at least one trustee be a U.S. citizen or domestic corporation, and that no distribution from the trust may be made without the approval of this trustee;
  • The trust must meet the requirements in the Treasury regulations to ensure the collection of the estate tax on a subsequent taxable event; and
  • The executor must make an election to have the QDOT provisions apply. (Your tax adviser should be consulted to determine that the requisite conditions are satisfied.)

Property passing from the decedent to the surviving spouse outside of the probate estate will qualify for QDOT treatment if transferred to the QDOT by the due date of the decedent’s estate tax return. A special rule (estate tax credit rule) is provided to coordinate the estate tax treatment of property passing to a non-U.S. citizen with the treatment of property passing to a U.S. citizen (which is eligible for the marital deduction). If the property passes to a non-U.S. citizen who later becomes a U.S. citizen or domiciliary and is later subject to U.S. estate tax, a credit will be permitted to the estate of the second spouse for estate tax paid by the first spouse on such property. This rule, which applies regardless of whether a QDOT is used, results in only one level of taxation on the property transferred to a spouse.

Non-domiciled Foreign Citizens

Most gifts made by non-domiciled foreign citizens (“NDFC”) are exempt from U.S. gift taxes. However, these individuals are subject to U.S. gift tax on gifts of real property and on tangible personal property located within the United States. Gifts of intangible property are generally not subject to the gift tax even if the intangibles are U.S. assets (e.g., U.S. stocks and bonds). Gifts by a NDFC to his or her spouse are treated the same as gifts by U.S. citizens. Thus, gifts qualify for the unlimited marital deduction if the spouse is a U.S. citizen and for the USD 128,000 annual exclusion if the spouse is not a U.S. citizen. The USD 12,000 annual exclusion (for 2008) per donee is allowed, but gift-splitting between spouses is not available. The gift tax rates for NDFCs are generally the same as for gifts made by U.S. citizens and U.S.-domiciled foreign citizens, except that the applicable credit amount (discussed above) is not available.

The taxable estate of a NDFC is limited to certain tangible and intangible property situated in the United States. For example, stocks and bonds of U.S. corporations or real property located in the United States are included in the U.S. estate of a NDFC. However, deposits with a U.S. branch of a U.S. or foreign bank, deposits with a foreign branch of a U.S. bank, portfolio debt obligations (the interest income on which is not taxable to nonresident aliens), and proceeds from a life insurance policy on the life of a deceased NDFC are not considered to be property situated in the United States and, therefore, are not included in the NDFC’s gross estate.

The estate tax rates that apply to the estates of NDFCs are the same rates applicable to the estates of U.S. citizens and U.S.-domiciled foreign citizens. A special unified credit is provided for NDFCs that will exempt the first USD 60,000 of the U.S. taxable estate from U.S. estate tax. Foreign citizens domiciled in certain countries that have estate tax treaties with the United States are allowed to claim a pro-rate portion of the credit allowed to a U.S. citizen. The United States has negotiated a number of treaties with respect to estate and gift taxes of foreign citizens. Their provisions should also be reviewed to obtain any available benefits.

Foreign Trust/Gift Reporting Requirements

A U.S. resident is required to report all gifts received from any foreign individual and/or any foreign estate that, in the aggregate, total greater than USD 100,000 in any tax year.  Amounts received from foreign partnerships and foreign corporations that a U.S. person treats as gifts for income tax purposes also must be reported if the aggregate value of all such gifts exceeds USD 13,258 for 2007 (USD 13,561 for 2008).

Beneficiaries or settlors of foreign trusts potentially have reporting requirements concerning certain transfers, distributions, and provisions of an annual statement of the foreign trust’s assets and income. Due to the complexity of this issue, it is strongly recommended that professional advice be sought concerning any reporting aspects of foreign trusts and foreign gifts.

A foreign trust for these purposes is defined as any trust where a court within the United States is not able to exercise primary supervision over the administration of the trust or no U.S. persons have the authority to control all substantial decisions of the trust. This is a very complex area and, therefore, professional advice should be sought where the creation of a trust is being considered or where trusts already exist and the foreign national is due to begin an assignment to the United State

Comment:

Married couples (where one spouse is a non-U.S. citizen) might wish to consider the following points when reviewing their estate plans:

  • Estate and gift planning should take place before the death of the U.S. citizen spouse, since the non-U.S. citizen surviving spouse will not be able to reduce or eliminate estate tax paid by the decedent on the transferred assets. (Use of a QDOT will only defer tax.)
  • The USD 128,000 annual exclusion for gifts to non-U.S. citizen spouses may be used to reduce or eliminate the U.S. gift and estate taxes.

State and Local Taxes

Most of the 50 states, the District of Columbia, and a number of municipalities, tax residents and nonresidents on income earned from sources within their jurisdictions. In many cases, the states’ rules for determining residence may be similar to the federal rules. However, a foreign citizen’s federal tax status does not generally control his or her state tax status. States will generally tax their residents on worldwide income and nonresidents on income from sources within the state. Treaties the United States has with other countries have no direct control over state taxation. States that have adopted the federal tax base, however, will generally exempt income that is exempt by treaty from federal taxation.

Certain states impose taxes on intangible property in lieu of or in addition to taxes on income. Moreover, many states also impose estate or inheritance taxes, which can be greater than the federal estate tax.

 

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