Tax planning for a nonresident entering the U.S. tax system
A previous Tax Clinic item set forth some planning options by which a person seeking to immigrate to the United States can mitigate the U.S. tax cost of doing so (see Garcia, “Tax Clinic: Tax Planning for High-Net-Worth Individuals Immigrating to the United States,” 47 The Tax Adviser 257 (April 2016)). This item covers some of the key issues an immigrant faces after entering the U.S. tax system as a nonresident.
Tax reporting and filing obligations for nonresident alien individuals
Many non-U.S. citizens plan to skirt entry into the U.S. tax system as either a U.S. tax resident or U.S. domiciliary, such as by never being present in the United States for more than 121 days (see Sec. 7701(b)(3)(A)) or by claiming benefits as a resident of a foreign country under the residency tiebreaker rules of an income tax treaty (Regs. Sec. 301.7701(b)-7). There is likely great value in doing this because, unlike U.S. tax residents, who are subject to U.S. income tax on a worldwide basis, nonresident aliens are subject to U.S. income tax only on two types of U.S.-source income: fixed or determinable annual or periodical income (FDAP) (Sec. 871(a)) and effectively connected income (ECI) (Sec. 871(b)).
Examples of the former generally include dividends, certain interest and royalties, but they do not include investment capital gains (unless they are not ECI and paid to a nonresident alien physically present in the United States for more than 183 days during the tax year (see below), bank deposit interest (Sec. 871(i)(2)), or portfolio investment interest (Secs. 871(h), 2104(c), and 2105(b)(3)). Examples of the latter include income earned from conducting a trade or business in the United States and gains and losses from the sale or exchange of U.S. real property interests (Sec. 897(a)(1)).
FDAP is taxed on a gross basis, with no deductions allowed, at a flat 30 percent rate unless a lower treaty rate applies (Sec. 871(a)(1)). For example, dividend income to Canadian citizens paid by U.S. corporations will be taxed at either 5 percent or 15 percent, depending on the relationship between the corporation and the shareholder. The tax is collected by having the payer of the FDAP income withhold at the source and remit the tax to the IRS. If a nonresident alien has no ECI and realizes only FDAP income upon which the tax was fully withheld at the source, the nonresident alien is not required to file a U.S. tax return. If the withholding was insufficient to cover the tax due, the nonresident alien must file a tax return and pay any remaining tax due.
The second type of U.S. income on which a nonresident alien is subject to U.S. income tax, ECI, consists of income from active trade or business activities and is taxed on a net basis at graduated rates (Sec. 871(b)(1)). The nonresident alien must file an annual U.S. income tax return to report the income from these activities. This is because, unlike FDAP income, ECI is not generally subject to withholding at the source except for wages, scholarship or fellowship grants (Sec. 1441(a)), partnership distributions (Sec. 1446(a)), and gain from the sale of real property (Sec. 1445(a)).
Foreign investors in U.S. real estate
Often, a nonresident alien’s first entry into the U.S. economy is through the purchase of U.S. real estate. From April 2015 through March 2016, foreign buyers purchased $102.6 billion of residential property in the United States (see 2016 Profile of International Activity in U.S. Residential Real Estate). As mentioned earlier, gains or losses from the disposition of U.S. real property interests by a nonresident alien or a foreign corporation are taxable as ECI (Sec. 897(a)(1)). The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), P.L. 96-499, governs the taxation of gains from the sale of U.S. real estate and requires that the transferee withhold 15 percent of the gross amount realized from the sale or exchange by a nonresident. U.S. partnerships, trusts and estates are generally required to withhold tax at a 35 percent rate on gain realized from a disposition to the extent that gain is allocable to a foreign partner or beneficiary (Sec. 1445(e)). A foreign person may request a reduced withholding at the source if proper conditions exist and a Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests, is submitted and accepted by the IRS (Sec. 1445(c)(2)). There are other exceptions to withholding and a provision for reduced withholding (to 10 percent) on the transfer of property to be used as the buyer’s residence if the sales price is between $300,000 and $1,000,000 (Sec. 1445(c)(4)(C)).
Taxation of capital gains
Not all investment capital gains escape U.S. tax for a nonresident alien. Capital gains not effectively connected with a trade or business in the United States are taxed at a flat rate of 30 percent (or lower by treaty) if the nonresident alien is physically present in the United States for more than 183 days during the tax year (Sec. 871(a)(2)). (Note that this 183-day rule has no correlation with Sec. 7701(b)(3), i.e., the substantial presence test.)
Taxation of rental activities
For a nonresident alien who receives rent from a property, the default rule is that the rental income is FDAP subject to a 30 percent (or lower by treaty) withholding tax (Sec. 871(a)(1)). The tax effect can be severe because FDAP withholding applies on a gross basis and no deductions are allowed. Alternatively, the nonresident alien can elect to have the rental income taxed as if it were ECI (Regs. Sec. 1.871-10). Once this election is made, there should be no withholding on the rental income. The effect of the election is that deductions are allowed to offset the gross income, with the net being taxed at graduated income tax rates (Regs. Sec. 871-10(c)(1)). Upon sale of the rental property, the taxpayer must recapture depreciation, which is taxed as ordinary income, with the taxpayer’s net capital gains subject to tax at the rates that generally apply to capital gains.
U.S. entity owned by foreign persons
Nonresident aliens often invest in U.S. businesses, usually in the form of a U.S. entity. They can do this in several ways. The simplest way is for a nonresident alien to acquire ownership in the business in an individual capacity, e.g., he or she may acquire shares in a U.S. corporation. The biggest disadvantage of owning shares in a U.S. corporation is the potential exposure to U.S. estate tax, which applies to U.S. situs assets, including U.S. corporate stock (Sec. 2103). Stock in U.S. corporations is subject to U.S. estate tax at rates up to 40 percent on values in excess of the paltry $60,000 exemption available to a nonresident alien (compared with $5,490,000 for a U.S. citizen dying in 2017). Advantages of direct investment in a U.S. corporation include simplicity of formation and the (capital gain) tax treatment upon sale.
Alternatively, a nonresident alien may invest in a U.S. entity through a foreign corporation, typically wholly owned by the nonresident alien. In this event, the foreign corporation acts as a “blocker” to protect the nonresident alien from U.S. estate tax since a foreign corporation is not subject to the U.S. estate tax (Sec. 2104(a)). Of course, funds repatriated from the U.S. subsidiary to the foreign parent may be subject to U.S. tax, depending on whether the funds are paid on the subsidiary’s equity or debt capital. The treatment of those payments is beyond the scope of this item.
Note that the foreign corporation must disclose the identity of its ultimate indirect 25 percent foreign shareholders (Sec. 6038C) on Form 5472, Information Return of a 25 Percent Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, which must be filed when a U.S. corporation is owned 25 percent or more by foreign persons (directly or indirectly) and has reportable transactions with the foreign persons. Failing to file may result in a penalty of $10,000 and an additional $10,000 for each 30-day period (or fraction thereof) that the delinquency continues after the expiration of the 90-day period after the IRS mails notice of the taxpayer’s failure to file (Sec. 6038A(d)(2)). In general, a “reportable transaction” is any exchange of money or property with the foreign shareholder, such as a payment for sales, rents, commissions, royalties or interest. A reportable transaction does not include the payment of dividends (Regs. Secs. 1.6038A-2(b)(3) and 1.6038A-2(b)(4)).
Partnerships with foreign partners
Another U.S. investment vehicle is a partnership. Nonresident aliens who invest in U.S. partnerships are taxed generally as follows: If a partnership (including a limited liability company taxed as a partnership) has income that is effectively connected with a U.S. trade or business, it must withhold on the income that is allocated to its foreign partners (Sec. 1446). A foreign partner includes a nonresident alien, foreign corporation, foreign partnership, foreign trust, foreign estate and any other person that is not a U.S. person (Sec. 1446(e)). The withholding rate is at the highest statutory rate, which is 39.6 percent for noncorporate foreign partners, 20 percent for individual long-term capital gain and 35 percent for foreign corporate partners (Secs. 1 and 11). If the nonresident alien has another U.S. loss that offsets the partnership income, the nonresident alien or partner must file a U.S. income tax return to claim a refund.
Notwithstanding any losses to offset partnership income, overwithholding commonly occurs because of the high withholding rates. Foreign partners may seek relief by annually submitting Form 8804-C, Certificate of Partner-Level Items to Reduce Section 1446 Withholding. The partner can submit the certificate to the partnership at any time during the partnership’s year. However, to obtain relief for the entire year, the partner must submit the certificate to the partnership each year before the first quarterly withholding done by the partnership (Regs. Sec. 1.1446-6). Although the partnership can reasonably rely on the deductions and losses disclosed on Form 8804-C until it has actual knowledge or reason to know that the certificate is defective, the partnership can reject the information if it suspects inaccuracies.
International tax filings related to nonresident aliens
If a foreign person is treated as a U.S. nonresident under the tiebreaker provisions of a treaty (Regs. Sec. 301.7701(b)-7), he or she must comply with the majority of the international tax reporting obligations that apply to U.S. tax residents and citizens (see Sec. 7701(b)). Under these rules, the foreign person must disclose relevant data regarding his or her non-U.S. assets and investments. While no tax may be due on those assets, the penalties for noncompliance are significant (up to $100,000) (see Sec. 6038B). More importantly, the statute of limitation remains open for all years of noncompliance, exposing the foreign person to IRS audit at any time (Secs. 6501(c)(1), (2), and (3)).
While several ways exist for a nonresident alien to avoid being taxed as a U.S. resident or U.S. domiciliary, the U.S. tax system is complicated, extensive and fraught with potential consequences with every misstep. Careful consideration of U.S. income and estate tax issues thus becomes paramount.
Excerpted from the April 2017 issue of The Tax Adviser. Copyright © 2017 by the American Institute of Certified Public Accountants, Inc.