Aliens & Citizens Foreign and Domestic Tax Issues

Transcription

1 Aliens & Citizens Foreign and Domestic Tax Issues Monica Haven Summary Whether from Venus or Venice, resident or nonresident, illegal worker or student, here or overseas, US taxpayers face a myriad of issues and must contend with countless special forms. This course offers an overview and provides the practitioner seeking to keep pace with a shrinking world economy with the tools necessary to serve a diverse clientele. Topics include tax consequences of investments held onand off-shore, tax treaties that offer relief in some cases and double taxation in others, foreign tax credit, earned income exclusion and dual-status filing requirements. The information contained herein is for educational use only and should not be construed as tax, financial, or legal advice. Each individual s situation is unique and may require specialized treatment. It is, therefore, imperative that you consult with tax and legal professionals prior to implementation of any strategies discussed. Instructor Monica Haven, E.A., J.D. will happily address follow-up questions. You may contact her at: (310) PHONE (310) FAX mhaven@pobox.com i

2 KEY TO ICONS (AUTHOR S NOTES) TRHOUGHOUT TEXT... Practice Tip... Cautionary Note Table of Contents I. Summary of Tax Treatment... 1 II. Determining Residency... 1 Green Card Test versus Substantial Presence Test Dual Status Aliens III. Tax Treatment of Income and Expenses... 5 Effectively Connected Cost Basis Deductions IV. Tax Credits... 8 V. Tax Return Specifics... 9 Filing Status Personal Exemptions VI. Administrative Issues Forms and Due Dates Tax Treaties Special Reporting Rules Estimated Tax Payments and Withholdings State Rules VII. Gift and Estate Taxes VIII. Leaving the US IX. US Citizens Living Abroad General Guidelines Exclusions and Deductions (Foreign Earned Income and Foreign Housing) Military Personnel Foreign Tax Credit Miscellaneous Provisions X. Taxpayer Concerns Inter-agency Cooperation Tax Avoidance Schemes XI. Tabular Summary of Filing Requirements APPENDIX A: Commonly Used Immigration Statuses APPENDIX B: Glossary of Terms ii

3 Men are from Mars. Women are from Venus. But taxpayers can be from either (or both)! I. Summary of Tax Treatment Unlike United States (US) citizens and permanent residents, non-resident aliens (NRAs) are taxed only on US-sourced income rather than worldwide income. Thus, NRAs will frequently have less taxable income to report to US tax authorities, but will also not be entitled to favorable deductions, credits, exemptions, filing statuses and preferential tax rates. NRA income that is US-sourced income only is categorized into two types: Income that is effectively connected, may be reduced by Itemized Deductions and the Personal Exemption, and will be taxed using graduated tax rates. Income that is not effectively connected is taxed at a flat rate of 30%. TAX TREATMENT OF NRAs Taxed only on US-sourced income Effectively connected income (reduced by deductions & exemptions) is taxed at graduated rates Not effectively connected income is taxed at a flat rate of 30% II. Determining Residency While citizenship may be readily determinable, residency is often a bit murky. To establish proper tax treatment, the taxpayer s residency must first be ascertained under one of two tests. A. Green Card Test Issued to Lawful Permanent Residents by U.S. Citizenship and Immigration Services (USCIS) 1 Considered permanent unless residency status is administratively or judicially removed, or voluntarily forfeited (abandoned) by application and remittance of the Green Card to the USCIS or a US Consulate. Permanent residents Taxed like US citizens B. Substantial Presence Test (SPT) GREEN CARD HOLDERS ARE A person is considered to be a US resident for tax purposes if he has been physically present in the US (including all 50 states and the District of Columbia, but not US possessions or territories) for at least 31 days during the tax year AND 183 days during the most recent 3-year period which includes all of the days in the current year, 1/3 of the days in the previous year and 1/6 of the days in the year prior to that. 1 The USCIS was formerly known as the U.S. Department of Immigration and Naturalization Service (INS) but became a part of the U.S. Department of Homeland Security since March

4 Aviv was physically present in the US for 120 days in each of the years 2008, 2009 and To determine if he meets the SPT for 2010, the following number of days must be counted: 120 days in 2010 plus 40 days in 2009 (1/3 of 120) plus 20 days in 2008 (1/6 of 120) Since the total for the 3-year period is only 180 days, he is not considered a resident under the SPT for Days not counted include: days on which the taxpayer regularly commutes to work in the US from either Canada or Mexico days during which he is in the US for less than 24 hours due to international transit days in US if he is a crew member of a foreign vessel days that he is unable to leave the US due to a medical condition. Exempt individuals (who do not count days in the US toward the SPT) include: Foreign government employees or diplomats who only temporarily reside in the US Teachers on J or Q visas [See Appendix A for commonly used immigration statuses] UNLESS living in the US longer than 2 years Students on F, J, M or Q visas UNLESS living in the US longer than 5 years Professional athletes in the US to compete in a charitable event Exempt individuals must file Form 8843 Statement for Exempt Individuals and attach it to the tax return. Exempt individuals are subject to the SPT for all periods before and after they held exempt status. A foreign student F-1 visa-holder arrived in the US on January 1 st, 2006 and is still considered an NRA for His wife (not a student) came with him on an F- 2 visa and is also an NRA in However, both husband and wife will be considered residents in 2011, regardless of their academic status. Exception Even if the SPT is met, the taxpayer can still be treated as an NRA if he: is present in the US for less than 183 days during the year AND maintains a tax home 2 in a foreign country AND has a closer connection to one foreign country Those claiming a closer connection a foreign country must file Form 8840 Closer Connection Exception Statement and attach it to the return. 2 Tax Home is defined as the place of business or employment and not necessarily the place of the family home. Facts and circumstances used to determine the closer connection to a foreign country include, but are not limited to country of residence, location of permanent home, family, personal belongings, affiliations, voting rights and driver s license. 2

5 Applicable tax treaties may override any of the rules stated above. If so, Form 8833 Treaty-Based Return Position Disclosure must be filed and attached to the tax return. NOTE that an illegal immigrant can still be considered a Resident Alien for tax purposes and must, therefore, file a US tax return. SUBSTANTIAL PRESENCE TEST 31 days in a year AND 183 days during most recent 3-year period (count ALL days in current year + 1/3 days in previous year + 1/6 days in year prior to previous) Certain days are not counted & some individuals are exempt from counting If taxpayer maintains a foreign tax home & closer connection abroad, he may be an NRA despite satisfying SPT C. Dual-Status Aliens Part-year residents are, by definition, deemed dual-status and must file as nonresidents for part of the year and as resident aliens for the other portion. The residency date begins on the first day that the taxpayer is present in the US or is issued the Green Card (whichever is later); assuming no travel in or out of the country ensues. Thus, to accumulate the requisite 183 days for residency status, the immigrant must enter the US on or before July 1 st. Maria entered the US on April 10 th and was issued a Green Card on June 15 th. Her residency would seemingly have begun on June 15 th, but since the Green Card was issued in the same year that her substantial presence began, her residency actually began on the earlier date. Special Elections: 1. First-Year Choice ( 6013) If an immigrant arrives on or after July 2 nd, he would not qualify under the SPT for residency until the following year. However, he may elect to backdate his residency status to the previous year if he: was present in the US for at least 31 consecutive days in the previous year AND meets the SPT for the current year Juan came to the US on November 1 st, 2009 and was here for 31 consecutive days before he returned to his home country to visit on December 1 st. He returned to the US on December 15 th and then stayed in the US throughout most of He will, of course be considered a resident for 2010, but may use the special election to be considered a resident for 2009 even though he did not meet the SPT. He must attach a statement claiming the election to his return. 2. Marriage Election ( 6013(g)) A married individual entering the US for the first time and considered to be dualstatus may opt to be treated as a resident for the entire year if: he was an NRA at the beginning of the year and is a resident alien or citizen at the end of the year 3

6 he is married to a US citizen or resident alien at year-end and his spouse agrees to the election and files a joint return with him This is a once-in-a-lifetime election and cannot be made again upon separation, divorce or remarriage. Danielle and Maxime are married and both are nonresident aliens at the beginning of the year. In June, Maxime became a resident alien and remained a resident for the rest of the year. Danielle and Maxime may both choose to be treated as resident aliens by attaching a statement to their joint return. They must file a joint return for the year they make the choice, but they can file either joint or separate returns for later years. Bob is a US resident with $12,000 in worldwide income. His wife lives abroad and has no income. Bob can file separately or elect to file jointly using 6013(g) and lower his tax liability. (His wife will need to obtain a taxpayer ID number.) Mathilde and her son live permanently in the US. Her husband Friedrich joins them during the year. Using the 6013(g) election, they may file jointly. Alternatively, Mathilde may file separately and claim the Head of Household status, even though she is married because her husband (not she) is an NRA. He would then be required to file his own non-resident or dual-status return. DUAL STATUS (PART-YEAR) RESIDENTS MAY ELECT: To back-date residency to year before he satisfies SPT Residency treatment if NRA files joint return with US citizen or resident alien spouse D. Special Note for Residents of US Territories 3 Residents from American Samoa or Puerto Rico for the entire year are treated as Resident Aliens for US tax purposes. These residents may exclude all Puerto Rico- or American Samoa-source income 4, except amounts earned as US government employees and can only claim exemptions for US citizen dependents. Taxpayers with income from US possessions may have to file a tax return with the tax department of that possession only, or may have to file with both the possession and the IRS [Refer to IRS Pub 570 Tax Guide for Individuals With Income From U.S. Possessions]. 3 If a taxpayer moves to or from a territory and has worldwide income of more than $75,000 that year, it is necessary to file Form 8898 Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession. The penalty for failure to file is $1, Currently, the possession exclusion applies only to individuals who are bona fide residents of American Samoa and Puerto Rico. Individuals in the following U.S. possessions or territories are not eligible for the possession exclusion: Baker Island, Commonwealth of Northern Mariana Islands (CNMI), Guam, Howland Islands, Jarvis Island, Johnston Island, Kingman Reef, Midway Islands, Palmyra, U.S. Virgin Islands, and Wake Island. 4

7 III. Tax Treatment of Income and Expenses A. Income Source of income is a mute point for US citizens and resident aliens who must report worldwide income. Although some income may be exempt from taxation under various treaties or be eligible for the Foreign Earned Income Exclusion, all income (regardless of source) must be reported on Form NRAs, however, need only report US-source income. Dual-status aliens may exclude all foreign source income for the part of the year during which they are considered non-residents, but must then include worldwide income for the remainder of the year during which they are considered residents. Income that is not US-sourced and, therefore, not taxable to NRA: Interest paid by a US corporation if at least 80% of the company s gross income is derived from sources outside the US due to active conduct of business in a foreign country in the preceding three years Interest if funds are deposited in a foreign branch of a domestic commercial bank Dividends from a domestic corporation if the company elects to take the Puerto Rico Economic Activity Credit Corporate dividends received from a foreign corporation if more than 25% of the company s gross income is effectively connected with business in the US Personal service compensation received for work performed outside the US. However, personal service income received for work performed in the US must be pro-rated based on the percentage of time worked in the US and included in US-sourced income Gain on sale of personal property, including furniture and equipment, as long as the taxpayer s tax home is not in the US Revenues from the sale of inventory is sourced where the property is sold regardless of where the items were originally purchased, but can be pro-rated if the items were produced in the US and sold abroad Gain on sale in excess of allowable depreciation can be pro-rated based on the amount of the depreciation taken in the US versus abroad Jean, an NRA, is a professional hockey player with a US hockey club. Under Jean s contract, he received $98,500 for 242 days of play during the year. This includes days spent at pre-season training camp, days during the regular season, and playoff game days. Of the 242 days, Jean spent 194 days performing services in the US and 48 days playing hockey in Canada. Jean s US source income is figured as follows: ( days) x $98,500 = $78,963. Community Property Issues State and foreign community property laws relative to community income (including France, Spain, Mexico and Philippines) must be disregarded if both spouses are NRAs or one spouse is an NRA while the other is not and 6013(g) is not elected. In this case earned, business and partnership income is attributed to the spouse who earned it. California has not conformed to this treatment of separate income. As there are no Green Card or Substantial Presence Tests, immigrants to California are considered residents for tax purposes on the day that they arrive in state. Thus, they must report worldwide income but may then also 5

8 claim all deductions and credits. The tax liability is computed based on the ratio of California-sourced taxable to worldwide taxable income. A married couple arrived in California on December 1 st, 2010 from Japan and now resides permanently in the US. As they did not meet the SPT for 2010, they must file non-resident federal returns for 2010 and part-year resident returns for California using the MFS status. Alternatively, they could take the special First-Year Election under 6013 and be treated as dual-status in 2010, allowing them to file a joint This, in turn, would allow them to file a joint California 540NR as the filing status in California must be the same as the one chosen for federal purposes. Connected or Not? For the NRA, income may be either effectively or not effectively connected to the US. Effectively connected income is revenue which is derived from a US trade or business, is reported on Page 1 of Form 1040NR, and can be reduced by personal exemptions and itemized deductions. The net taxable income is then subject to the graduated tax rates currently in effect. On the other hand, income which is not effectively connected is reported on Page 4 of Form 1040NR and cannot be reduced by exemptions and deductions. Instead, it is subject to a flat tax of 30%, unless a lower treaty rate applies. Effectively Connected Income is determined under the: Asset-use Test: Whether income is derived from assets used in the conduct of a US business, or Business-activities Test: Whether the activities of the US business were a material factor in the realization of income Not Effectively Connected Income: Includes fixed, determinable or periodic income such as interest, dividends, rents, royalties and annuities Any income that does not meet the Asset-use or Business-activities Tests Effectively Connected (taxed at graduated rates) Wages earned in the US Partnership income Business income Gains on sale of US real estate or bus. assets Nonqualified scholarships Transportation income (if fixed place of business in US and 90% attributable to regularly scheduled transportation) Pension income Foreign income (if fixed place of bus. in US and income is produced in the ordinary course of bus.) Not Effectively Connected (taxed at 30% rate) Interest from banks, credit unions, insurance companies, government & municipal securities Dividends Capital gains (tax exempt if taxpayer in the US < 183 days) Rental and royalty income Social Security benefits (85% includable unless exempt under treaty) Transportation income earned for travel that begins/ends in US but does not meet fixed place and 90% tests (taxed at 4% flat rate) Since rental and royalty income is considered to be not effectively connected, it cannot be reduced by deductions typically applicable to the maintenance and management of rental property. Thus, the NRA is taxed on the gross rental revenue. 6

9 However, the NRA may elect to treat the rental income as effectively connected under 871(d) and would then be allowed to deduct rental expenses, so that he would ultimately be taxed on the net rental income only. Manel is a nonresident alien and is not engaged in a US trade or business. She owns a single family house in the US which she rents out for $10,000/year. It is her only US source income. Since the rental income is considered to be not effectively connected, it is subject to tax at a 30% rate. Manel receives a Form 1042S Foreign Person s US Source Income Subject to Withholding showing that her tenants properly withheld this tax from the rental income. She does not have to file a U.S. tax return because her US tax liability is satisfied by the withholdings. However, if she chooses to consider the rental income effectively connected, she can offset the $10,000 income by allowable rental expenses. The resulting net income is then taxed at the usual graduated rates. Additional examples of US-sourced income, not effectively connected and excludable: Portfolio interest, unless NRA owns more than 10% of the outstanding stock Gain on sale of a personal residence may be excluded under 121 up to $250,000 if single, or $500,000 if married, as long as all other applicable provisions are satisfied US-sourced employee compensation is tax-exempt if the NRA worked for a foreign company, the NRA was only temporarily present in the US for periods less than 90 days at a time AND the wages received were less than $3,000 in total Alfred, an NRA from Kenya, worked abroad for a US company but was sent to work in the US for 2 months. He was paid $2,500 in December 2009 and again in January Although US-sourced, Alfred s wages would have been tax exempt had he earned less than $3,000 in total, but because he received $5,000 he will have to include his earnings in each of the taxable years. NRA s TAXABLE INCOME: Must be US-sourced Is effectively connected if used in US business Can only be reduced by associated deductions if effectively connected Foreign community property laws are disregarded; income is attributed to spouse who earned it Excludable income includes bank interest, most investment income, gain on sale of personal residence, & de minimus wage income if only temporary job in US B. Cost Basis NRAs may take advantage of a pre-immigration tax planning opportunity: By engaging in certain transactions prior to becoming subject to US taxation, the NRA may be able to reset the cost basis of his assets. The NRA may sell US-sited assets to an offshore entity, thereby engaging in a transaction that recognizes a step-up in basis for US tax purposes without actually being subject to US taxation. He may then sell the asset with its stepped-up basis in the year that he becomes a US resident, avoiding most if not all taxable gains. 7

10 C. Deductions Unlike US citizens and resident aliens, NRAs may not claim the Standard Deduction. QUIRKY EXCEPTION: Students and business apprentices from India are eligible to use the Standard Deduction under Article 21(2) of the US-India Income Tax Treaty! All allowable deductions must be related to effectively connected income. Therefore, the NRA may deduct state, local and real estate taxes paid, as well as charitable contributions to qualified US (not foreign) organizations, casualty losses, and unreimbursed employee expenses. The NRA may not deduct medical expenses, personal property taxes, and mortgage interest. Dual-status aliens may not use the Standard Deduction, but may claim all of the same Itemized Deductions allowed to US residents and citizens. Additional rules to note: NRAs may make contributions to Individual Retirement Accounts (IRAs), SEPs, SIMPLEs and other qualified retirement plans under the same rules which apply to US residents NRAs may claim moving expenses for coming to the US under the same rules as US residents, but may not deduct the expenses related to the move which returns them to their foreign home INcoming moving expenses are deductible OUTgoing expenses are not Student loan interest can be deducted by the NRA under the same rules which apply to US residents Penalties on early withdrawals of savings can only be deducted if the interest income is effectively connected IV. Tax Credits NRAs with effectively connected income are eligible to claim only some of the credits available to US residents, including: Adoption Credit only available to married NRAs if they elect to file jointly with their US citizen spouse Child and Dependent Care Credit only available to married NRAs if they elect to file jointly with their US citizen spouse Child Tax Credit if the NRA has a qualifying child who is a US citizen or resident and is claimed as a dependent on the tax return Credit for Prior Year Minimum Tax may be claimed by the NRA under the same rules which apply to US residents Earned Income Credit only available to married NRAs if they elect to file jointly with their US citizen spouse Education Credits only available to married NRAs if they elect to file jointly with their US citizen spouse Energy Credits may be claimed by the NRA under the same rules which apply to US residents Foreign Tax Credit may be claimed for income taxes paid to a foreign country on income from foreign sources which is effectively connected to the US Retirement Savings Contribution Credit may be claimed by the NRA under the same rules which apply to US residents 8

11 TAX DEDUCTIONS & CREDITS: NRAs may only claim Itemized (not Standard) Deductions and these must be related to effectively connected income Most tax credits are only available to NRA who is married to and files jointly with a US citizen spouse, except Prior-year Minimum Tax, Energy, Foreign Tax and Retirement Savings Contribution credits V. Tax Return Specifics A. Filing Status Only Single (S), Married Filing Separately (MFS) or Qualifying Widower (QW) filing statuses are available to the NRA unless the NRA is married to a US citizen or resident and chooses to file jointly under 6013(g). Head of Household (HOH) status is not available to the NRA. (However, the resident spouse may file HOH if married to an NRA who is not treated as a spouse for tax purposes.) Married NRAs may elect to file as single, only if: they reside in Canada, Mexico, or South Korea or are married to a US national (a resident of American Samoa or Northern Mariana Islands who has sworn allegiance to the US) AND have lived apart from their spouse for the last six months of the tax year In addition to US citizens, residents of Canada, Mexico, South Korea, American Samoa, and Northern Mariana Islands may file as QW if all other criteria are satisfied. B. Personal Exemptions NRAs may only claim an exemption for themselves on the tax return except NRAs who are residents of Canada, Mexico, American Samoa, or Northern Mariana Islands and have a spouse who has no US-source income and is not the dependent of another taxpayer, may claim an extra exemption. Additional exemptions may be claimed for qualified dependents under the same rules which apply to US residents. Special Rules Under applicable tax treaties, Japanese and South Korean residents may claim additional dependency exemptions if the spouse and children lived with the NRA in the US at some time during the tax year Students and business apprentices from India may also be eligible to claim the exemptions under Article 21(2) of the US-India Treaty for a spouse with no gross income and children who are citizens or residents An ITIN 5 (or SSN) is required for all exemptions claimed. 5 ITINs are issued by the IRS to taxpayers who are otherwise not eligible to apply for Social Security Numbers (SSNs) and can be used for tax purposes only. They do not affect the taxpayer s immigration status or work eligibility. NRA dependents and spouses must have an ITIN for proper filing. Use Form W-7 Application for IRS Individual Taxpayer Identification Number to apply. 9

12 FILING STATUS & EXEMPTIONS: Single NRA may only file S or QW Married NRA may only file MFS (or MFJ if 6013(g) election is made) Married NRA living in Canada, Mexico or South Korea may file S if married but separated from a US national NRA may not file HOH Generally, NRA may only claim one exemption VI. Administrative Issues A. Forms to Use US citizens and resident aliens must use Form 1040, 1040A or 1040EZ NRAs must use Form 1040NR Dual-status aliens must use: o Form 1040 if the immigrant became a US resident during the year and is a resident on December 31 st o Form 1040NR if the former US resident gave up his residency and does not reside in the US on December 31 st The return should be notated across the top as a Dual-status Return B. Due Dates US citizens and resident aliens must file by April 15 th NRAs must file by April 15 th, or June 15 th if they did not receive any wages subject to withholdings Mail to: Department of the Treasury, Internal Revenue Service Center Austin, TX C. Tax Treaties [Refer to IRS Publication 901 US Tax Treaties for additional information] The US has signed income tax treaties with numerous foreign countries allowing for reduced tax rates or exempting certain types of income received here and abroad by NRAs. If a treaty does not address a particular type of income, or if there is no treaty between the foreign country and the US, the income is taxed as per the instructions for Form 1040NR. Not all states conform to the federal treatment of income and thus international tax treaties may not apply. Tax treaties reduce the US tax of NRAs. With certain exceptions, they do not reduce the tax of US citizens or residents. Treaty provisions are usually reciprocal in nature and offer tax benefits to taxpayers in each signatory country. Treaty-based positions must be disclosed on Form 8833 Treaty-based Return Position Disclosure which should be attached to the timely filed return. A return must be filed even if a treaty-based position eliminates all taxable income. Failure to file Form 8833 may result in a $1,000 penalty. 10

13 Yoshi is an NRA who is single and a resident of a foreign country that has a tax treaty with the US. He received gross income of $25,500 during in 2010 from US sources, consisting of the following items: $1,400 dividends on which the tax is limited to a 15% rate by the tax treaty and $24,100 compensation for personal services on which the tax is not limited by the tax treaty. Yoshi s dividends are not effectively connected and he has no deductions other than his own personal exemption. His tax liability is determined as follows: Personal service compensation $24,100 Less: Personal exemption 3,650 6 Taxable income $20,450 Tax as per tax table for Single $2,653 Plus: Tax on gross dividends 210 Total Tax Due $2,443 A foreign government employee s wage (not pension) income will be exempt from US taxation by treaty or by US law if the NRA performs services for the foreign government similar to those services that would be required by his US government employee counterparts. D. Special Reporting Rules Calendar Year If income was earned abroad in countries which use a different tax year, the taxpayer must allocate income and expenses to properly reflect and report what was earned on a calendar-year basis on his US return. Foreign Currency All amounts reported on US tax returns must be reported in US dollars. If income was earned abroad and received in foreign currency, it must be translated into US dollars at the prevailing exchange rate on the date the income was received. If income was earned evenly throughout the year, the taxpayer may use an average exchange rate for the period if the foreign currency was in fact reasonably stable. Many online currency converters are available; for example, Depreciation Real property outside of the US used in a trade or business must be depreciated on a straight-line basis over a 40-year period; personal property held abroad must be depreciated over a 12-year life. Additional Disclosures Gifts and inheritances received from abroad must be disclosed on Form 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts if they exceed $100,000 Owners of foreign entities may be required to file Form 5471 Information Return of U.S. Persons with Respect to Certain Foreign Corporations, Form 8858 Information Return of U.S. Persons with Respect to Foreign Disregarded Entities, Form 8865 Return of U.S. Persons with Respect to Certain Foreign Partnerships, Form 8891 U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans, amongst others 6 Applicable exemption amount in

14 Certain transfers of property to foreign corporations must be disclosed on Form 926 Return by a U.S. Transferor of Property to a Foreign Corporation E. Estimated Tax Payments NRAs must make estimated tax payments (ES) under the same rules as a US resident. However, if the NRA does not have any wages subject to withholding, the first ES payment can be made by June 15 th instead of April 15 th. In that case, one-half of the ES liability must be paid by June 15 th ; the remaining balance may be paid in quarterly installments on September 15 th and January 15 th. F. Withholdings NRAs are subject to tax withholdings on wages earned and must provide their employers with Form W-4 indicating Single and 1 or preferably Single and 0, as they are not allowed to claim dependency deductions. NRAs are also subject to withholdings of Social Security and Medicare taxes unless they are in the US on a student visa performing only on-campus work. NRAs, who are self-employed, are not subject to Social Security and Medicare taxes unless they are residents of Puerto Rico, Virgin Islands, Guam or Northern Mariana Islands. Raul authored and published a book in Argentina while he was a resident there. He later became a US resident alien and continued to receive royalties from the foreign publisher. He must report these royalties as self-employment income in the year received on his US return and must pay self-employment tax on these earnings. If a Social Security or Totalization Agreement 7 is in effect between the US and a foreign country, the employee will only pay Social Security tax to the country in which he is working. If he normally works abroad, but is sent to the US to work temporarily, he will pay Social Security taxes only to his home country. Pension income will automatically be withheld at a 30% rate unless Form W-8ECI is used to elect graduated rates because the pension is effectively connected. 10% of the amount realized upon disposition of real property will be automatically withheld. Form W-8BEN can be used to request an exemption or reduction from withholding due to treaty provisions. PAYROLL TAX WITHHOLDINGS NRA s wage income is subject to income tax & FICA withholdings NRA students working on-campus are exempt from FICA taxes Self-employed NRAs are subject to SE Tax Totalization agreements ensure that Social Security taxes are paid only to the country in which the employee works (not lives) 7 The United States currently has Social Security agreements in effect with 24 countries - Australia (2002), Austria (1991), Belgium (1984), Canada (1984), Chile (2001), Czech Republic (2009), Denmark (2008), Finland (1992), France (1988), Germany (1979), Greece (1994), Ireland (1993), Italy (1978), Japan (2005), Luxembourg (1993), the Netherlands (1990), Norway (1984), Poland (2009), Portugal (1989), South Korea (2001), Spain (1988), Sweden (1987), Switzerland (1980), and the United Kingdom (1985). Social Security Handbook, 107 Totalization Agreements, available at [last accessed May 18, 2011]. 12

15 G. State Rules Individual states may have differing rules applicable to non-residents which should be verified on a case-by-case basis. California, for example, considers everyone present in the state regardless of the length of time spent to be a resident. Therefore, everyone must file either Form 540 if present in-state for the entire year or Form 540NR if present only part of the year. Additionally, California requires the filing of Form 592 Resident and Nonresident Withholding Statement along with Form 592-V Payment Voucher for Resident and Nonresident Withholding by any individual or entity making payments of California-source income to non-resident (out-of-state) individuals, partnerships, corporations, estates or trusts that do not have a permanent place of business in-state. Tax is required to be withheld at a rate of 7% on the following types of income: Compensation for services performed Rents and royalties for properties in California Estate and trust distributions Prizes and lottery winnings Partnership income Form 592 must be filed and withholdings must be submitted to the tax authority quarterly on April 15 th, June 15 th, September 15 th and January 15th VII. Gift and Estate Taxes US citizens and residents are subject to the US estate and gift tax laws. For these purposes, residency is not determined in the same manner as it is for income tax purposes. Rather than by application of the Green Card or Substantial Presence Tests, a decedent quite simply is considered to have been a resident if he was domiciled in the US at the time of his death. If he lived in the US, even for a brief period of time, and did not have any definite intention of returning to a foreign country, he was domiciled in the US. The executor of the estate must file an Affidavit of Domicile to certify the decedent's place of residence at the time of death. US-domiciled NRAs are subject to US estate taxation as follows: The gross estate will include all tangible and intangible property located in the US The deduction for allowable administrative expenses will be limited by the ratio of the NRA decedent s US gross estate to his worldwide gross estate NRAs are allowed the unlimited marital deduction only if the surviving spouse either already is a US citizen or becomes a US citizen by the due date (plus extensions) of the tax return, or if the assets are left to a qualified domestic trust, or if treaty provisions stipulate accordingly NRAs are allowed a $60,000 estate exclusion amount rather than the $5 million 8 exclusion currently allowed to US citizens Foreign estates defined as those of US citizens who are permanent residents of foreign countries, whose assets are located entirely abroad, and whose fiduciaries are foreign corporations located abroad are subject to US taxation only on income derived from US sources or income that is effectively connected. 8 Applicable Unified Credit in 2011 is $1,730,800 which equates to an estate exclusion of $5 million. 13

16 NRAs are subject to tax on gifts of US-situated property (i.e real estate and tangible personal property located within the US). However, NRAs generally are exempt from gift tax on transfers of intangibles, such as stock and securities, regardless of where the property is situated. ESTATE & GIFT TAX RULES Only US citizens & residents are subject to US estate tax Residency is based on domicile (determined by the taxpayer s intent to remain in the US) Gross Estate of US-domiciled NRAs consists only of US-based property Deductions & exclusions for US-domiciled NRAs are limited NRAs must pay gift tax on transfers of real estate & tangible (but not intangible) property VIII. Leaving the US Prior to leaving the US, all resident and non-resident aliens must prove that they have satisfactorily complied with US tax laws. To that end, they must obtain a clearance document known as a sailing or departure permit by filing Form 1040C US Departing Alien Income Tax Return and paying any tax due. The taxpayer may instead file the shorter Form 2063 US Departing Alien Income Tax Statement if he has previously filed all requisite income tax returns, paid all taxes due, and does not have any taxable income for the year of departure and for the preceding year. Filing Form 1040C or Form 2063 does not, however, satisfy the taxpayer s final filing requirement. The taxpayer is still required to file his normal US return on Form 1040 or Form 1040NR, whichever is applicable, although any amounts paid with Form 1040C may be included as tax payments. Certain aliens are exempt from these filing requirements if they can be included in one of the following categories: Foreign government diplomats and members of their households, if accompanying the diplomat Employees of international organizations whose wages are tax exempt and who receive no other income from US sources Students who entered the US on F2, H3, H4, J1, J2 or Q visas and who receive no US-source income Students on M1 or M2 visas who receive only interest income that is not effectively connected NRAs only temporarily in the US who have received no taxable income during their stay in the US Alien residents of Canada or Mexico who commute in and out of the US, but whose US wages are subject to withholding Aliens must apply in person for the departure permit no sooner than 30 days prior to their scheduled departure and must provide the following items to a local IRS office: Passport or Alien Registration Card Document verifying US taxpayer ID number, whether SSN or ITIN Copies of filed tax returns for the past two years and proof that taxes due were paid Documentation verifying the deductions and exemptions claimed on these returns Employer statement verifying the wages paid to date in the current year or a statement of income and expenses, if self-employed Proof of estimated tax payments paid in the current and previous years Documents detailing capital transactions and scholarships, if any Documents detailing tax treaty provisions, if applicable Documents verifying date of departure 14

17 Form 2063 can be used by aliens who have no taxable income in the current year. All others must use Form 1040C. IX. US Citizens Living Abroad [See IRS Publication 54 Tax Guide for US Citizens and Resident Aliens Abroad for additional information] A. General Guidelines US citizens and resident aliens living abroad have the same filing requirements as those living in the US. If the taxpayer is living outside of the US on the due date of his return (April 15 th ), he will receive an automatic two-month extension (until June 15 th ) to file and must attach a statement of explanation to his return when filing. The taxpayer will receive an automatic six-month extension (until October 15 th ) if he files Form He may choose to file Form 4868 as late as June 15 th, but will then still only receive an extension until October 15 th. All amounts of income and expenses must be reported in US dollars on the tax return. The prevailing exchange rate at the time the income was received or the expenses paid should be used. US employers must withhold US income tax from wages paid to US citizens living abroad, unless the employer is required by law to withhold foreign income tax. If the taxpayer expects to be eligible for the Foreign Earned Income or Foreign Housing exclusions, he may use Form 673 Statement for Claiming Exemption From Withholding on Foreign Earned Income Eligible for the Exclusion (Provided by Section 911), exempting the employer from US withholding requirements. B. Exclusions and Deductions To qualify for foreign earned income exclusions and deductions, the taxpayer must: have foreign earned income be either a US citizen or resident alien who resides in a foreign country for at least one full tax year from January 1 st through December 31 st (Bona Fide Residence Test) or is physically present in the foreign country for at least 330 days during any consecutive 12-month period (Physical Presence Test) AND have a tax home 9 in a foreign country 10 (with no abode in the US) Amanda is a US citizen who lives and works abroad. She has lived in Germany for 14 months from September 1, 2009 through October 31, However, she is unable to meet the Bona Fide Residence Test since she has not been in Germany for a full calendar year. Instead, she is able to pass the Physical Presence Test. 9 Tax Home may be (a) the taxpayer s main place of business or employment, or (b) the place where he is permanently or indefinitely engaged to work, and (c) may depend on whether the work is temporary (less than one year) or indefinite. Example: An itinerant s tax home is wherever he works. 10 A foreign country is defined as any territory under the sovereignty of a government other than that of the United States (Treas. Reg (h)). Based on this definition, the 7 th Circuit Court of Appeals upheld IRS denial of a taxpayer s claim for the Foreign Earned Income Exclusion. Arnett, a US citizen, attempted to exclude wage income of $48,894 earned while working at McMurdo Station in Ross Island, Antarctica. However, Antarctica has been deemed to be a sovereign-less region based on the Antarctic Treaty of 1961 that provided that the continent was to be used for peaceful and scientific purposes and that all questions of sovereignty would be put into abeyance. Arnett v. Comm., USTC 50,162; 7 th circ

18 Nick is employed on an offshore oil rig in the territorial waters of Scotland and works a 28-day on/28-day off schedule. He returns to his family residence in the US during his off periods. He is considered to have an abode in the US and does not satisfy the tax home test in the foreign country. He cannot claim the exclusions. Bob is a marketing executive with a US company which transferred him to London for a minimum of 18 months. Before he left, Bob distributed business cards showing his new business and home addresses in London. He kept ownership of his US house, but rented it to another family after moving his family, furniture and pets to London. He and his wife obtained British driving licenses, opened local bank accounts and joined a neighborhood civic association. Bob s abode is in London he satisfies the tax home test in the foreign country. The time limits for the Bona Fide Residence or Physical Presence tests may be waived if the taxpayer is forced to leave the foreign country due to war or civil unrest as determined annually by Internal Revenue Bulletin. 11 Once the Physical Presence Test has been satisfied, the taxpayer may check to see if he can amend a prior-year return on which he did not claim the income exclusion because he had not yet been in-country for the requisite 330 days. If the taxpayer resides in a foreign country in violation of US law (i.e. Cuba 12 ), neither of the tests can be met and thus, the taxpayer is not eligible for the exclusions. Foreign Earned Income must be paid for personal services performed and does not include: the value of meals and lodging pension or annuity payments US government salaries Investment or passive income 1. Foreign Earned Income Exclusion The maximum exclusion for 2011 is the lesser of $92,900/year or the amount of the foreign earned income less any foreign housing exclusion claimed. If both spouses work in a foreign country and meet the qualifications for the exclusion, up to $185,800 of foreign earned income can be excluded in The excludable limit is adjusted annually for cost-of-living. Although excluded, foreign earned income may still be subject to Social Security taxes under some circumstances. The election to claim the exclusion can be made on a timely filed return or a late-filed return within one year after the original due date. If the exclusion is claimed, the taxpayer may not take the Foreign Tax Credit for taxes paid on the excluded income and is ineligible to claim the Earned Income Credit. 11 For example, the IRS has just announced that residency requirements may be waived for Haiti (on or after January 13, 2010) and Cote d Ivoire (on or after December 19, 2010). Federal Tax Alert, May 2011, For 2010, the only country to which travel restrictions applied was Cuba which applied for the entire year. 16

19 2. Foreign Housing Exclusion Amounts received for employer-provided housing (less a government-calculated base amount) are eligible for the exclusion 13. Unless self-employed, all earnings are considered employer-provided, making the entire housing amount eligible for exclusion. Housing expenses include rent, repairs, utilities, real and personal property insurance, occupancy taxes, furniture rental, and residential parking. Expenses not eligible for the exclusion are deductible mortgage interest and property taxes, cost of purchasing a property, cost of domestic labor, leasehold and homeowner s improvements, and depreciation. Tom was a bona fide resident of and had his tax home in Ghana from August 17, 2007 through the end of the year, while his wife Jane began her residency one month later on September 15 th. Tom paid $10,000 for housing expenses; $7,500 of this amount was incurred from September 15 th through the end of the year. Jane paid $3,000 for housing expenses. Although Tom and Jane will file jointly, they can choose to let either Tom or Jane claim the housing exclusion. If Tom claims the housing exclusion, their housing exclusion would be $7,890 (= $13,000 less the government-calculated base amount of $5,110). If Jane instead claims the housing exclusion, their allowable exclusion would be $6,480 (= $10,500 expenses less the government-calculated base amount of $4,020). The housing exclusion must be elected before the foreign earned income exclusion, as the latter is reduced by the amount of housing exclusion claimed. Although amounts excluded under the income and housing exclusion are not taxed, they are nevertheless added back when computing regular and alternative minimum tax liabilities; thereby bumping taxable income into higher marginal tax brackets. Taxpayer has $80,000 of foreign earned income eligible for the exclusion plus $20,000 of other non-excluded income which will be taxed at the marginal rate applicable to $100,000 (not $20,000). 13 The base amount is calculated as follows: 16% of the amount (computed on a daily basis) of the Foreign Earned Income Exclusion for the calendar year in which the tax year begins [$92,900 (for 2011) 16% = $14,864 divided by 365 days = $40.72/day] multiplied by The number of days of the tax year within the applicable period of foreign residence (bona fide residence test) or presence (physical presence test) for that tax year The allowable Housing Exclusion is limited to 30% of the Income Exclusion [$92,900 X 30% = $27,870 divided by 365 days = $76.36/day]. Thus, only housing costs in excess of $40.72/day and less than $76.36/day are excludable resulting in a maximum exclusion of $13,009 in Certain high-cost locales (detailed in the Instructions for Form 2555) are eligible for additional exclusion amounts (Notice , I.R.B , October 6, 2006). 17

20 3. Foreign Housing Deduction This deduction is available only to the self-employed and is limited to foreign earned income less any foreign earned income and/or housing exclusions claimed. Disallowed deductions in excess of the limitation may be carried over for one year only. The deduction is calculated in the same manner as the housing exclusion but claimed on the front page of the taxpayer s Form 1040 as an adjustment to gross income. 14 Thus, the deduction offers the taxpayer the possibility that he may actually exclude more from his taxable income than might otherwise be allowed by the foreign income and housing exclusions alone. Felipe s total foreign earned income was $130,000 in 2010, of which half was from self-employment and half from services as an employee. Therefore, half of his total housing amount of $12,000 is considered to have been provided by his employer, allowing Felipe to claim $6,000 as a housing exclusion. The remainder is eligible for the housing deduction. However, because Felipe has exceeded the limitation ($92,900 in 2011), he must carry the $6,000 deduction forward and hope that he can claim the deduction in Forms to File Form 2555 Foreign Earned Income must be attached to the tax return Form 2555-EZ may be used if foreign earned income is less than $92,900 (in 2011), the taxpayer is not self-employed, and the taxpayer does not claim the housing exclusion or deduction FOREIGN EARNED INCOME & FOREIGN HOUSING EXCLUSIONS US citizen or resident must have foreign earned income, a foreign tax home, AND meet the Bona Fide Residence or Physical Presence Tests Can exclude up to $92,900 ($185,800 if married) of foreign earned income from US taxation in 2011 May also exclude amounts received for employer-provided foreign housing, but combined housing and income exclusion cannot exceed annual limitation Self-employed taxpayer may not claim the housing exclusion, but may instead claim an above-the-line housing deduction C. Military Personnel [See IRS Publication 3 Armed Forces Tax Guide] Includes all uniformed members serving in the Army, Navy, Air Force, and Coast Guard. The following items of income are includable as taxable income unless received for service in a combat zone: Active and reserve duty pay Special pay, including hostile fire and special duty Re-enlistment bonuses Leave and other payments The following items are excludable: Combat zone pay as designated by Presidential Order Living, death, family, moving and travel allowances 14 Enter amount from Form 2555, Part IX, Line 50 on Form 1040, Line 36 with the notation Form Add this amount to all other adjustments claimed on Line 36 and subtract from gross income to arrive at Adjusted Gross Income (AGI). 18