Category Archives: Tax Corner

New Taxation Rules for Expatriated Americans

It is well-known that the United States is one of the few countries in the world that taxes its citizens and residents on their worldwide income and assets irrespective of their physical presence or the actual source of income and assets.  Due to this taxation of persons who no longer live in the United States, and who don’t make earn income in the U.S., many of these taxpayers often decide to cut the ties that continue to link them to the United States.

The U.S. government of course has a vested interest in discouraging tax avoidance by “expatriation”. The Internal Revenue Service is involved in a never-ending process of closing actual or perceived loopholes and taking measures of discouraging any form of tax avoidance.  The result is an unmanageable tax code riddled with pitfalls.

Initially the IRS took the stance that if a US citizen renounced citizenship with tax avoidance as a goal, that person would be subject to harsher income tax reporting for the next ten years, as well as more punitive special gift and estate tax rules.

In 1995, the IRS took steps to abandon the existing system and to replace it with a so-called exit tax, similar to that of other countries. Taxpayers (now including green card residents as well as U.S. citizens) now bear the burden of proving the motivations behind expatriation. Under the new rules, a taxpayer had to continue to report for the next ten years.  The reporting applied to every citizen or long term resident that expatriated that had either $500,000 in net worth or an average income tax in excess of $100,000.

In order to avoid a substantial tax hit, the taxpayer had to get a ruling from the IRS, that tax avoidance was not a principal reason for expatriation.

In 1999, an exit tax was once again considered and abandoned.  The issue of intent was subsequently removed. Reasons behind expatriation are no longer relevant. The thresholds were adjusted to $124,000 of tax or $2,000,000 of net worth and an additional requirement was added that those under the thresholds also had to certify under penalty of perjury that they had complied with all tax laws for the previous 5 years.

The conduct by the Revenue Service was egregious. Merely renouncing your citizenship, which is governed by the U.S. State Department, is no longer enough.  The Revenue Service now added the requirement of having to provide notice to the IRS or the taxpayer will continue to be deemed a citizen and the 10 year period doesn’t begin until the reporting requirement has been met.

The changes implemented by the IRS had created a situation where people, like Green Card holders, are going home to their countries with no thought of the tax implications, and no intention to violate rules that they are unaware of, now are officially “tax cheats”…

Now let’s put the shoe on the other foot. Imagine a US citizen working for a US company relocated to Germany or Japan or China for 10 years. Now he’s retiring and going home. Wouldn’t it seem a bit unfair that for the next ten years, he would have to comply with a complex reporting regime and pay tax to a country that he is no longer working in and has severed all ties with?

There is also another group of affected persons, those that I refer to as “accidental citizens”. These are persons who have lived their lives in countries other than the US but are citizens either because their parents were citizens or because the best obstetrician at that critical moment was in the US.

Many foreign women give birth unexpectedly in the US. Many more appreciate the quality of US healthcare and come here to have their children. These children go through life with the scarlet letter A on their chest. Not for Adulterer, but for American.

After 2004, even if you had never permanently lived in the US (unless you had also never had a passport, never exceeded the substantial presence test and hadn’t exceeded 30 days in the US in any of the last 10 years), regardless of the fact that your abandonment of citizenship had nothing to do with taxes, you would still have to at least do 5 years of taxes before giving up your citizenship and another 10 years thereafter under the old rules.

Beginning as of June 18, 2008, expatriates will now be subject to an exit tax, and then except for certain specific items, be done with their US reporting requirements.  This onetime tax should be much easier to enforce and much easier to comply with. However, it may be harder to avoid and or plan around.

The other major change is a loosening of the limitations on the above referenced “accidental citizens”. Now instead of the 30 day residency limitation, the expatriate only needs not to have violated the substantial presence test in 10 of the last 15 years to be out of the tax regime. This provides a much broader exemption.

The revised rules now  apply to anyone who expatriates after June 16, 2008.  The general provisions provide that anyone who is a “Covered Expatriate” is deemed to have sold all their assets on the date of expatriation for fair market value. A Covered Expatriate is any citizen or long term resident, who:

·        gives up or loses his/her status,
·        has a net worth in excess of $2,000,000, or
·        an average annual income tax liability in excess of $139,000 (inflation adjusted) for the five years preceding expatriation, or
·        fails to certify compliance with the code for the five years preceding expatriation.

This last requirement is a remaining trap for the unwary because, regardless of your economic circumstances or actual compliance history, if you don’t do the paperwork you will be considered a Covered Expatriate.

Notwithstanding the foregoing, certain persons are excluded. This includes individuals who are born U.S. citizens and  citizens of another country (and remain  dual citizens), and who for 10 of the 15 years (or less if under 18) preceding expatriation have not been in the US in excess of the amount provided for substantial presence test (oversimplified analysis…less than 120 days per year on average).

Special rules also apply for deferred compensation items and other tax deferred items. Special exceptions apply to the special rules in the case of Covered Expat’s that subsequently become subject to tax as a citizen or resident in the future.

In the estate and gift tax arena, the new rules turn the US tax system on its head with the creation of Section 1208. Under §1208 any direct or indirect gift or bequest from a Covered Expat to a U.S. person is subject to tax at the highest applicable rate. The tax is reduced by any estate or gift taxes paid. The tax is paid by the recipient.

Many expats under these rules, will be relieved from the burdens of the expatriation tax and long term reporting requirements.  The new reverse inheritance tax will not affect those expatriates whose natural objects of bounty are non-U.S.  Temporary residents returning home with not too much net worth increase should feel little pain.

On the other hand, those high net worth individuals who made their fortunes while in the United States, will bear a high exit tax.  Also negatively impacted will be the American descendants and loved ones of expatriates.

When Immigrants Pay In, but don’t collect… then what?

According to a recent piece by “News USA”, 78 million baby boomers are nearing retirement, at which point they will leave the workforce to receive massive amounts of Social Security Administration (SSA) benefits. In a time of major economic downturn, the unlikely “saving grace” is the immigrant population, which pays into the Social Security system without collecting benefits.

The article goes on to say that so-called undocumented immigrants in the U.S. account for some 5 percent of the nation’s workforce. Contrary to popular belief, between one-half and three-quarters of
undocumented immigrants pay federal and state income taxes, Social Security and Medicare taxes – in addition to sales and property taxes.

As of October 2005, the Social Security Administration concluded that undocumented immigrants contributed an estimated $520 billion to the Social Security system – a figure that would increase exponentially if all of these immigrants were required to earn their legal status and contribute their share.

As the Babyboomers approach retirement age, immigrants will be knowingly or unknowingly subsidizing Social Security benefits, making a basic retirement even possible for millions of Americans.

Many experts and proponents of Comprehensive Immigration Reform have stated repeatedly that by requiring the undocumented aliens to come out of the shadows and earn legal status, immigrants will not only contribute by paying taxes, but will play a hefty role in shoring up the teetering Social Security system, and provide a fiscal windfall to U.S. taxpayers. …what’s so bad about that?

Tax Filing and Compensation of Owners for Different Business Entities

The following provides a basic overview for owners or stakeholders of U.S. businesses, in terms of tax filing obligations and how compensation is to be declared. This information is in no way a substitute for the advice and counsel of a Certified Public Accountant (CPA).

Sole Proprietorship (unincorporated):

Owner reports business income on Schedule C of personal tax return (Form 1040). The business profit shown on Schedule C is reported on Line 12, page 1 of the owner’s personal tax return. The owner cannot be on payroll and cannot take a salary from the business.

Partnership (unincorporated):

Requires two or more owners. Owners report business income on Form 1065 U.S. Return of Partnership Income. The partner cannot be on payroll and cannot take a salary from the business per se. But, the partner can receive a “guaranteed payment” which is like a salary and is reported on line 10 of Form 1065. The partner can also receive his or her respective share of the profit from the partnership.

C-Corporation:

The corporation would report its income on Form 1120 U.S. Corporation Income Tax Return. The corporation pays corporate taxes on its profit. A shareholder can be an employee of a C Corporation.

S-Corporation:

The corporation reports its income on Form 1120S U.S. Income Tax Return for an S Corporation. The corporation does not pay corporate taxes on its profit. Instead, the corporation issues Schedule K forms to its shareholders that report their respective share of the profit based on their ownership interest. The shareholder reports his or her share of profit on Schedule E and Line 17, page 1, of their personal tax return. The shareholder can be an employee of an S Corporation.

Limited Liability Company (LLC) — Single Member/Owner:

The member can elect to have the LLC taxed like an S Corporation (if the member is a U.S. tax resident). Otherwise it would be taxed like a sole proprietorship.

Limited Liability Company (LLC) — Multiple Members/Owners:

The members can elect to have the LLC taxed like a partnership, C Corporation, or S Corporation (if the members meet S Corporation criteria).

Foreign Tax Credits

Foreign tax credits allow U.S. taxpayers (incl. foreigners subject to U.S. taxes) to avoid or reduce double taxation. You may choose to take a deduction for foreign taxes paid instead of choosing a credit. In most cases, it is to your advantage to take foreign income taxes as a tax credit.

You can claim a credit only for foreign taxes that are imposed on you by a foreign country or US possession. Generally, only income, war profits and excess profits taxes qualify for the credit.

Generally, the following four tests must be met for any foreign tax to qualify for the credit:

1. The tax must be imposed on you
2. You must have paid or accrued the tax
3. The tax must be the legal and actual foreign tax liability
4. The tax must be an income tax (or a tax in lieu of an income tax)

File Form 1116 Foreign Tax Credit to claim the foreign tax credit if you are an individual, estate or trust, and you paid or accrued certain foreign taxes to a foreign country or U.S. possession. Corporations file Form 1118 to claim a foreign tax credit.

* The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. If you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country, only that reduced tax qualifies for the credit.

* If a foreign tax redetermination occurs, a redetermination of your US tax liability is required in most situations. You must file a Form 1040X or Form 1120X. Failure to notify the IRS of a foreign tax redetermination can result in a failure to notify penalty.

* A foreign tax credit may not be claimed for taxes on excluded income.

U.S. Citizens and Resident Aliens Abroad – Filing Requirements

If you are a U.S. citizen or resident alien living or traveling outside the United States, you generally are required to file income tax returns, estate tax returns, and gift tax returns and pay estimated tax in the same way as those residing in the United States.

Your income, filing status, and age generally determine whether you must file a return. Generally, you must file a return if your gross income from worldwide sources is at least the amount shown for your filing status in the Filing Requirements table in Chapter 1 of Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

Foreign Earned Income Exclusion

United States citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the United States. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.

A common misconception that contributes to the international tax gap is that this potentially excludable foreign earned income is exempt income not reportable on a US tax return. In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income and this exclusion applies only if a tax return is filed and the income is reported.

To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

* Have foreign earned income (income received for working in a foreign country),
* Have a tax home in a foreign country, and
* Meet either the bona fide residence test or the physical presence test

The foreign earned income exclusion amount is adjusted annually for inflation. For 2008, the maximum foreign earned income exclusion is up to $87,600 per qualifying person.

If married and both individuals work abroad and both meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $175,200 for the 2008 tax year.

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited.

The limitation on housing expenses is generally 30% of the maximum foreign earned income exclusion. For 2008, the housing amount limitation is $26,280 for the tax year. However, the limit will vary depending upon the location of the qualifying individual’s foreign tax home and the number of qualifying days in the tax year.

The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion.

Since the foreign earned income exclusion is voluntary, qualifying individuals must choose to claim the exclusion. The foreign earned income exclusion and the foreign housing cost amount exclusion are claimed and figured using Form 2555 , which must be attached to Form 1040. However, if only the foreign earned income exclusion is claimed, a shorter Form 2555-EZ may be used instead.

Once the choice is made to exclude foreign earned income, that choice remains in effect for the year the election is made and all later years, unless revoked.

Not foreign earned income: Foreign earned income does not include the following amounts:

* Pay received as a military or civilian employee of the U.S. Government or any of its agencies
* Pay for services conducted in international waters (not a foreign country)
* Pay in specific combat zones, as designated by an Executive Order from the President, that is excludable from income
* Payments received after the end of the tax year following the year in which the services that earned the income were performed
* The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer
* Pension or annuity payments, including social security benefits

Self-employment income: A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce the individual’s regular income tax, but will not reduce the individual’s self-employment tax. Also, the foreign housing deduction – instead of a foreign housing exclusion – may be claimed.

A qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions.

Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded. If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.

Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year.

Timing of election: Generally, a qualifying individual’s initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

* A return filed by the due date (including any extensions),
* A return amending a timely-filed return. Amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid, or
* A return filed within 1 year from the original due date of the return (determined without regard to any extensions)

U.S. Tax Withholding on Payments to Foreign Persons

Most types of U.S. source income paid to a foreign person are subject to a withholding tax of 30%, although a reduced rate or exemption may apply if stipulated in the applicable tax treaty.

In general, a person that makes a payment of U.S. source income to a foreign person must withhold the proper amount of tax, report the payment on Form 1042-S and file a Form 1042 by March 15 of the year following the payment(s).

The person making the payment is considered to be the withholding agent. You are a withholding agent if you are a U.S.or foreign person that has control of any item of income of a foreign person that is subject to withholding.

A withholding agent may be a(n): 1) Individual, 2) Corporation, 3) Partnership, 4) Trust, 5) Association, 6) Nominee, or 7) Any other entity, including any foreign intermediary, foreign partnership, or U.S. branch of certain foreign banks and insurance companies.

Important note: As a withholding agent, the payer is personally liable for any tax required to be withheld, independent of the tax liability of the foreign person to whom the payment is made.

A payment to a foreign person is subject to withholding if it is from sources within the United States, and it is either: 1) Fixed or determinable annual or periodical (FDAP) income, or 2) Certain gains from the disposition of timber, coal, and iron ore or from the sale or exchange of intangible property (such as patents or copyrights).

Examples of FDAP income subject to withholding include (but are not limited to): Compensation for personal services, dividends, interest, pensions and annuities, alimony, real property income (such as rents), royalties, and taxable scholarships and fellowship grants.

When you make a payment of U.S. source income to a foreign person or entity you are normally required to withhold U.S. income tax at a rate of 30% and report it on Forms 1042-S and 1042 by March 15 of the year following the payment(s).

The penalty for not filing Forms 1042-S and1042 when due (including extensions) is usually 5% of the unpaid tax for each month or part of a month the return is late, but not more than 25% of the unpaid tax. Additional penalties apply for failure to provide complete and correct information or if you fail to provide a complete and correct statement to each recipient. The maximum penalty is $100,000 per year.

U.S. Tax Guide For Aliens (non-U.S. citizens)

For tax purposes, an alien is an individual who is not a U.S. citizen.

Aliens are classified as nonresident aliens and resident aliens. This publication will help you determine your status and give you information you will need to file your U.S. tax return. Resident aliens generally are taxed on their worldwide income, the same as U.S. citizens. Nonresident aliens are taxed only on their income from sources within the United States and on certain income connected with the conduct of a trade or business in the United States.

The IRS has published a convenient tax guide for Aliens, essentially containing all about “What You Need To Know About U.S. Taxes”.

Business Plans, Financial Projections and Tax Filings…

USCIS and the State Department, as part of their adjudcations process, are examining financial records of U.S. businesses under control or ownership of foreign citizens. While this in itself is nothing new, the thoroughness and level of scrutiny with which these records are examined is unprecedented.

I cannot encourage any past, present and future client of mine strongly enough, to seek the advice and cooperation of experienced business advisors and CPA’s (Certified Public Accountants). While there are many skilled and knowledgeable advisors available, many of them do not frequently encounter or handle international clients, or fully understand international implications. Therefore seek out the help of advisors and CPA’s who specifically focus a large part of their practice on international and immigration-related financial and tax advice.

Whether you are preparing to apply for an immigration benefit (like a visa) based on a U.S. business activity, or whether you are already in the process of running your business, maintaining proper financial recordsis crucial, not only for good business sense, but also as part of your documentary evidence for the U.S. authorities.

Please keep in mind that while a business owner wants to minimize tax liability by showing little profit, the U.S. immigration authorities frequently neglect to recognize this and equate low profits with business failure. Many adjudicating officers have little or no formal business or economics training, and many concepts of legal tax avoidance are not understood or otherwise taken into consideration when examining the financial state of being of the company.

As a foreign business owner, you must strike a balance between tax avoidance (supressing profits on paper), and showing stronger, higher numbers in order to satisfy Immigration. Work with your business and tax advisors on appropriate strategies and prepare additional documentation in layman’s terms that supplement your tax filings and other financial records, to give adjudicating officers a more accurate picture of your company’s financial state of health.