An immigrant coming to America for longer than a certain time period will become a Resident Alien for U.S. income taxes at some point in time. In doing so, they are subjecting themselves to a potential U.S. tax income on their annual worldwide income, an estate tax on their deaths on their worldwide assets and a tax on gifts of their worldwide wealth.2
Presently the United States taxes its citizens on their worldwide income and gains. The tax is on net income and the U.S. tax code provides for numerous deductions and tax credits in arriving at net income. The tax rates on net ordinary income start at a rate of 15% and graduate to a high of 35% on $10.0 Million or more.
There is a different tax rate for gains from the sale of investment assets and other capital assets. Gains from the sale of capital assets held for more than a year have a maximum tax of 15%.
These income taxes can be mitigated to one extent or another for the potential u.s. immigrant, by careful tax planning before the immigrant becomes a resident alien.
Tax Residency in the U.S.The first step in income tax planning is for the Nonresident alien who is immigrating to the U.S., to determine exactly when that immigrant will become a Resident Alien for income tax purposes.
The general rule is that an alien is not considered to be a Resident Alien for U.S. income tax purposes if the alien does not have either (1) a green card representing permanent residency in the U.S. or (2) a “substantial presence” or time period in the U.S. as described below. There are exceptions to this “substantial presence” general rule that will also be discussed.
An alien individual has a “substantial presence” in the United States, or may become a Resident Alien subject to tax on worldwide income for any calendar year in which the alien is both physically present in the U.S. for at least 31 days and; in that same calendar year is considered to have been in the U.S. for a combined total of 183 days or more over the past three years pursuant to a formula.
For purposes of calculating this combined 3 year, 183-day requirement; each day present in the United States during the current “combined” calendar year counts as a full day, each day in the preceding year as one-third of a day and each day in the second preceding year as one-sixth of a day. This is shown on the example below.
The United States has tax treaties with many countries. These treaties generally provide that the residents and corporations of each country are entitled to a more liberal tax treatment than residents and corporations of non-treaty countries. The concept of tax residency under the treaties is usually different than the general definition and may permit a nonresident alien to spend more time in the U.S. each year without being a U.S. tax resident. Generally, the tax treaties will permit the alien individual to remain a non-resident for U.S. tax purposes so long as the alien covered by the treaty stays less than 183 days in the U.S. each separate year; and not over the cumulative three year period.
This same type of treatment that is granted under the Treaty, that of permitting aliens to have an extended stay in the U.S. of less than 183 days in each year without becoming a U.S. tax resident, is also available to certain aliens that are not from countries governed by a U.S. tax treaty. If an alien has his or her provable most important business ties to his or her native country; the substantial presence test is extended due to their “closer connection” to a foreign country than to the U.S.
The “Income Tax Residency Starting Date”Generally there will be a specific point in time when the Nonresident Alien becomes a “Resident Alien” for U.S. tax purposes. This is an important date since it represents a total change in tax regimes and the point in time when all of the individual’s tax planning as a nonresident alien must be completed if it is to be successful. Pre Immigration tax planning generally cannot be accomplished after the Residency Starting Date.
There are different starting points of “income tax residency” during the year, depending upon the circumstances of obtaining the residency. Those are known as the “Residency Starting Dates”.
For example, once the alien individual has passed the “substantial presence test”, the individual is considered to be a Resident Alien from the beginning of the calendar year in which the test was exceeded.
On the other hand an individual who becomes a Resident Alien because of the issuance of a “green card” that represents permanent residency does not have a Residency Starting Date for tax purposes until that point in time during the year that the alien has received the green card and is present in the United States. However, if a “green card” recipient is a resident under both the green card test and the “substantial presence test”, the taxpayer’s taxable year is the full calendar year and not that date of the year in which the substantial presence in the U.S. physically began.
Missing a Residency Starting Date for the completion of pre residency tax planning transactions often will be fatal.
The Income Tax Objectives
- A Nonresident Alien, prior to becoming a U.S. tax resident will want to make sure that he or she does not have to pay a U.S. tax on gains that have accrued as a practical matter before their residency period. The first strategy is to accelerate (realize and recognize) any and all gains earned by the Taxpayer prior to becoming a Resident Alien.
- The second key strategy is to accelerate income that is expected to be paid after residency. Income payments should be collected prior to residency to avoid being taxed by the U.S.
- The third strategy is to defer recognizing a loss until after obtaining tax residency as a Resident Alien so that the loss can be used against post residency gains. Assets with a fair market value below cost can be sold after residency. Those losses may be taken against gains in assets earned after U.S. residency. These losses can reduce or wipe out gains from the sale of assets that accrue after U.S. residency.
- The fourth strategy is to defer paying deductible expenses until after the Residency Starting date. Many types of payments (both business and personal) in the U.S. are deductible from a U.S. Taxpayer’s income to determine the actual taxable amount of income.
ACHIEVING THE OBJECTIVESAn example of acceleration would be to trade securities with unrealized gains and sell them before residency. There would be no tax on the gain. If the Taxpayer cares to keep the shares, the taxpayer can repurchase the shares immediately with a new high cost basis for U.S. tax purposes.
Accelerate Gains Prior to Residency Starting Date
Assume a nonresident alien owned $1.0 Million Dollars worth of shares of Ford Motor Company that was purchased for $100,000. If the shares are sold after U.S. tax residency is assumed when the immigrant is a Resident Alien, there will be a tax on $900,000 in gains. A sale of these same shares by a Nonresident Alien before becoming a Resident Alien would result in no taxable gain.
There are multiple ways to accomplish this acceleration of gain. Another example would be that of an individual who owned a private foreign corporation that was not listed and could not be bought and sold on an exchange. Assume, like the prior example, the owner has a cost basis in the shares of $100,000 and the corporation is worth One Million Dollars. A liquidation of the corporation prior to the Residency Starting Date may result in the owner having a new cost or “tax basis” in the assets of the corporation received in the liquidation. This would be the $1.0 Million fair market value of the assets received. Assume a sale of these assets after the residency starting date for a purchase price of $1,200,000. This would only produce a taxable profit for U.S. tax purposes for $200,000
Under certain circumstances appreciated assets can be sold for tax purposes to a trust or family members to accomplish the increased basis for tax purposes of the appreciated assets. This allows the transferor to retain certain rights in the asset in spite of the transfer to another entity or person. Each asset must be carefully dealt with on an individual basis.
One extremely favorable U.S. Internal Revenue Service announcement has ruled that if a nonresident alien sells an asset prior to becoming a Resident Alien for a promissory note and not immediate cash, the proceeds of the note when received will not be considered taxable even after the residency starting date. The sale is considered to be completed and the funds are earned for tax purposes when the sale took place during the Taxpayer’s Non Resident Alien statue.
An example of the above might find a non resident alien father selling a valuable painting worth millions more than its cost to his nonresident alien son for a Promissory Note. The purchase price cash payment on the Promissory Note can be made tax free to the father when the son later sells the painting and after the father immigrates to the U.S. This is because the sale to the son realizing the gain was made prior to the Resident Alien starting date.
A sale by the son of the painting after the Residency Starting date will result in no taxable gain to the father to the extent of the original sales price. Amounts paid in excess of this would be taxable only to the son who most likely is not subject to U.S. taxes.3
There are several sophisticated and complex tax moves or actual sales that can be completed to accomplish this increase in basis or actual sales when foreign corporations comprise some or most of the would be immigrant’s wealth.
Accelerate Income Prior to Residency Starting DateSo long as an immigrating alien is not a Resident Alien, any and all income items that the Non Resident Alien earns from non U.S. sources before becoming a Resident Alien, should be accelerated for tax purposes so that the recognition of this income occurs prior to the taxpayer becoming a resident alien. This can include a host of different types of income, all of which may be treated in different ways in order to accomplish the acceleration of the income.
For example, assume a non resident alien owns a foreign corporation that conducted a business in his home country that now has $1 Million in receivables that will not be collected until after the owner has become a Resident Alien for U.S. tax purposes.
These receivables might be accelerated, for example, by the liquidation of the taxpayer’s company and the transfer of the receivables to the taxpayer at their present fair market value, prior to the Residency Starting Date.
The taxpayer may also sell his interest in the company or to the company for a Promissory Note. The ongoing foreign company may collect the receivables which are then paid to the seller and Non Resident Alien, in payment of the Promissory Note he received to sell his shares to the company.
Another type of deferred income that should be accelerated prior to U.S. tax residency is money from deferred compensation plans, such as pensions and profit sharing plans. Early releases and distributions of these type of payments in a lump sum from the plan would prevent the taxation of the distributions after one becomes a Resident Alien. In fact, there are several sophisticated techniques involving both annuities and life insurance products that could be very helpful in this regard. This same principal can apply to the acceleration of stock options and other forms of deferred and incentive compensation.
Actually any type of non U.S. periodic payment that the immigrating non resident alien can receive in advance prior to becoming a Resident Alien should be sought. For example, rental payments on personal property and real property can be paid in advance as can royalties and license fees, and even interest payments on promissory notes. If the immigrating taxpayer is not in a country where the taxes on these types of income are extremely low, there is a good deal of tax savings in paying attention to the acceleration of income items.
Defer Recognizing LossIn today’s times there are many wealthy immigrants coming to the U.S. who have significant losses in their investment portfolios from the last few years. If it is economic, these portfolios should not be liquidated and losses should not be realized and recognized prior to immigration to the U.S; as they can be extremely valuable to use against capital gains in the U.S.; and even against ordinary income in the U.S. under certain circumstances.
Assume a non resident alien taxpayer from Panama has purchased a Panama apartment at the high end of the market for $4.0 Million, and it is worth $3.0 Million before he immigrates to the United States. Assume the Panamanian taxpayer will be immigrating to the U.S. effective January 1, 2011. Assume that same taxpayer invests $100,000 in a Florida corporation after obtaining tax residency and sells the Florida corporation after obtaining Resident Alien status for $1 Million in excess of its cost to the Panamanian investor.
In the event the investor were to sell his Panama apartment at a loss prior to becoming a Resident Alien and then sell his profitable Florida corporation at a gain in the following year when he is a Resident Alien, there will be a capital gains tax on the $1.0 Million gain at a cost of $150,000. Had the Panama apartment8 been sold in the year of Residency there would be no tax cost at all since as a Resident Alien, the taxpayer would pay a tax on all of his worldwide net losses and gains, thereby reducing his U.S. gains by his Panama losses.
Deferring the Payment of Deductible ExpensesThe same principal that would work in deferring the payment of losses is also present in the principal of deferring the payment of deductions from the year of non residency to the year of tax residency.
The United States has a complicated tax code and offers numerous different “personal deductions” and “investment” or “business deductions” that will reduce the taxpayers overall tax burden. Most of these deductions are available only in the year of payment and several are subject to limitations. Nevertheless, an immigrating taxpayer should be familiar with the deductions that can be deferred.
One simple example. There is a limited deduction for medical expense that can reduce the taxpayer’s taxable income if those medical expenses are paid after obtaining Resident Alien status, they might reduce the taxpayer’s overall taxable income.
Preparing for the FutureFinally, the immigrating Non Resident Alien must prepare for a tax life as a Resident Alien. This means taking advantage of all of the tax deductions and tax investment incentives offered by the U.S. Tax Code. It may actually mean leaving certain of the taxpayer’s foreign investments in place. This is also the subject of a separate article on the Taxation of Immigrating to the United States.
- This article focuses on foreign individuals that are not U.S. citizens but who nevertheless may be classified as a U.S. resident for U.S. income tax purposes. (“Resident Alien”). A non-citizen who is classified as a nonresident for U.S. income tax purposes is referred to herein as a “Nonresident Alien”.
- This Article is directed only to income tax planning. A forthcoming Article will consider Estate Tax Planning for the U.S. Immigrant. All of the income taxes discussed are subject to numerous exclusions, deductions and tax planning techniques that make the U.S. taxes within reason. However, the immigrant from countries where the taxing authorities are lax will find the U.S. taxing authorities to be very vigilant.
- It is important to note that not all of an immigrating alien’s foreign assets need to be sold or exchanged or otherwise alienated. Good tax planning when one becomes a Resident Alien for tax purposes may mean keeping good foreign investments. Such assets will often fit well in the overall scheme because the U.S. taxes, on certain types of foreign income from outside the United States that is earned in a business, can be deferred and paid at a later point in time when the cash from the foreign business is actually distributed to the taxpayer.