U.S. Residency — A Taxing Proposition?
Becoming a U.S. resident is an important event in the life of any foreign national. For some it represents only a temporary stay in the U.S., but for many others it marks the end of a long process to obtain what is commonly referred to as a "green card" (a holdover reference to when the cards were actually green), which represents the holder's legal right to reside permanently in the United States.
Becoming a U.S. resident is an important event in the life of any foreign national. For some it represents only a temporary stay in the U.S., but for many others it marks the end of a long process to obtain what is commonly referred to as a “green card” (a holdover reference to when the cards were actually green), which represents the holder’s legal right to reside permanently in the United States.
Although foreign nationals generally realize that the advice of immigration counsel is imperative to navigate properly the constantly changing U.S. immigration laws, few realize the importance of seeking early advice from U.S. tax counsel to obtain a comprehensive review of the tax consequences associated with U.S. residency. Delaying that tax advice can be an extremely costly decision due to the extensive tax implications U.S. residency carries with it.
This article provides a brief summary of the more significant tax consequences of U.S. residency, which are frequently unanticipated by prospective U.S. residents. Unfortunately, in this area, what you don’t know can cost you.
For U.S. income tax purposes, there generally is no distinction between green-card holders and persons who are U.S. residents under the Physical Presence Test.
Important Distinctions Between Categories of U.S. Residents
While all green-card holders are U.S. residents, not all U.S. residents are green-card holders. Some foreign nationals become U.S. residents, possibly inadvertently, by virtue of their physical presence in the United States (the “Physical Presence Test”). The Physical Presence Test generally provides that a foreign person will be considered a U.S. resident if that person is physically present in the United States for an average of 122 days a year over a three-year period.
For U.S. income tax purposes, there generally is no distinction between green-card holders and persons who are U.S. residents under the Physical Presence Test. However, there is a highly relevant distinction in two significant situations: (i) in estate planning matters for the U.S. resident; and (ii) if the U.S. resident later wants to expatriate (i.e., surrender all rights as a U.S. resident).
Residency and U.S. Estate Taxes. The U.S. imposes an estate tax on the worldwide assets of deceased U.S. citizens and residents who have established a U.S. domicile. However, in the case of non-citizens who are not domiciled in the U.S., the estate tax is imposed only on assets that are located in the United States.
“Domicile” is a vague term, which in this context generally means the person has become a U.S. resident and has no present intention of leaving the United States. Without the intent to remain in the U.S. indefinitely, U.S. residence will not constitute domicile. Thus, domicile generally requires both physical presence and the intent to remain here indefinitely.
Although ultimately based on all the facts and circumstances, the determination of whether domicile has been established is affected by the basis on which the individual has established U.S. residence. Green-card holders generally are deemed to have evidenced much more clearly an intent to reside permanently in the United States. While meeting the Physical Presence Test evidences some intent with respect to U.S. residency, that test’s focus on prior presence makes it less clear that the individual’s intent is permanent, unless he or she has taken affirmative steps to acquire permanent legal residence or citizenship.
In any event, the foreign national must always be aware of the estate tax implications of U.S. residency, particularly given the significant U.S. estate tax rates, which can be as high as 46 percent. Moreover, the United States has executed estate and gift-tax treaties with a number of countries, making it important for prospective U.S. residents to consider any additional planning opportunities before residency begins.
Surrendering Legal Residency. After acquiring U.S. residency, some persons want to return to their home country and give up their status as U.S. residents. The procedures for doing so differ depending on whether the person is a U.S. resident by virtue of the Physical Presence Test or by virtue of holding a green card.
If residence is based on the Physical Presence Test, relinquishing U.S. residency is relatively easy. All that is required is that the person leave the United States for a sufficient period of time to no longer qualify under the Physical Presence Test. To ensure that U.S. tax is not inappropriately avoided, the individual must apply for and obtain a “sailing permit” from the U.S. government.
In the case of green-card holders, surrendering U.S. residence is more complicated. Generally, Treasury regulations provide that resident status continues until it is either rescinded or administratively or judicially determined to have been abandoned. A green-card holder may only rescind or abandon the green card by taking affirmative steps and filing the necessary paperwork (i.e., INS Form I-407) with the local U.S. consulate or embassy. U.S. tax law does not provide for passive abandonment of a green card (e.g., failure to use the green card).
In some circumstances, it may be worthwhile delaying residency to avoid serious income tax consequences or the need to take other remedial measures.
In 2004, Congress significantly revised the expatriation rules, which apply to U.S. citizens and long-term green-card holders (but not to persons who attained U.S. residence solely by meeting the Physical Presence Test). Those revised rules have very significant implications for green-card holders who have held their green cards for at least eight out of the last 15 years. Such “long-term residents” are essentially equated with U.S. citizens for purposes of the expatriation rules. In general, the rules institute an alternative tax regime for expatriates if their expatriation is found to be tax motivated. The new rules set out objective criteria which, if satisfied, create a presumption that an act of expatriation was tax motivated.
The revised rules also require expatriates to expressly notify the U.S. government of an act of expatriation by filing Form 8854 and an accompanying statement with the Internal Revenue Service. Failure to make the required filings and submissions results in an ineffective expatriation, meaning the individual continues to be treated as a U.S. resident.
Residency Start Dates — When Does Residency Really Begin?
U.S. residents often assume that their residency began when they obtained their green card or when they met the Physical Presence Test. It may be surprising to some when they find out that their U.S. residency began months earlier than they expected. That difference in residency start dates can have a dramatic impact on the foreign national’s U.S. tax obligations.
For example, assume a foreign person, who is not a U.S. resident, sells his foreign business in a taxable stock sale during June of 2006. The sales price is to be paid in installments over a five-year period. In November of 2006, the foreign person meets the Physical Presence Test and thus becomes a U.S. resident.
The preliminary issue for the foreign person is whether his stock sale is taxable in the United States when he receives payments after obtaining U.S. residency. Under U.S. tax law, taxpayers must report gain from installment sales when they receive payments unless they timely elect out of installment sale treatment. However, foreign persons typically see no reason to file an election to avoid installment sale treatment at a time when they are generally not subject to U.S. taxation. Fortunately, IRS guidance provides that foreign persons are generally treated as if they elected out of installment sale treatment when a taxable sale occurs prior to U.S. residency.
When a foreign person becomes a U.S. resident, the entire U.S. tax code becomes relevant.
However, the foreign person in our hypothetical may be surprised to learn that he is considered a U.S. resident as of January 2006 rather than November when the Physical Presence Test was met. For Physical Presence Test residents, residency begins on the first day during the calendar year when the individual was physically present in the United States. Thus, although the foreign person did not meet the test until November 2006, his residency relates back to January 2006 because he was present in the United States at some point in that calendar year. As a result, the foreign person was a U.S. resident at the time of the sale, thus making the gain subject to U.S. income tax (absent taking certain remedial steps).
For green-card holders, residency generally begins on the first day of the year that the foreign person is present in the United States as a green-card holder. A very important exception to this rule is that if the green-card holder also meets the Physical Presence Test, then residency begins on the earlier of the days the foreign person was present in the United States either as a green-card holder or under the Physical Presence Test.
Thus, residency for both green-card holders and Physical Presence Test residents may begin long before expected. In some circumstances, it may be worthwhile delaying residency to avoid serious income tax consequences or the need to take other remedial measures. To avoid potential U.S. tax obligations, it is very important that prospective U.S. residents be aware of this issue and timely consult a U.S. tax advisor.
Implications of U.S. Residency for Foreign Business Owners
For the last few years, corporate inversions (the change of a corporation’s place of organization from the U.S. to a non-U.S. jurisdiction) have been the talk of Washington. So much so that in 2004 Congress passed anti-inversion legislation to discourage U.S. corporations from inverting into foreign corporations, which potentially undermines the U.S. tax base.
However, to the surprise of many unsuspecting foreign nationals who become U.S. residents, a foreign-owned corporate structure can also be inverted into a U.S.-owned corporate structure (with resulting U.S. tax consequences) simply because the majority owner(s) becomes a U.S. resident. Accordingly, the U.S. tax base may be increased by the foreign corporation’s income that was not subject to U.S. tax prior to the majority owner’s U.S. residency.
When a foreign person becomes a U.S. resident, the entire U.S. tax code becomes relevant. For foreign business owners, no other portion of the tax code may be more relevant than the provisions governing U.S.-owned foreign corporations (commonly referred to as “Subpart F”). At the risk of extreme oversimplification, Subpart F may require the U.S. owner(s) of foreign corporations to pay tax on phantom income. More specifically, if U.S.-owned foreign corporations earn certain types of income, or make certain types of U.S. investments, the U.S. shareholders may be required to recognize U.S. taxable income even though the foreign corporation makes no actual distribution to the shareholders.
The Fundamentals of Subpart F
The rules under Subpart F are exceedingly complex, and a thorough discussion of them is well beyond the scope of this article. However, an overview of those rules is necessary because of the significance of the effects of Subpart F on prospective U.S. residents who own foreign businesses.
Generally, Subpart F is an anti-deferral tax regime designed to frustrate attempts by U.S. residents to avoid paying U.S. tax on income earned outside the United States through foreign corporations. The Subpart F rules come into play when one or more U.S. shareholders (defined as U.S. residents who each owns, directly, indirectly or constructively, 10 percent or more of the total voting stock of the foreign corporation) own more than 50 percent of the stock of a foreign corporation. Such foreign corporations are termed “controlled foreign corporations” or “CFCs.”
U.S. tax advisors have become skilled at devising structures to avoid triggering the application of the then-current rules of Subpart F. As a result, Subpart F has become increasingly complex to adapt to the changing landscape of the law and to the variety of structures implemented by tax advisors.
Subpart F is designed to apply to income that is easily manipulated through artificial arrangements between related corporations that produce inappropriate tax deferral. For example, Subpart F generally requires that passive income (e.g., dividends, interest and royalties) earned by a CFC be subject to current U.S. income tax because passive income can be artificially structured to be earned in a low-tax jurisdiction. Likewise, Subpart F requires current U.S. income tax on certain investments that a CFC may make in the United States. For U.S. tax purposes, such investments are treated as repatriated earnings that are currently taxable to the U.S. shareholders as dividends.
Unintended Sandwich Structures
Due to its complexity, Subpart F can have unexpected and detrimental tax consequences to U.S. residents. One of the more common and unexpected consequences for recent U.S. residents is the creation of what is known as a corporate “sandwich” structure. These structures involve foreign persons who own a foreign corporation that may do business in the United States either directly or through a U.S. subsidiary. If the foreign corporation becomes a CFC when the foreign person becomes a U.S. resident, then the sandwich structure is in place. The result is that a U.S. resident is conducting business in the United States indirectly through a foreign corporation — an inefficient and costly tax structure.
For example, assume a Japanese foreign national owns a Japanese manufacturing business with several subsidiaries throughout the world (including the United States). The foreign national acquires a green card and moves to the United States as a U.S. resident. As a result, the Japanese manufacturing company becomes a CFC, and the Subpart F rules apply to its operations. One of the CFC’s investments is its U.S. subsidiary, which it is continuing to expand due to its profitable U.S. operations. Unbeknownst to the Japanese individual, each additional investment by the Japanese manufacturing company in the U.S. subsidiary triggers a constructive dividend to him, resulting in current U.S. tax liability. Consequently, the Japanese individual has phantom income (i.e., U.S. taxable income with no corresponding cash).
Equally disturbing is the taxation of dividends paid by the U.S. subsidiary of the CFC. If the Japanese resident of the United States owned the U.S. subsidiary directly, dividends would generally be subject to a 15 percent U.S. income tax. However, under this structure, dividends must be paid first to the Japanese manufacturing company (which will most likely incur a tax in Japan) before they reach the Japanese individual (the dividend to the Japanese company would not itself be subject to U.S. tax under the terms of the U.S. income tax treaty with Japan). Any Japanese income taxes paid by the manufacturing company on dividends received from the U.S. subsidiary would not be allowed as tax credits in the United States. Therefore the Japanese individual is in a potentially triple tax structure (i.e., U.S. income tax on the U.S. subsidiary’s income, Japanese tax on dividends paid by the U.S. subsidiary, and U.S. tax on dividends paid by the Japanese manufacturing company).
While pre-residency planning is always preferable to avoid an impending sandwich structure, post-residency measures may be taken as well to minimize this costly impact. Once again, it is critical to be aware at an early stage that U.S. residency may carry with it unsuspecting consequences, and the best protection is to seek in timely fashion the advice of competent U.S. tax counsel.
Implications of U.S. Residency on Foreign Pensions and Retirement Savings
U.S. residency can have significant implications on how earnings from retirement savings accounts are taxed. Income tax treaties that the United States has concluded with other countries generally provide rules to govern the taxation of distributions from pensions and retirement savings accounts. In addition, the United States has concluded 21 bilateral agreements (referred to as “Totalization Agreements”) to address dual social security coverage when persons have connections to two countries. Any applicable Totalization Agreement should be consulted to determine what, if any, impact U.S. residency may have on the resident’s social security obligations in the U.S. and abroad.
U.S. residency brings with it a labyrinth of legal consequences, many of which are not apparent or intuitively obvious. It is highly advisable for any foreign national who anticipates becoming a U.S. resident to seek early advice from legal counsel to make sure that the potential adverse consequences of U.S. residency are addressed in advance.