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Tax Issues for Recent U.S. Residents When a nonresident alien becomes a resident alien (RA) for U.S. tax purposes, he is taxed on worldwide income and subject to estate and gift taxes. This article examines the Code's residency tests and how tax treaties may alter these rules. Recent RAs may have significant reporting requirements because of ownership or directorship in a foreign corporation or a relationship with a foreign trust. In addition, significant tax issues may arise if the individual returns to nonresident alien status.
Michael
L. Moore, Ph.D., CPA For more information about this article, contact Mr. Moore at mooremlmcpa@cs.com. Editor's note: Mr. Moore is a Lecturer at California State University, Fullerton, CA.
Executive Summary
A number of excellent articles have been published advising tax practitioners about pre-immigration planning for nonresident aliens (NRAs).1 These articles propose that planning be completed before immigration to maximize opportunities and minimize taxes. In this mobile age, many foreign individuals may inadvertently become U.S. resident aliens (RAs) without the benefit of such planning or perceiving the need for it. Tax advisers understand that when an NRA becomes a resident for U.S. tax purposes, he is taxed on worldwide income and subject to estate and gift taxes. Less well known is how an NRA becomes an RA for U.S. tax purposes, which may differ from becoming a legal RA, and other issues that may arise (e.g., reporting requirements). In addition, significant tax issues may exist if an individual returns to NRA status.
What is an "RA"? Sec. 7701(b) defines RA and NRA. Under Sec. 7701(b)(1)(A), an alien individual will be treated as an RA if he meets one of three requirements—the green-card test, the substantial-presence test or the first-year election test. As is discussed below, tax treaties may override the Code's prescribed tests; thus, an individual may comply with the Code's residency requirements, but may nonetheless be deemed an NRA under an income tax treaty.
Green-card Test Sec. 7701(b)(1)(A)(i) provides that an RA is a person who is a lawfully permanent RA at any time during the calendar year. Sec. 7701(b)(1)(A)(i) defines a "lawful permanent resident" as an individual who has been lawfully granted the privilege of residing permanently in the U.S. as an immigrant under immigration laws (i.e., a green-card holder). This residency status continues unless it is rescinded or administratively or judicially ruled abandoned. For the first year of residency, if the individual does not meet the substantial-presence test discussed below, the residency starting date under Sec. 7701(b)(2)(A) is the first day in the year he was present in the U.S. while a lawful permanent resident.
Substantial-presence Test An individual satisfies the substantial- presence test for any calendar year if he has been present in the U.S. for at least 183 days during a three-calendar-year period and 31 days during the current calendar year. Under Sec. 7701(b)(3)(A), the 183 days is determined based on the sum of the days present in the current year, plus 1/3 of the days present in the first preceding year plus 1/6 of the days present in the second preceding year. An exception applies under Sec. 7701(b)(3)(B) if an individual is present in the U.S. fewer than 183 days during the current year and has a tax home in a foreign country and a closer connection to that country than to the U.S.; according to Sec. 7701(b)(3)(C), the exception does not apply if the individual has applied (or taken other steps to apply) for permanent-resident status. Under Sec. 7701(b)(3)(D), days in the above formula do not count if the individual has a medical condition that arose while in the U.S. that prevents his departure.
Under the substantial-presence test, an individual is deemed a resident on the first day during the calendar year on which he is present in the U.S. (Certain nominal presence is disregarded.) Under Sec. 7701(b)(2)(C), an individual is not treated as present in the U.S. (up to a maximum of 10 days) for which he establishes a closer connection to a foreign country than to the U.S. According to Sec. 7701(b)(5)(A), certain individuals are exempt from the substantial-presence test, such as foreign-government-related individuals, teachers and trainees, students and professional athletes temporarily in the U.S. to compete in a charitable sports event. A foreign-government-related individual includes any individual (and his family) temporarily present in the U.S. on diplomatic status or a visa determined to represent full-time diplomatic or counselor status and a full-time employee (and his family) of an international organization. A teacher or trainee is an individual temporarily present in the U.S. under the Immigration and Nationality Act (Act), Section 101(15)(J) or (Q), and who substantially complies with the requirements. Under Sec. 7701(b)(5), a student is an individual temporarily present in the U.S. under Act Section 101(15)(J), (Q), (F) or (M) and who substantially complies with the requirements. Commuting days spent by regular commuters from Canada or Mexico are not days present in the U.S. Also, a person traveling between two foreign points is not present in the U.S. if there for less than 24 hours. Under Sec. 7701(b)(7), days present in the U.S. by a regular crew member on an international carrier are not counted as U.S. presence unless the individual engages in any trade or business in the U.S. on those days.
First-year Election Test An individual may elect to be treated as an RA under certain conditions. First, he must not be a green-card holder for the current, immediately preceding or immediately following year. Second, he must be present in the U.S. for at least 31 days during the election year and for at least 75% of the days in a testing period, which begins on the first day of the 31-day period and ends on the last day of the election year. In applying the 75% test, an individual is treated as present in the U.S. for up to five days during which he was actually absent from the country. Sec. 7701(b)(4) provides that, once an individual makes the election, he will be treated as an RA for the portion of the election year that begins on the first day of the earliest presence period that satisfies both the 31-day and 75% tests. The election is made on the individual's tax return for the election year, but may not be made before he has met the substantial-presence test for the calendar year following the election year. Once made, the election can be revoked only with IRS consent.
Income Tax Treaties U.S. income tax treaties with other countries may override the above Code rules, possibly treating an apparent RA under the Code as an NRA. A tax adviser should ask a client about his home-country tax status and examine the relevant treaty to determine residency status. Treaties contain so-called "tie breaker" provisions—i.e., a list of factors designed to settle the residency question when two countries claim an individual as a resident. For example, Article 4 of the U.S.-France Income Tax Treaty2 defines "resident." It provides that a green-card holder is an RA only if he has a substantial presence in the U.S. or would be a resident of the U.S. and not of a third country under the tie-breaker provisions. The first tie-breaker rule states that an individual is deemed to be a resident of the country in which he has a permanent home available. If he has a permanent home in both countries, he is deemed a resident of the country in which his personal or economic relations are closer (center of vital interests). If the center of vital interests cannot be determined, or a permanent home is not available in either country, he is deemed a resident of the country in which he has a habitual abode. If he has a habitual abode in both countries (or neither), he is a resident of the country in which he is a national. If he is a national of both countries (or neither), the competent authorities will settle the residency question by mutual agreement. Thus, the fact that a French national holds a green card does not mean that he is automatically deemed an RA (as he would be under the Code). The residency determination includes additional factors, such as the time the individual spends in the U.S. and any treaty provisions.
Reporting Requirements Once it is determined that an individual is an RA, he is Federally taxed on worldwide income. Significant reporting requirements may exist for a shareholder in a foreign corporation, foreign personal holding company (FPHC) or passive foreign investment company (PFIC), a partner in a foreign partnership or the owner of a foreign trust.
Foreign Corporations and FPHCs Many NRAs own stock in foreign corporations at the time they become RAs. U.S. citizens or residents who are foreign corporate officers, directors or shareholders may have significant reporting requirements as to the foreign corporation's ownership (and possibly, operations). Citizens and residents may be required to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, to meet the reporting requirements of Secs. 6035, 6038 and 6046 and the regulations. In addition, if a foreign corporation is an FPHC or a controlled foreign corporation (CFC) with subpart F income, the individual will be required to include that entity's income on his return. There are five categories of filers. Category 1 filer: Under Sec. 6035(a), this is a U.S. citizen or resident who is an officer, director or 10% shareholder of an FPHC. According to Sec. 552(a), an FPHC is any foreign corporation that satisfies two tests: at least 60% of its gross income for the tax year is FPHC income (50% after the first year) and more than 50% of its stock (by vote or value) is held by no more than five U.S. citizens or residents. Sec. 553(a) defines FPHC income to include interest, dividends, royalties and annuities; gains from stock, security or commodity transactions; income from estates, trusts and personal service contracts; and use of corporate property by a shareholder. In addition to the filing requirement, the individual must report his share of FPHC income.
Category 2 filer: Under Sec. 6046(a)(1)(A), this category includes a U.S. citizen or resident who is an officer or director of a foreign corporation, and who either: 1. Owns 10% or more of the vote or value of a foreign corporation's stock. 2. Acquires an additional 10% or more (in vote or value) of the foreign corporation's outstanding stock. 3. A person has acquired stock when he has an unqualified right to receive it, even if not actually issued. Category 3 filer: Sec. 6046(a)(1)(B) provides that a Category 3 filer meets one of the following: 1. A U.S. person who owned stock in a foreign corporation and meets the 10% requirement with newly purchased stock. 2. A U.S. person who acquired stock that meets the 10% requirement without regard to stock already owned. 3. A shareholder in a captive insurance company under Sec. 953(c). 4. A person who becomes a U.S. person while meeting the 10%-stock-ownership requirement. 5. A U.S. person whose disposition of foreign corporation reduces his ownership below 10%. Many NRAs who own sufficient stock in, or are directors of, a foreign corporation become Category 3 filers when they become RAs. Category 3 filers must attach a statement showing the amount and type of any debt of the foreign corporation to a related person. A related person is described in Regs. Sec. 1.6046-1(b)(11) and includes a U.S. person or another foreign corporation owning at least five percent in value of the foreign corporation's stock. Category 4 filer: Under Regs. Sec. 1.6038-2(a), this is an individual who had control of a foreign corporation for an uninterrupted period of at least 30 days during the corporation's annual accounting period. If a U.S. person owns more than 50% of the total combined vote or value of a foreign corporation for at least 30 days during its annual accounting period, he is a Category 4 filer. Sec. 957(a) defines a CFC as a foreign corporation in which U.S. shareholders own more than 50% of the vote or value. According to Sec. 951(b), a U.S. shareholder is a U.S. person (as defined in Sec. 957(c)) who owns 10% or more of the voting power of all classes of a CFC's voting stock. Thus, an individual who controls a foreign corporation when he becomes an RA is a Category 4 filer and must report his share of the CFC's subpart F income. Category 5 filer: This is a U.S. shareholder who owns stock in a CFC for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned that stock on the last day of such year. Thus, ownership or directorship in a foreign corporation by a recent U.S. resident can trigger significant reporting requirements and inclusion of FPHC or subpart F income. Many new RAs resist these intrusive reporting requirements; however, failure to file Form 5471 and related schedules may result in significant civil and/or criminal penalties. For example, under Sec. 6679(a), failure to file Form 5471 and Schedule N by a Category 1 filer or Form 5471 and Schedule O by a Category 3 filer may result in a $1,000 penalty per reportable transaction. Under Sec. 6038(b)(1), a Category 4 filer who fails to file Form 5471 and Schedule M may be subject to a $10,000 penalty for each annual accounting period the information is not filed. Under Sec. 6038(b)(2), if the information is not filed within 90 days after the IRS has mailed notice to the U.S. person, an additional $10,000 penalty is charged for each 30-day period the failure continues, up to a $50,000 maximum. In addition to these penalties, there may be a loss of foreign tax credits (FTCs) through reductions in creditable foreign taxes.
PFICs A U.S. citizen or resident who owns PFIC stock (e.g., in a foreign mutual fund) must file Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. This form must be filed for each year a U.S. person is a direct or indirect shareholder in a PFIC. A separate Form 8621 must be filed for each PFIC in which stock is held. A PFIC includes companies other than foreign mutual funds (which the legislation originally targeted). Under Sec. 1297(a), a foreign corporation is a PFIC if:
For this purpose, passive income is defined in Sec. 954(c).3 The PFIC provisions do not apply if the shareholder is also a CFC shareholder. One copy of Form 8621 must be attached to the shareholder's return; another copy must be filed with the Internal Revenue Service Center in Philadelphia. Once this filing requirement is identified, a tax adviser must be familiar with the six elections on the form, as well as the other financial information required. The six elections are as follows: 1. Election to treat the PFIC as a qualified electing fund (Sec. 1295). 2. Deemed sale election (Regs. Sec. 1.1291-10). 3. Deemed dividend election (Regs. Sec. 1.1291-9). 4. Election to extend time for payment of tax on undistributed earnings (Temp. Regs. Sec. 1.1294-1T(d)). 5. Election to recognize gain on deemed sale of PFIC (Temp. Regs. Sec. 1.1297-3T(b) and (c)). 6. Election to mark-to-market PFIC stock (Sec. 1296).
Foreign Partnerships A U.S. person qualifying under one or more of the four filer categories must file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. A separate Form 8865 must be filed for each foreign partnership. Category 1 filer: Under Regs. Sec. 1.6038-3(a), a Category 1 filer is a U.S. person who has a more-than-50% interest in a foreign partnership at any time during the partnership's tax year. A Category 1 filer must file Form 8865 for foreign partnership tax years ending after Dec. 30, 2000. Category 2 filer: Under Sec. 6046A(a), a Category 2 filer is a U.S. person who at any time during the tax year owned a 10%-or-greater interest in a foreign partnership controlled by U.S. persons owning at least 10% interests. A Category 2 filer must file Form 8865 only for foreign partnership tax years ending after Dec. 30, 2000. Category 3 filer: Under Sec. 6038B(a)(1)(B), a Category 3 filer is a U.S. person who contributed property during his tax year to a foreign partnership in exchange for a partnership interest, if he:
Category 4 filer: According to Regs. Sec. 1.6046A-1(a)(2), a Category 4 filer is a U.S. person who had a "reportable event" during his tax year. There are three categories of re-portable events under Regs. Sec. 1.6046A-1(b)(1)—acquisitions, dispositions and changes in proportional interests. An acquisition is a reportable event if the person did not own a 10%-or-more direct interest in the partnership and, after the acquisition, owns a 10%-or-more direct interest. A reportable event has also occurred if a person has a direct interest that increases since his last reportable event by at least 10%. A disposition is a reportable event if the person owned a 10%-or-more interest in a foreign partnership before the disposition and less than 10% after, or after the disposition, has a direct interest decrease of at least 10%. A change in proportional interest is a reportable event if the person's direct proportional interest in the partnership increased or decreased by 10%. Form 8865 is attached to the individual's income tax return and filed by the return due date. In addition to criminal penalties, Categories 1, 2 and 4 filers are subject to a $10,000 penalty under Sec. 6038(b)(1) for each foreign partnership tax year for failure to furnish the required information within the time prescribed. Sec. 6038(b)(2) provides that, if the information is not filed within 90 days after the IRS has mailed a notice to the U.S. person, an additional $10,000 penalty is charged for each 30-day period it continues, up to a $50,000 maximum. In addition to these penalties, there may be a loss of FTCs. Under Sec. 6038B(c)(1), Category 3 filers who fail to properly report a contribution to a foreign partnership are subject to a penalty of 10% of the property's fair market value (FMV). The penalty is limited to $100,000, unless the failure is due to intentional disregard, under Sec. 6038B(c)(3). In addition, the transferor must recognize gain on the contribution as if the property contributed had been sold for FMV.
Foreign Trusts An NRA who becomes an RA may be required to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, in the following circumstances:
A "reportable event" includes the following:
A "responsible party" is the transferor (in the case of a reportable event) or the executor (in any other case). A "qualified obligation" is any obligation that meets the following tests:
Under Sec. 6677, if Form 3520 is not timely filed, or if the information is incomplete or incorrect, a penalty applies, equal to (1) 35% of the gross value of any property transferred to a foreign trust, for failure by a U.S. transferor to report a transfer; (2) 35% of the gross value of the distributions received from a foreign trust, for failure by a U.S. person to report receipt of the distribution; or (3) five percent of the amount of certain foreign gifts, for each month the failure to report continues, up to 25%. In addition to the Form 3520 requirement, Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, must be filed if a foreign trust has at least one U.S. owner. Under Sec. 6677(b), a U.S. person treated as an owner of a foreign trust under Secs. 671–679 must ensure that the trust files an annual return setting forth a full and complete accounting of its activities, operations and other relevant information. Failure to file the annual return subjects a U.S. owner to a five-percent penalty under Sec. 6677(c) on the gross value of trust assets treated as owned by him.
Foreign Guarantee and Hybrid Companies Some practitioners advising new RAs about reporting requirements are unsure of the proper treatment of certain types of entities, such as Companies Limited by Shares, Companies Limited by Guarantee or Hybrid Companies, formed in jurisdictions like the British Virgin Islands, Cayman Islands, Gibraltar, Isle of Man and Republic of Ireland. These entities are used for a variety of purposes, such as quasi-trusts in countries that do not recognize or have restrictive trust law, for exchange control planning or to avoid home-country taxes. A Company Limited by Shares is an association whose members contribute to the company's capital and acquire rights pro rata to their contribution. These rights are called shares (different from shares of stock). Liability is limited to the amount contributed. Shares may be issued as registered shares or bearer shares. A Company Limited by Guarantee is an association whose members are elected into membership without necessarily having to contribute capital on election. Persons can be elected into membership without a cash requirement; however, each member is normally expected to pay an entry subscription on election to membership, as determined by the directors. Members have liquidation rights. There is usually transferability if a member dies. A Hybrid Company is a entity limited by guarantee and having shares. Some members contribute to the company's capital and acquire rights pro rata to their contribution, but also must contribute later should the company go into liquidation while insolvent. Other members are elected into membership without having to contribute capital on election, but may have to contribute should the company go into liquidation while insolvent. U.S. tax practitioners are sometimes faced with an ethical dilemma when advising clients about such arrangements. Some foreign tax advisers claim that these entities need not be reported for U.S. tax purposes, because they do not have the typical form of U.S. entities. Often, there is great resistance to comply with U.S. reporting requirements. For example, it is argued that, because a membership certificate issued by a Guarantee Company does not constitute a share of stock or a security, there is no Form 5471 reporting requirement. Also, a Guarantee Company may be converted to a trust on the occurrence of certain events. It may have many of the characteristics of a trust without a formal designation. Again, some foreign tax professionals advise that these entities are not trusts and are free from U.S. reporting requirements. However, organizations are classified for U.S. tax purposes based on substance, not structure. Certain foreign entities (called corporations per se) are automatically treated as corporations for Federal tax purposes, under Regs. Sec. 301.7701-2(b)(8). Guarantee and Hybrid Companies formed in jurisdictions such as the British Virgin Islands, Cayman Islands, Gibraltar, Isle of Man and Republic of Ireland are not included on the list; however, any reference to a Limited Company on the list also includes companies limited by shares or by guarantee. Any business entity not classified as a corporation under Regs. Sec. 301.7701-2(b)(8) can elect its classification for Federal tax purposes ("check-the-box") on Form 8832, Entity Classification Election. The regulations also provide default classification rules, as follows: If all members of a foreign entity have limited liability, the entity is treated as an association taxed as a corporation. If a foreign entity has two or more members, and at least one member has unlimited liability, the entity is classified as a partnership. Thus, regardless of foreign tax advisers' opinions on U.S. reporting requirements for ownership in various offshore entities, some form of reporting is required, depending on the classification of the entity as a corporation, partnership or trust for U.S. tax purposes.
Terminating Residency An individual's resident status continues until rescinded or administratively or judicially deemed abandoned. RA status is considered rescinded if a final administrative or judicial order of exclusion or deportation is issued. The RA, the Immigration and Naturalization Service (INS) or a consular officer may initiate an administrative or judicial determination of abandonment of resident status. If an individual initiates this determination, resident status is deemed abandoned under Sec. 7701(b)(6) and Regs. Sec. 301.7701(b)-(3) when his application for abandonment (or a letter stating his intent to abandon his resident status, with the Alien Registration Receipt Card enclosed) is filed with the INS or a consular officer. During the last year of a person's U.S. residency, he is not an RA for any portion of the calendar year after the last day he was present in (or a lawful permanent resident of) the U.S. After departure, Sec. 7701(b)(2)(B) provides that he must have a closer connection to a foreign country and cannot be a resident of the U.S. at any time during the next calendar year (a nominal presence of 10 days or less is disregarded). If an individual treated as an RA for three consecutive years (the initial residency period) ceases to be an RA and resumes U.S. residency within three calendar years of the close of the initial residency period, he will be subject to tax under Sec. 877 for the intervening period of nonresidency in the same fashion as a U.S. citizen who renounced citizenship to avoid taxes. Sec. 877 was designed to discourage U.S. citizens and long-term permanent residents from moving abroad to avoid taxes on U.S. investment income. It provides that the tax on income not connected with an U.S. trade or business under Sec. 871 will be taxed at higher U.S. marginal rates than might otherwise be levied on an NRA. Thus, instead of the 30% (or lower treaty) rate prescribed on certain U.S.-source passive-type income, regular tax rates will apply. In addition, one of the principal purposes for relinquishing U.S. residency must be the avoidance of income or transfer taxes. A long-term resident is any individual, not a U.S. citizen, who is a lawful permanent U.S. resident in at least eight of the 15 tax years before giving up U.S. residency. Any year a lawful permanent resident is treated as a resident of a foreign country under a tax treaty with the U.S. does not waive treaty benefits and is not counted as a year of lawful residency. An individual has a principal purpose of avoiding income or transfer taxes if his average net income tax for the previous five tax years is more than $115,000 (for 2001) or net worth on the date residency terminates is at least $579,000 (for 2001).4 An individual below these thresholds may nevertheless be subject to expatriation tax, unless he shows that the loss of residency did not have tax avoidance as its principal purpose. Under Secs. 877(c), 2107(a)(2)(B) and 2501(a)(3)(C), a former U.S. citizen who exceeds either threshold will not be presumed to have a principal purpose of tax avoidance if he is described in Sec. 877(c)(2) and seeks a ruling within one year of the date of the loss of U.S. citizenship as to whether such loss had tax avoidance as a principal purpose. A former long-term resident whose net worth or average tax liability exceeds the above thresholds will not be presumed to have a principal purpose of tax avoidance if he submits a complete, good-faith ruling request as to whether such loss had a tax avoidance principal purpose.5 In determining gain subject to the expatriation tax, long-term residents are generally treated as having a basis equal to the property's FMV as of the first date of U.S. residency. An irrevocable election may be filed not to apply FMV basis, under Sec. 877(e)(3)(B).
Conclusion This article explored the intricacies of an NRA becoming an RA for U.S. tax purposes, which may invoke a different set of rules from those for becoming a legal RA. It also addressed the many significant reporting requirements that a new RA may face. In addition, there may be significant tax issues if an individual becomes an RA (or U.S. citizen), then returns to NRA status. |
