A Taxation of Foreign Nationals by the United States Overview

U.S. Tax Planning for Foreign Nationals

US Tax Planning for Foreign Nationals  

When Foreign Nationals consider relocating to the United States or even just investing in the US economy, oftentimes the excitement of their new adventure overshadows proper US tax planning. Especially in a situation in which the taxpayer may be high-net-worth and/or have various foreign investments and assets, the taxpayer should properly plan to try to avoid any (unnecessary) tax surprises. For example, once a Foreign National becomes a US Person, they may unwittingly become the owner of a foreign trust, foreign corporation, and/or PFIC – just by gaining US status. The taxpayer may then become subject to the Controlled Foreign Corporation, GILTI, and Subpart F Income rule — and/or get hit with the PFIC tax. Let’s look at some very important aspects of US tax planning for foreign nationals.

Are You Remaining a Foreign National?

The strategies for US tax planning for foreign nationals will vary depending on whether or not the person becomes a US person or not. Here are four important tax issues for foreign nationals who will not become non-US persons:

FDAP Income

FDAP refers to Fixed, Determinable, Annual, and Periodical. This is the type of income that is typically classified as passive income. When a person is a foreign national, non-resident alien (and has US-sourced income), they may be taxed 30% on that income. The amount of tax and/or withholding may be reduced, depending on whether there is a tax treaty and whether or not it is the type of income that qualifies for an ECI election.

ECI Income

ECI refers to Effectively Connected Income. If a foreign national, non-resident alien has a US trade or business, then the tax on that income will be similar to if they were a US person. In other words, the taxpayer is generally taxed on ECI at the corresponding progressive tax rates, and some deductions are allowed. For example, while the default position for rental income in the United States would be FDAP, if a person makes an election for it to be treated as ECI, then they can take all the deductions that a person would otherwise take for their US rental income, that are typically found on Form 1040 Schedule E.

FIRPTA

FIRPTA refers to the Foreign Investment in Real Property Tax Act. In general, capital gains generated by foreign nationals are not taxable in the United States – noting that certain exceptions, exclusions, and limitations may apply. Nevertheless, when a foreign national sells US real estate other USRPI (United States Real Property Interest), they are taxed on the gains and there are certain withholding requirements in accordance with FIRPTA.

Form 5472

Form 5472 is required by non-US persons who have ownership of certain US companies including US disregarded entities. When a Non-Resident Alien has ownership of certain US entities or disregarded entities, they are required to report the information on Form 5472 — usually accompanied by Form 1120. The failure to file Form 5472 may result in significant fines and penalties starting at $25,000.

Foreign National Who Becomes a US Person

When a foreign national becomes a US person, that’s when the real tax headaches can begin. But with proper tax planning, the taxpayer may be able to limit or eliminate certain US taxation. Let’s look at some of the more common issues:

Citizenship Based Taxation Is Not Just for Citizens

One very important aspect of US taxation is that once a person is considered a US person, they are taxed on their worldwide income. It does not matter if the income was sourced in the United States or overseas, it is all taxable to US persons. Moreover, the term Citizenship-Based Taxation is a misnomer because it is not limited to just US Citizens, but also includes Lawful Permanent Residents and Foreign Nationals who meet the Substantial Presence Test.

10% Ownership of a Foreign Corporation

In the first year that a foreign national becomes a US person, if at that time they had 10% or more ownership of a foreign corporation, then they may have to file a Form 5471 to report their ownership. If it turns out that more than 50% of the company is owned by US persons, then it may be categorized as a Controlled Foreign Corporation and extensive (and ongoing) Form 5471 reporting may be required.

PFIC (Ownership of Foreign Pooled Funds)

When a foreign national becomes a US person and they owned pooled foreign funds such as mutual funds or ETFs, these funds are considered PFIC. A PFIC is a Passive Foreign Investment Company — and unlike other types of forms, it does not require the taxpayer to own a significant portion of the PFIC in order to have to file certain forms under the PFIC regime. The tax implications of owning a PFIC can be very harsh, especially in any year that the taxpayer has excess distributions. While certain elections are available, not all foreign entities will be amenable to providing the taxpayer with information sufficient for them to make the election (such as a QEF election) and may instead drop the taxpayer from the investment.

Ownership or Beneficiary of a Foreign Trust

When a Foreign National becomes a US person and is either the owner or beneficiary of a foreign trust, they have a significant amount of reporting they have to do each year on Forms 3520 and/or Form 3520-A. In recent years, the Internal Revenue Service has significantly increased enforcement of Form 3520 compliance – and the failure to file these forms timely and properly may result in significant fines and penalties.

Tax Treaties and Savings Clause

Once a foreign national becomes a US person, while they may still be able to rely on US tax treaties to reduce or eliminate US taxation, it is typically much harder to apply the treaty to a US person living in the United States than it would be as a foreign resident. In addition, the Saving Clause severely limits the application of certain articles within the tax treaty. Thus, taxpayers should not delay tax planning and ignore US tax implications until later — when it becomes much more difficult to unwind.

Sourcing Rules

Sourcing rules refer to how certain income is sourced. For example, is the income sourced where the income was generated, or is it sourced where the owner of the income resides? In general, this is more important for non-residents who are trying to avoid taxation on income that is generated in the United States. This is because oftentimes Non-Resident Aliens want to take the position that the income was sourced abroad where they live — because the foreign country in which they reside may not levy any taxes on the particular category of income. But, once a person is considered a US person, then generally they are taxed on their worldwide income regardless of the source (exceptions, exclusions, and limitations do apply).

Current Year vs. Prior Year Non-Compliance

Once a taxpayer missed the income tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.