Most people are aware that U.S. federal income taxation of citizens and resident aliens (“RA”) is radically different from taxation of nonresident aliens (“NRA”). However, few immigrants or immigration counsel understand the critical details. Similarly, most immigrants and their immigration counsel have, at best, a limited understanding of the myriad rules that determine how and when a NRA becomes a U.S. tax resident. Serious U.S. tax consequences may await immigrants who fail to put into place appropriate plans to minimize their U.S. taxes prior to becoming a U.S. tax resident.
These are the main differences between income taxation of a RA and NRA
A RA is fully taxable on all worldwide income, just as if he or she were a U.S. citizen. Joint tax returns and favorable long-term capital gains and qualified dividends rates are available. In general, RAs are responsible for reporting and paying their own taxes, no withholding is required (except for employment income), net investment income tax applies (the NIIT rate is 3.8%), and passive and certain active income of certain foreign companies may be subject to current taxation by their owners.
In contrast, NRAs are taxed at a flat rate of 30% of the gross income on specific types of U.S.-source investment income. This is generally enforced by the U.S. payor withholding taxes. The rates (and, in some cases, the underlying taxation rules) may be modified under an applicable income tax treaty. Income of a NRA that is “effectively connected” with a U.S. trade or business, including U.S. employment income, is taxable under the same rules generally applicable to a citizen or RA. There are special rules for certain types of income, in particular, relating to rentals and sales of U.S. real estate. Most foreign source income is not subject to U.S. tax. NIIT does not apply to a NRA.
When does U.S. residency begin?
The day that a NRA becomes a RA has great tax significance and is called the residency starting date (“RSD”). In general, the RSD for a U.S. immigrant or long-term visitor will occur on the first of the following events:
- The first day the individual is present in the U.S. as a lawful permanent resident – i.e., with a “green card.”
- When the substantial presence test is met. This is done by counting and weighing the days of U.S. presence over the past three years.
There are a number of exceptions and qualifications to these rules that may affect the RSD. For purposes of the substantial presence test, certain days are not counted and there is an exception if the individual has a closer connection to a foreign country. There is a tax treaty “tiebreaker” test for dual residents. There are special first year rules, and a first-year election. There is usually some flexibility and room for planning in this area.
The importance of pre-immigration planning
There is less flexibility with respect to tax consequences occurring on the RSD. Unfortunately, many immigrants and business visitors to the United States fail to effectively plan in advance for their transition to RA. Failure to properly implement an effective plan prior to the RSD may result in the immigrant or long-term business visitor being unexpectedly and irrevocably stuck with one or more of the following negative consequences:
- U.S. tax on post-immigration investment gains attributable to the pre-immigration time periods;
- Highly taxed ordinary income rather than tax-favored capital gains and qualified dividends on investment income;
- Extra “tax deferral” charges on investment income from certain foreign funds;
- Failure of spouses to make highly favorable joint tax elections when one is a RA and one still a NRA; and/or
- Gains on exchange of foreign currency or on repayment of debt denominated in foreign currency.
Pre-immigration tax check-up
Every prospective U.S. immigrant and long-term business visitor should have a “tax check-up” well in advance of his or her expected RSD. A timely review will maximize planning opportunities and minimize the possibility of an expensive mistake. This check-up should be conducted by a tax advisor experienced in this area and should include a careful review of:
- The business and activities currently performed and to be performed in the United States, foreign countries, and cross-border;
- The legal and tax structures of business ownership;
- Investments owned and the legal and tax structures of such ownership;
- The detailed history of taxpayer presence in the United States;
- The steps planned or taken, trajectory and timeline towards U.S. tax residency, including (but not limited to) the expected RSD; and
- Personal details, including relevant facts regarding the taxpayer’s marital status, home and financing details.