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George F. Bearup, J.D. Senior Legal Trust Advisor

10-Oct-18

Primer on U.S. Taxation of Non-Citizens

Take-Away: The U.S. subjects its citizens to U.S. federal income tax and transfer tax on their worldwide income and assets.  But the U.S. distinguishes between a U.S. citizen and a non-U.S. citizen, resident or non-resident, for  U.S. taxation purposes. Not all resident non-U.S. citizens can escape U.S. federal income and transfer taxes on their worldwide income and assets. Making this distinction in taxation even more confusing is that the definition of resident is different for the imposition of the U.S. federal income tax on a resident non-U.S. individual than it is for the imposition of U.S. transfer taxes on that same individual. Consequently, an individual may be a non-U.S. resident for U.S. federal income tax purposes but not a resident for U.S. transfer tax purposes, or vice versa.

Caveat: The following is a gross over-simplification of highly complex U.S. tax rules. It is intended solely as a generalized overview of these U.S. tax rules to assist in issue-spotting tax exposure to non-U.S. individuals, as it ignores multiple exceptions and overlooks the possibility of U.S. treaties with other countries that override these general rules of U.S. taxation of non-U.S. individuals.

Generalization: Residents of the U.S. for either its income or its transfer tax regime (gift, estate, generations skipping), citizen or non-citizen, must pay U.S. federal income or federal transfer taxes on their worldwide income or assets. These tax consequences turn on if the non-U.S. individual is considered to be a U.S. resident.

Income Tax Background for Non-U.S. Residents: A non-U.S. individual may have to pay U.S. income taxes depending upon if that individual is a resident of the U.S. when the U.S. income tax is assessed.

  • Resident: For U.S. federal income tax purposes, a non-U.S. individual is considered to be a resident in the U.S. if that individual either: (i) holds a ‘green card’ or (ii) satisfies what is known as the substantial presence test in the U.S..
  • Substantial Presence Test: The substantial presence test is an objective mechanical day-count test that is used to determine if the non-U.S. individual is a resident of the U.S.. This test is satisfied if the non-U.S. individual is present in the U.S. for at least 31 days in the current year and 183 days or more days in the current and the two prior years, which is determined by using a weighted formula; that weighted formula counts all of the days in the current year, 1/3rd of the days in the first preceding year, and 1/6th of the days in the second preceding year. Being present for any part of one day constitutes a full day’s presence for purposes of applying this day-count test, subject to a couple of exceptions, e.g. hospitalization for medical conditions are ignored, but only if the medical condition occurred while inside the U.S.; and,  some individuals in the U.S. under specific via programs may also have their days spent in the U.S. ignored when the day-count test is applied.
  • Rule of Thumb: As a general ‘rule of thumb’ a non-U.S. individual who is never present in the U.S. for more than 121 days in any one calendar year will never satisfy the substantial presence test.
  • Impact of Treaties: The U.S. has entered into income tax treaties with several foreign countries. These income tax treaties include ‘tie-breaker’ provisions for individuals who are treated as a resident in both of the participating jurisdictions; the terms of these treaties then give primary or exclusive income taxing rights to one of the two taxing jurisdictions. All of which means that before reaching any conclusion if a non-U.S. individual is a resident of the U.S. for income tax imposition purposes, it will be necessary to check if there is an existing treaty that overrides these general rules.

Transfer Tax Background for Non-U.S. Residents: Unlike the largely objective day-count test that is used to determine an individual’s residency for U.S. federal income tax purposes by counting days while inside the U.S, the determination of  for U.S. transfer tax purposes of a non-U.S. individual is a subjective test.

  • Domicile: A non-U.S. individual is treated as a resident in the U.S. for its transfer tax purposes if that individual is domiciled in the U.S. Domicile is established by living in a place for any period of time with ‘no definite present intention of later removing therefrom.’ [Reg.20.01-1.]
  • Elements of Domicile: Domicile of an individual requires proof of two separate elements: (i) an actual physical presence in the U.S.; and (ii) an intention to remain indefinitely in the U.S. Accordingly, proof of the non-U.S. individual’s intention to indefinitely remain in the U.S. is a facts-and-circumstances determination, in contrast to the day-count test that is used to determine residency for imposition of U.S. income taxes on non-U.S. residents.
  • Treaties: While treaties exist that deal with the imposition of U.S. transfer taxes on a non-U.S. resident, there are far fewer of these treaties than with regard to the imposition of U.S. income taxes on dual resident non-U.S. individuals.

Income Tax Background for Non-U.S. Non-residents: Non-resident aliens of the U.S. for income tax purposes are generally subject to the U.S. federal income tax only on the income that is effectively connected with a trade or business conducted within the U.S., or that is U.S.-sourced income that is ‘fixed,  determinable, annual or periodical.’

  • Passive Income: As a generalization, the U.S. sourced income that is ‘fixed, determinable, annual or periodical’ is passive investment income.
  • Capital Gains: Non-U.S. individuals who are not income tax residents because of the number of days they are present in the US, but who are nevertheless physically present in the U.S. for 183 days or more in the calendar year, may be subject to U.S. federal income tax on capital gains in their income from that year, even though capital gains, as a general rule, are sourced to the residence of the individual.

Transfer Tax Background for Non-U.S. Non-residents: Non-resident aliens of the U.S. are subject to the federal estate tax only on transfer of their U.S. situs real property and tangible personal property which has a U.S. situs. More importantly, those noncitizen, non-resident aliens are not subject to U.S. federal gift tax on transfers of intangible personal property wherever situated, or on transfers of non-U.S. situs real and tangible property. [IRC 2501(a)(1) and (2), and IRC 2511(a).]

  • Intangible Personal Property: This exemption from U.S. gift tax on gifts by a non-resident alien of intangible personal property, e.g. stocks and bonds,  is important to remember as the use of ‘entity-wrappers’ can convert those interests to intangible personal property, thus avoiding the imposition of the US federal gift tax on transfers of the entity interest.
  • $60,000 Federal Estate Tax Exemption: Unlike the $11.18 million unified gift and estate tax exemption available to a U.S. citizen, a non-resident alien will benefit from only a $60,000 exemption from U.S estate taxation for transfers that occur at death (but not during life.) [IRC 2102(b)(1).]
  • Tax on U.S. Situs Property Only: While there is obviously a much smaller federal estate tax exemption available to a non-resident alien for exposure to U.S. estate taxes, a non-resident alien will enjoy a far more limited exposure to  U.S. transfer taxes as they have U.S. estate tax exposure only with regard to U.S situs property, and U.S. situs real and tangible personal property for lifetime gifts. [IRC 2103, 2501(a)(1) and (2) and 2511(a).]
  • Estate and Gift Tax ‘Entity Blockers’: If the non-resident alien owns real estate located in the U.S. it will be exposed to federal estate or gift taxes, with a very low ($60,000) estate tax exemption available. However, if the real estate, or the tangible personal property, is owned by a corporation or an LLC, then the asset that is to be gifted becomes an intangible property interest which is exempt from U.S. transfer tax system. Accordingly, a gift of an interest in intangible personal property will not attract the U.S. federal gift tax. [IRC 2501(a)(2)] assuming the change in nature of the gifted asset does not trigger a challenge by the IRS on audit. Example: A non-U.S. non-resident individual owns a Miami condominium. That individual wishes to gift that condo to family members. The delivery of a deed to the condo triggers the U.S. gift tax, as it is a transfer of situs U.S. real estate. If, however, the non-resident individual first transfers title to the Miami condo to a limited liability company and then gifts the LLC membership units to family members, that is the gift of an intangible personal property interest (not real estate), and no U.S. gift tax will be imposed.

Conclusion: As our world becomes even more of a global economy, the chances are good that at some time in the future you will either encounter a non-U.S. individual who is a resident of the U.S. or you will work with a non-U.S. individual who while not a resident, nonetheless owns property in the U.S. A working knowledge of these basic rules of taxation will be important to guide those individuals in navigating U.S. taxes. In the end, given the complexity of these rules and the existence of multiple tax treaties that might change the outcome of these basic taxation rules, it is best to seek the guidance of an expert in international taxation and estate planning.