2018 Individual Tax Rates | International Tax Lawyer & Attorney

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The Tax Cuts and Jobs Act of 2017 modified the tax brackets that existed in tax year 2017. In this short essay, I will discuss the new 2018 individual tax rates.

2018 Individual Tax Rates: Historical Background

Tax rates seem to change every time there is a new President. For example, when President Bush got elected in 2000, the Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 creating a new tax bracket and bringing the rest of the tax rates down; the top rate was gradually reduced to 35% from 39.6%.

Then, under the new administration of President Obama, the American Taxpayer Relief Act of 2012 increased the tax rates again with the top rate going back up to 39.6%.

2018 Individual Tax Rates: 2017 Tax Reform

Under President Trump, the Congress passed a major reform of the US tax system through the Tax Cuts and Jobs Act of 2017. The tax rates were among the most important changes with respect to domestic US tax law.

While the tax reform preserves the same seven tax brackets for individual tax payers, it introduces new 2018 individual tax rates for almost each of them. Under the previous law, the tax brackets were 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. Now, the new rates starting tax year 2018 are much lower: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

It is important to emphasize that these are not permanent changes. The new tax brackets will operate only through tax year 2025; starting January 1, 2026, the tax rates will return to those that existed in 2017.

2018 Individual Tax Rates: Income Thresholds for Tax Brackets Increase

In addition to lower tax rates, the 2017 tax reform also restructured the income thresholds that apply to most tax brackets. Generally, the income thresholds went up.

For example, in order to be subject to 39.6% tax in 2017, taxpayers filing a joint tax return must have had income in excess of $470,700. In 2018, in order to be subject to the top bracket’s tax rate of 37%, the same couple will have to have income in excess $600,000. The income of $470,700 would only trigger the 35% tax rate in 2018.

Sherayzen Law Office has long held the view that the increase in the income thresholds for tax brackets is especially important (perhaps, more so than the decrease in tax rates) to alleviate the tax burden of the middle class. However, we do note with alarm that the benefits might have been spread too widely to include the top 1% of the earners while the 10% bracket was kept essentially the same. We believe that this was one of the reasons why the Congress made the increase in income thresholds for tax brackets a temporary one despite the anticipated inflation pressures in the future.

Interest Income Sourcing | International Tax Lawyer & Attorney

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This article is a continuation of a recent series of articles on the US source of income rules. In this article, I would like to introduce the readers to the interest income sourcing rules.

Interest Income Sourcing: Definition of “Interest”

Let’s first understand what is meant by the word “interest”. It is very curious that there is no definition of this term in the Internal Revenue Code nor in the Treasury regulations. Indeed, when applied to real life situations, the tax definition of interest spreads to items which do not at first appear as interest income (the most famous example is the original issue discount); the contrary is also true – sometimes an income that appears to be interest income is not considered to be such by the IRS (for example, commitment fees).

Generally, “interest” is a payment for the use of money. In most cases, there is a relationship of indebtedness that accompanies the requirement to pay interest; however, this is not always the case. In fact, there are numerous rules and rulings that one must know in order to properly determine how the IRS will treat a certain payment.

Interest Income Sourcing: General Rule

Generally, the interest is sourced at the residence of the obligor. IRC § 861(a)(1). Thus, if the obligor resides in the United States, then the interest paid on the obligation will be considered as US-source income. This is the case even if the obligor is a foreign national who resides in the United States. On the other hand, if a US citizen resides in a foreign country, then the interest that he pays to his lender is a foreign-source income.

This rule may lead to a paradoxical situation. For example, if a US citizen resides in Spain and pays interest to a Spaniard, this interest would be considered as Spanish-source income. At the same time, if a Spaniard resides in the United States and pays interest to a US citizen who resides in Spain, then the interest would be considered as US-source income.

Generally, interest paid by domestic corporations and domestic partnerships follows the same interest income sourcing rules. There are, however, some exceptions to this rule. For example, with respect to banks, interest on deposits with a foreign branch of a domestic corporation is not considered to be US-source income. IRC § 861(a)(1)(A)(i).

I wish to emphasize that I am stating here a general rule only. There are various exceptions, especially with respect to the portfolio interest. Most of these exceptions are especially relevant to nonresident aliens who receive interest from the United States.

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H.R. 7358 & Modified Residency-Based Taxation | International Tax News

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On December 20, 2018, Congressman George Holding, a Republican from North Carolina and a member of the House Ways and Means Committee, introduced The Tax Fairness for Americans Abroad Act of 2018 (H.R. 7358). According to the analysis below, Sherayzen Law Office believes that H.R. 7358 seeks to modify it in a manner that moves it closer to something that can be described as a modified residency-based model of taxation. Yet, in no way should H.R. 7358 be viewed as an attempt to completely repeal the current citizenship-based model of taxation.

Current US Tax Law: Citizenship-Based Model of Taxation

Currently, all US citizens are obligated to report their worldwide income and pay US taxes on this income irrespective of their actual place of residence. In other words, even if a US citizen resides abroad, he is a US tax resident and must file a US tax return to report his worldwide income.

The current US tax law does allow such citizens to exclude a certain amount ($104,100 in 2018) through the operation of IRC Section 911, commonly known as the Foreign Earned Income Exclusion.

The United States and Eritrea are the only two countries in the world that tax their citizens in this manner. Everyone else taxes their citizens based only on their actual place of residence or under even more restrictive territorial model of taxation.

Lack of Residency-Based Taxation Results in Higher Tax Burden for Americans Who Live Abroad

The current law imposes an enormous burden on over nine million Americans who live abroad. Not only do they have to comply with all local tax laws, but they are also forced to comply with all US international tax laws, including the numerous US international tax reporting requirements.

Undoubtedly, the Foreign Earned Income Exclusion (“FEIE”) helps on the income side, but it only applies to earned income; US taxes must still be paid on all passive income. Moreover, the FEIE is limited to a certain threshold amount of earnings, which can easily be exceeded by the salaries normally paid to mid-level and upper echelon of corporate executives as well as small business owners.

Furthermore, the unincorporated American owners of small businesses may still be subject to US self-employment taxes (despite the income exclusion under the FEIE). Their income may also be disqualified from FEIE under the infamous 30% rule.

The Tax Fairness for Americans Abroad Act of 2018: Moving Current U.S. Tax System In the Direction of Modified Residency-Based Model of Taxation

H.R. 7358 seeks to alleviate the suffering of millions of Americans by modifying the current citizenship-based model of taxation. It proposes to move the US tax system to something that is reminiscent of a residency-based model of taxation.

If it passes, H.R. 7358 would create a new IRC Section 911A which would apply to the new category of taxpayers – qualified nonresident citizens. Such qualified nonresident citizens could exclude from their gross income the entire foreign earned income and foreign unearned income. In other words, nonresident citizens would only have to pay taxes on US-source income (with one exception concerning gains from sale of personal property).

Who would be a “qualified nonresident citizens”? Basically, in order to qualify for this designation, a citizen would have to be a nonresident citizen, not make an election under the IRC Section 911 and make an election under the IRC Section 911A.

A nonresident citizen would be a US citizen who: (a) has a “tax home” in a foreign country; (b) is in full compliance with US income tax laws for the three previous tax years; and (c) either physically resides in foreign country for at least 330 full days during the relevant tax year OR is a bona fide resident of a foreign country for the entire tax year.

Modified Residency-Based Taxation is Proposed by H.R. 7358

It is important to understand that, as it is written at this moment, H.R. 7358 proposes to modify the current tax system, not establish a true residency-based system of taxation. Even if today’s version of the bill passes, all nonresident US citizens will continue to be US tax residents while they reside in a foreign country. In other words, what is really proposed here is a major expansion of the FEIE, not a complete repudiation of the citizenship-based model of taxation.

This is a highly important legal conclusion, because it allows us to clearly see the limits of the relief offered by H.R. 7358. For example, since nonresident citizens will continue to be tax residents, they will still need to file their Forms 8938 and FBARs. Moreover, it does not appear that the bill would affect the obligation to file other international information returns, such as Forms 3520, 5471, 8865, et cetera.

Additionally, it is unclear what would happen to income recognized under the tax deferral regimes, such as Subpart F rules and the GILTI tax. If this income is excluded, H.R. 7358 will become a powerful incentive to residing outside of the United States for a certain period of time in order to implement certain tax planning strategies.

Thus, instead of eliminating citizenship-based taxation, the bill simply attempts to continue the modification of the US international tax system in a way similar to the 2017 tax reform introduced on the corporate side.

Obviously, this is just the initial version of the bill. It is possible that a more overt repudiation of the citizenship-based model of taxation will be enacted, including the elimination of FBAR and Form 8938 requirements for nonresident citizens. It is also possible, however, that this bill will not be enacted in any format at all.

Source of Income: Sale of Real Property | International Tax Law Firm

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One of the most common questions that often arises is whether a sale of real property is considered to be a foreign-source or US-source income. In this short essay, I will briefly describe the source of income rule for the sale of real property and discuss its importance.

Sale of Real Property: What is “Source of Income”

The sourcing rules within the United States Internal Revenue Code (“IRC”) determine to which part of the world a particular income item needs to be assigned. In other words, the source of income rules allow a taxpayer to determine whether his income is considered to be “domestic” or “foreign” for US tax purposes.

Sale of Real Property: the Importance of the Source of Income Rules

The importance of the source of income rules is difficult to overstate. For US tax residents, the source of income rules determine the amount of foreign tax credit that can be claimed on their US tax returns. Moreover, the source of income rules may have other important effects, especially for corporate taxpayers.

However, the significance of the source of income rules is felt the most by nonresident aliens. For these foreign persons, the determination of whether income is foreign or domestic may result in a complete escape from US taxation or, on the opposite end, the obligation to submit a US tax return (even if the nonresident alien has no other connection to the United States). Moreover, the sourcing of income has direct implications for the numerous US tax withholding obligations.

Sourcing of a Sale of Real Property

The US source of income rule with respect to sales of real property is clear: the gain from a sale of real property is sourced to the place where the property is located. In other words, if a house is located in the United States, then the gains from the sale of the house will be considered US-source income. On the other hand, if a house is located in a foreign country, then it will be considered foreign-source income (actually, sourced to the specific country where the sold property is located).

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Dividend Income Sourcing | International Tax Lawyer & Attorney

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One of the most important issues in US international tax law is the sourcing of income – i.e. the determination of whether the income is foreign or domestic for US tax purposes. In this article, I will introduce readers to US tax rules concerning dividend income sourcing (note, I will not be discussing substitute dividends and so-called “fast-pay” stocks as part of this article).

Dividend Income Sourcing: General Rule

Aside from limited exceptions, the source of dividend income is determined by whether the corporation that pays the dividends is foreign or domestic.

Dividend Income Sourcing: Domestic Corporations

Generally, if a US domestic corporation pays a dividend to its shareholders, the income is sourced in the United States. IRC §861(a)(2)(A).

There are three limited exceptions to this general rule, but only the first exception is really relevant at this point. The first exception is found in the complex rules concerning a Domestic International Sales Corporation (“DISC”). Basically, under IRC §861(a)(2)(D), dividends from a DISC are US-source income unless the dividends are attributable to “qualified export receipts”. In other words, if all of the gross income of a DISC satisfies the definition of qualified export receipts, then the entire gross income will be considered as derived from a foreign source. This is the basic rule and there are important exceptions and considerations that must be considered if one engages in a detailed analysis.

The second exception was a dividend paid by a Section 936 corporation. A Section 936 corporation was a special type of a domestic corporation that did business in the US possessions. At this point, the repeal of IRC §936 makes this section largely irrelevant.

Finally, the third exception existed mostly prior to 1987. At that time, if a taxpayer was able to show that 80% of the gross income of the payor corporation for the relevant period of time consisted of foreign-source income, then the dividend was also foreign-source even if it was paid by a domestic corporation. The relevant period of time for making this determination included the three fiscal years of the corporation preceding the year in which the dividend was declared (obviously, if the corporation existed for less than three years, then the period of time was reduced to the number of years the corporation had been in existence). Interestingly, with the exception of mergers and consolidations, the dividends were foreign-source even if the payor corporation filed a consolidated return with an affiliated group which did not meet what was known as the 80/20 rule.

This third exception became largely irrelevant as of January 1, 1987. However, the 80/20 corporations were exempted from tax withholding even as late as prior to 2010. At that time, the Congress finally repealed the 80/20 company rule, though it still left a grandfather clause for it.

Dividend Income Sourcing: Foreign Corporations

Dividend income sourcing with respect to foreign corporations is more complex. Generally, dividends from foreign corporations are considered to be foreign-source income unless 25% or more of the corporation’s gross income for the three years preceding the taxable year (in which the distribution occurred) was from income that was effectively connected with a trade or business in the United States. This is the so-called “25% exception”.

If the 25% threshold is satisfied, then the dividend is apportioned according to the percentage of the corporation’s income effectively connected to the United States versus foreign-source income. This rule obviously affects the ability of a US person to take full foreign tax credit.

Now, let’s look at the 25% exception from the perspective of a foreign person receiving a dividend from a foreign corporation. Again, if a foreign dividend was paid to a foreign person from a company that did not satisfy the 25% exception, then no part of the dividend was sourced to the United States. If, however, the 25% exception was satisfied, then a foreign person had US-source income according to the apportionment rule described above. In other words, a foreign dividend paid from a foreign company to a foreign individual may result in US-source income even though none of these persons are US tax residents!

Moreover, prior to 2005, such a foreign individual would have to declare this US-source income in the United States and, theoretically, pay tax on it. Obviously, this was unlikely to happen because either the foreign corporation was subject to the branch profits tax which offset the tax on dividends paid by the corporation or a tax treaty prevented the taxation of such dividend. Nevertheless, if neither exception applied, a foreign person could find himself in noncompliance with US tax laws (and there was even some litigation on this subject).

When it passed the American Jobs Creation Act of 2004, the US Congress finally relented and exempted from US taxation all dividends that fell within the 25% exception and were paid to foreign persons on or after January 1, 2005. IRC §871(i)(2)(D).

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