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Definition of “U.S. person” for FBAR (Report on Foreign Bank and Financial Accounts) Purposes

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Since October of 2008, the definition of a “U.S. person” has been going through a turbulent phase of uncertainty with periodic expansions and retractions. The pre-2008 FBAR instructions (dating back to July of 2000 version) defined the “U.S. person” broadly as: “(1) a citizen or resident of the United States, (2) a domestic partnership, (3) a domestic corporation, or (4) a domestic estate or trust.” See IRS Announcement 2010-16.

Two important features of this definition stand out. First, the term “person” is defined to include not only individuals, but also virtually any type of business entity, estate or trust. 31 C.F.R. §103.11(z) Even a single-member LLC, which is generally disregarded for tax purposes, may be classified as a U.S. person because it has a separate juridical existence from its owner. A partnership or a corporation created or organized in the United States is considered to “domestic” under 26 U.S.C. §7701(a)(4). Second, the definition of who should be considered as a U.S. resident is interpreted under 26 U.S.C. §7701. Under 26 U.S.C. §7701(b), an individual is a U.S. resident if he meets any of the three bright-line tests: (1) lawful admission for permanent residence to the United States (“green card”); (2) substantial presence in the U.S.: the sum of the number of days on which such individual was present in the United States during the current year and the 2 preceding calendar years (when multiplied by the applicable multiplier determined under the following table) equals or exceeds 183 days; (3) and first-year election to be treated as a resident under 26 U.S.C. §7701(b)(4). Thus, the definition of a U.S. resident under the tax rules is much broader than the one used in immigration law.

In October of 2008, the IRS revised the FBAR instructions and further expanded the definition of a “U.S. person” by including the persons “in and doing business in the United States.” This revision caused a widespread confusion among tax professionals. The outburst of comments and questions prompted the IRS to issue Announcements 2009-51 and 2010-16, suspending FBAR filing requirement through June of 2010 (i.e. for calendar years 2008 and 2009) for persons who are not U.S. citizens, U.S. residents, and domestic entities. Instead, the tax professionals were referred back to July of 2000 FBAR definition of a “U.S. person.”

In the meantime, in February of 2010, the IRS published new Proposed FBAR regulations under 31 C.F.R. §103. The proposed rules modify the definition of a “U.S. person” as follows: “a citizen or resident of the United States, or an entity, including but not limited to a corporation, partnership, trust or limited liability company, created, organized, or formed under the laws of the United States, any state, the District of Columbia, the Territories, and Insular Possessions of the United States or the Indian Tribes.” 75 Fed. Reg. 8845 (proposed February 23, 2010) (to be codified as 31 C.F.R. 103.24(b)). This definition applies even if an entity elected to be disregarded for tax purposes. Id. The determination of a U.S. resident status is to be done according to 26 U.S.C. §7701(b) and regulations there under, except the meaning of the “United States”(which is to be defined by 31 U.S.C. 103.11(nn)). Id.

Thus, if the proposed regulations will ultimately be codified in their current form, the definition of the “U.S. person” will be slightly broader than that of the July of 2000, but will represent a major regression from October 2008 definition. Nevertheless, based on even existing (July of 2000) definition of the “U.S. person,” the IRS has been able to cast a wide net over U.S. taxpayers, trying to force disclosure of as many foreign financial accounts as possible.

Effect of the Foreign Earned Income Exclusion on the Self-Employment Tax on Business Activities Oversees

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In this essay, I would like to explore the relationship between the self-employment tax and the tax exclusion of income earned by the U.S. businesses abroad.

The self-employment tax is a social security and Medicare tax on net earnings from self-employment. A self-employed U.S. citizen or resident must pay self-employment tax if his net earnings from self-employment are at least $400. In tax year 2009, the maximum amount of net earnings that is subject to the social security portion of the tax is $106,800, while all net earnings are subject to the Medicare portion of the tax.

Despite the commonly-held belief, in calculating his self-employment tax liability, a U.S. citizen or resident must take all of his self-employment income into account, even if this income is exempt from income tax because of the foreign earned income exclusion. For example, suppose A, a U.S. citizen, provides consulting services in a European country as part of his business activities. Under the independent contractor agreement, A is paid $120,000 for his services; A’s total business deductions are $50,000, and his net income is therefore $70,000. A can successfully exclude $70,000 from taxable gross income (the exclusion for year 2009 is up to $91,400). He, however, must pay the self-employment tax on all of his net profit, including those $70,000 that he excluded from taxable income.

Similar rule applies to U.S. citizens or residents alien who own and operate a business in the U.S. possessions (Puerto Rico, Guam, the Commonwealth of the Northern Mariana Islands, American Samoa, and the U.S. Virgin Islands). Self-employment tax must be paid on all of the self-employment income (as long as it is $400 or more) derived from such businesses, even if the income is exempt from the U.S. income taxes. Schedule SE (Form 1040) must be attached to the U.S. income tax return. If the owner of the business is a resident of any of the U.S. possessions and he does not have to file Form 1040, then the self-employment tax should be determined on Form 1040-SS. Residents of Puerto Rico may file the Spanish-language Form 1040-PR, Self-Employment Tax Form — Puerto Rico (Spanish Version).

While non-resident aliens generally are not subject to the self-employment tax, they still have to pay the tax on self-employment income received while they were resident aliens, even if such income was paid for services performed while they were non-resident aliens. For example, royalties received by a U.S. resident for the intellectual property created while this person was non-resident alien.

Finally, one must be aware that the United States has entered into social security agreements (also known as Totalization Agreements) with foreign countries to eliminate duel coverage and duel social security tax payments for the same work. Hence, the social security taxes (including the self-employment tax) are paid only to one country. If a person’s self-employment earnings should be exempt from foreign social security tax and subject only to U.S. self-employment tax, he should request a certificate of coverage from the U.S. Social Security Administration, Office of International Programs. The certificate will establish this person’s exemption from the foreign social security tax.

To establish that one’s self-employment income is subject only to foreign social security taxes and is exempt from U.S. self-employment tax, this person must request a certificate of coverage from the appropriate agency of the foreign country. If the foreign country will not issue the certificate, he should request from the U.S. Social Security Administration a statement that his income is not covered by the U.S. social security system.

House passes the Tax Extenders Act of 2009

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On December 9, 2009, the U.S. House of Representatives approved H.R. 4213, the “Tax Extenders Act of 2009.” The bill would extend for one more year more than forty tax provisions that are set to expire at the end of this year, including the research credit and a number of important tax breaks for individuals. In order to offset more than $30 billion in tax relief, the bill also requires stricter reporting on U.S.-held foreign assets by foreign financial institutions and U.S. citizens.

Three provisions draw particular attention. First, starting with tax year 2013, the foreign financial institutions, foreign trusts, and foreign corporations are required to obtain and provide information from each of their account holders to determine if any account is American-owned. Foreign financial institutions must also comply with verification procedures and to report any U.S. accounts maintained by the institution on an annual basis. Then, any foreign financial institution that complies with the new verification and reporting standards would be subject to a 30 percent tax on income from U.S. financial assets held by the foreign institution. Where the owner of the account is a foreign government, an international organization, a foreign central bank, or any other class identified by the Treasury Department as posing a low risk of tax evasion, the withholding tax would not apply. Notice, the H.R. 4213’s requirements only apply if the aggregate value of the accounts in the foreign institutions exceeds $10,000. Hence, the basic FBAR rule that the owners of foreign financial accounts with the aggregate value of below $10,000 do not need to report the accounts still applies.

Second, H.R. 4213 requires any U.S. taxpayer with a foreign financial asset exceeding $50,000 in value to report the asset with their tax return. The penalty for failure to report a foreign financial asset would be $10,000 and could possibly increase to as much as $50,000.

Third, additional annual reporting requirements (similar to other U.S. holders of foreign assets) are imposed on the shareholders of passive foreign investment companies and U.S. owners of foreign trusts. A U.S. taxpayer failing to report a foreign owned trust would pay the greater of $10,000 or 35 percent of the amount of the trust.

Finally, the Tax Extenders Act of 2009 increases the tax rate on so-called “carried interest” levied on investment partnerships by treating carried interest as normal income and taxing it at the standard income tax rate (currently 35 percent) rather than the capital gains rate (currently 15 percent). This measure would have a particular impact on most private equities and hedge funds (which operate as partnerships with a general partner managing the fund and contributing partners supplying the capital), because the managers of these funds generally receive two forms of compensation from the fund: a small percentage of the fund’s assets like a contributing partner, and a higher percentage of the fund’s annual earnings that only the fund’s manager receives (i.e. carried interest).

While most of the provisions of the H.R. 4213 are expected to pass the Senate, the “carried interest” provision might present a significant problem.

Definition of Foreign Earned Income for the purposes of Foreign Income Exclusion under I.R.C. §911

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Under I.R.C. §911, if certain conditions are met, a qualified individual can exclude as much $91,400 (for tax year 2009) of foreign earned income from taxable gross income. Two questions arise: what is earned income, and when is such income considered to be foreign earned income?

Earned Income

Earned income usually means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered.

The issue of earned income becomes complicated in a situation where a taxpayer engaged in a trade or business in which both personal services and capital are material income producing factors. Capital is a material income-producing factor if the operation of the business requires substantial inventories or substantial investments in plant, machinery, or other equipment. In this case, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income (I.R.C. §911(d)(2)(B)). This rule, however, would not apply where the capital is merely incidental to the production of income (see Rousku v. Commissioner (Tax. Ct.1971)).

In a situation where the services rendered abroad culminate in a product that is either sold or licensed, it is difficult to determine whether the proceeds are earned income. Usually, such issues are resolved on a case-by-case basis.

Foreign Earned Income

Earned income is usually considered as “foreign earned income” if it is attributable to services actually rendered by the taxpayer while oversees. The place at which the taxpayer receives the income is not relevant. For example, an employee working abroad for a U.S. employer does not lose the exclusions by having her compensation paid into a bank account in the United States. Note, however, that services rendered in anticipation of, or after the conclusion of an oversees assignment are not covered by the exclusion. I.R.C. §911(b)(1)(A) and §911(d)(2)

Understanding Foreign Income Exclusion under I.R.C. §911: General Information

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Under I.R.C. §911, a U.S. citizen or resident can elect to exclude as much as $91,400 (for tax year 2009) of foreign earned income and some or all foreign housing costs from taxable gross income if two conditions are met. First, the individual must satisfy either a foreign presence or bona fide residence test. Second, the individual’s tax home must be in a foreign country. The first requirement (foreign presence/bona fide residence test) is satisfied when: (i) the individual is a U.S. citizen or resident who is physically present in a foreign country for at least 330 full days during any 12 consecutive months, or (ii) the individual is a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. The second requirement is satisfied if the individual’s tax home – i.e. main place of business, employment, or post of duty – is in a foreign country. Tax home generally means the place where the individual is permanently or indefinitely engaged to work as an employee or self-employed individual.