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Residents versus Nonresidents: US Tax Differences | International Tax Lawyer Minneapolis

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There is a huge difference between the US tax obligations of a US tax resident versus nonresident alien. This brief essay strives to outline the main differences in the US tax treatment of tax residents versus nonresidents.

Residents versus Nonresidents: Worldwide Income Taxation

One of the key differences in the tax treatment of residents versus nonresidents is concerning what income is subject to US taxation.  A resident alien is subject to worldwide income taxation similarly to a US citizen. It does not matter where the income is earned, whether it is subject to taxation in a foreign country, whether it has been repatriated to the United States, whether it comes from pre-US funds, et cetera – a resident alien is always subject to worldwide income taxation.

Moreover, a resident alien may also be subject to highly invasive anti-deferral tax regimes such as Subpart F rules and GILTI tax (see below). Under these regimes, a resident alien may have to recognize income that the IRS deems that he earned, but there was no actual distribution.

On the other hand, a nonresident alien may have to pay US taxes on only four types of income. First, US-source income (that the Internal Revenue Code does not otherwise exclude from taxation) that the IRS considers as FDAP income (fixed, determinable, annual or periodical income) under IRC §871(a) (see below more on this subject). Second, a nonresident alien has to pay US taxes on US-source capital gains.  Third, a nonresident alien has to declare on his US income tax returns all ECI (Effectively Connected Income) income from a trade or business within the United States. Finally, certain other US-source and certain other foreign-source income under highly limited exceptions. All other income is excluded from taxation of nonresident aliens.

Residents versus Nonresidents: Deductions

On the other hand, a resident alien has available (at least hypothetically) a far broader range of deductions, including a more expanded list of itemized deductions (for example, mortgage interest, property taxes, et cetera) and a standard deduction.

A nonresident alien, however, has available a far more limited range of deductions.  First, deductions related to the ECI earnings. Second, only three specific kinds of itemized deductions: casualty/theft losses from property located in the United States, charitable contributions to qualified US charities only and one personal exemption (which is a moot point at the time of this writing). Third, a nonresident alien can only claim a standard deduction in the case of a few income tax treaties that allow the claim of a standard deduction; otherwise, the standard deduction is not available.

Residents versus Nonresidents: Tax Filing Status

If a resident alien marries another resident alien or a US citizen, then the couple may elect to file a joint US tax return. Married Filing Jointly is probably the most beneficial tax filing status in the United States.

On the other hand, nonresident aliens (if they want to keep their nonresident status) married to a resident alien or a US citizen can only file as “married filing separately”.  In most situations, this is the most unfavorable tax filing status from the US tax perspective.

Residents versus Nonresidents: US International Information Returns

Compliance with US international information returns is potentially a huge difference between the US tax burden of residents versus nonresidents. A resident alien may be required to file a bewildering array of US international information returns depending on his particular situation.  A failure to do so may result in the imposition of very high IRS penalties.

The main examples of such returns are: FBAR (officially FinCEN Form 114, the Report of Foreign Bank and Financial Accounts), Form 3520, Form 3520-A, Form 5471, Form 8621, Form 8865, Form 8938, Form 926, et cetera.

Residents versus Nonresidents: Tax Withholding on US-Source Income

There are several situations in which a payment to a non-US person may be classified as a US-source income and subject to tax withholding under IRC §§1441 and 1442 solely due to the “US resident” classification of the payor.  Here, I am referring to a situation where the US tax code classifies an interest payment as US-source income only because it is a resident alien made the payment. If such a payment were made by a nonresident alien, then it would be foreign-source income not subject to US tax withholding.

The most common example of such a situation involves interest payments.  Under §861(a)(1), interest paid by noncorporate resident of the United States is US-source income potentially subject to tax withholding. However, if the individual is a nonresident alien for US tax purposes, then the interest is not US-source income exempt from US tax withholding, at least under IRC §§1441 and 1442.

As a side note, I should mention that if the interest made by a US tax resident is classified as “portfolio interest” under §871(h), it would be exempt from the 30% tax withholding pursuant to §§871(a)(1) and 881.  There is also a potential for the exclusion from tax withholding under a particular tax treaty. As always, an international tax attorney should analyze each particular set of facts in its own context in order to determine whether income would be subject to US tax withholding.

Residents versus Nonresidents: Anti-deferral Tax Regimes

A US tax resident may be subject to a wide variety of various US anti-deferral tax regimes, such as PFIC (Passive Foreign Investment Company), GILTI, Subpart F rules, et cetera.

Moreover, a situation may occur where US resident classification as resident under the IRC does not impact this particular individual’s US income tax obligations but may affect such obligations of other US persons.  The most common example is the classification of a foreign corporation as a Controlled Foreign Corporation or CFC. 

Imagine where a person is a US tax resident under the IRC but utilizes the “tie-breaker” provisions of an income tax treaty to continue being classified as a nonresident alien. In this case, this individual’s US income tax obligations are the same as before. However, for the purposes of classifying a foreign corporation as a CFC, he remains a US tax resident. For example, if he owns 10% and the other US owners own at least 41% of this foreign corporation, then the corporation itself will become a CFC without any regard to the treaty provisions. See Reg. §301.7701(b)-7(a)(3).

Contact Sherayzen Law Office for Professional Help Regarding US International Tax Law

In this article, I summarized some of the most important US tax differences between US residents versus nonresidents.  There are many more complexities and tax traps in this area of law.

This is precisely why you need to contact Sherayzen Law Office for professional help with your US tax classification and any other US international tax issue. Our firm has extensive experience in advising clients concerning their US tax status and the potential US tax consequences of a particular US tax classification.

Contact Us Today to Schedule Your Confidential Consultation!

January 28 2021 Inbound Transactions Seminar | US International Tax Lawyer

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On January 28, 2021, Mr. Eugene Sherayzen, an international tax attorney and founder of Sherayzen Law Office, Ltd., co-presented with a business lawyer a seminar titled “Investing in US Businesses by Foreign Persons – Common Business and Tax Considerations” (the “Inbound Transactions Seminar”). The Inbound Transactions Seminar was sponsored by the International Business Law Section of the Minnesota State Bar Association. Due to the ongoing COVID-19 pandemic, the seminar was conducted online.

Mr. Sherayzen began his part of the Inbound Transactions Seminar with an explanation of the term “inbound transactions” and how it differs from “outbound transactions”. He then laid out a flowchart which represented the entire analytical tax framework for inbound transactions; the tax attorney warned the audience that, due to time restraints, the breadth of the subject matter only allowed him to generally highlight the most important parts of this framework.

Then, Mr. Sherayzen proceeded with an explanation of each main issue listed on the inbound transactions tax framework flowchart. First, he discussed the explanation of the concept of a US person and how it related to the flowcharted. The international tax attorney provided definitions for all four categories of US persons: individuals, business entities (corporations and partnerships), trusts and estates.

Then, Mr. Sherayzen focused on the second part of the flowchart – US income sourcing rules. After the general explanation of the significance of the income sourcing rules, the international tax attorney discussed in general terms the application of these rules to specific types of income: interest, dividends, rents, royalties, sales of personal property, sales of inventory, sales of real estate and income from services. Despite the time limitations, he was even able to provide a few examples of some of the most paradoxical outcomes of some of the US source-of-income rules.

The third part of the Inbound Transactions Seminar was devoted to the definition of “US trade or business activities”, an important tax term. Mr. Sherayzen provided a general definition and gave some specific examples, warning the audience that this is a highly fact-dependent issue.

In the next two parts of the seminar, the international tax attorney explained one of the most important terms in US taxation – ECI or Effectively Connected Income. Mr. Sherayzen not only went over all three ECI income categories but he also explained how ECI should be taxed. He also mentioned the affect of specific tax regimes (such as BEAT and branch taxes) on the taxation of ECI.

After finishing the left side of the flowchart (the part that was devoted to the analysis of the ECI of US trade and business activities), Mr. Sherayzen switched to the explanation of inbound transactions that do not involve US trade or business activities. In this last part of his presentation, the international tax attorney discussed the definition of FDAP income and the potential Internal Revenue Code and treaty exemptions from US taxation.

While the ongoing pandemic currently limits the number of options for conducting seminars, Mr. Sherayzen already plans future talks in 2021 on the subjects of US international tax compliance and US international tax planning.

§318 Downstream Estate Attribution | International Tax Lawyer & Attorney

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This article continues a series of articles on the Internal Revenue Code (“IRC”) §318 constructive ownership rules. Today, the topic is §318 estate attribution rules – i.e. attribution of ownership of corporate stock from estate to its beneficiaries and vice versa. Since this is a long topic, I will divide it into three articles. This article focuses on the §318 downstream estate attribution rules.

§318 Estate Attribution Rules: Two Types

There are two types of the IRC §318 estate attribution rules: downstream and upstream. The downstream attribution rules attribute the ownership of corporate stocks owned by an estate to its beneficiaries. On the other hand, the upstream attribution rules attribute the ownership of corporate stocks owned by beneficiaries to the estate. As I stated above, this article focuses on the first type – i.e. §318 downstream estate attribution rules.

§318 Downstream Estate Attribution: Attribution from Estate to Beneficiary

Under the IRS §318(a)(2)(A), corporate stock owned directly or indirectly by or on behalf of an estate is deemed to be owned proportionately by its beneficiaries. It is very important to understand that the actual disposition of estate property by the testator does not matter to the proportionate attribution of estate property between the beneficiaries. Thus, even if the will demands that all corporate stocks be inherited by only one beneficiary, the ownership of these stocks will be attributed to all beneficiaries in proportion to their respective interests in the estate.

Three questions arise with respect to the application of this §318 downstream estate attribution rule: (1) What stocks are considered to be owned by the estate? (2) Who is deemed to be a beneficiary of an estate? and (3) How does the proportionality rule work?

§318 Downstream Estate Attribution: Stocks Owned by Estate

Treas. Regs. §1.318-3(a) defines when an estate is deemed to be an owner of corporate stock for the §318 attribution purposes. It states that corporate stocks (as well as any other property) shall be considered as owned by an estate if “such property is subject to administration by the executor or administrator for the purpose of paying claims against the estate and expenses of administration.” This is the case even if the legal title to the stock vests immediately upon death in the decedent’s heirs, legatees, or devisees under local law. Id.

§318 Downstream Estate Attribution: Definition of a Beneficiary

I address the definition of a beneficiary for the §318 attribution purposes in more detail in another article. Here, I will only state the general rule.

Treas. Regs. §1.318-3(a) states that “the term beneficiary includes any person entitled to receive property of a decedent pursuant to a will or pursuant to laws of descent and distribution.” Hence, in order to be considered a beneficiary under §318, a person must have a direct present interest in the property of the estate or in income generated by that property.

§318 Downstream Estate Attribution: Proportionality

As in many other cases concerning attribution proportionality, there is very little guidance from the IRS and Treasury regulations concerning determination of a beneficiary’s proportionate interest in an estate. Hence, an attorney has a considerable freedom in determining the reasonable methodology with respect to the application of the proportionality requirement. It appears that one method may be particularly acceptable to the IRS: measuring the relative values of each beneficiary’s interest.

§318 Downstream Estate Attribution: No Re-Attribution

Similarly to many other IRC provisions concerning constructive ownership, §318 estate attribution rules contain a prohibition on re-attribution of stocks. Under §318(a)(5)(C), a beneficiary’s stock constructively owned by an estate through the operation of the §318 estate attribution rules cannot be attributed to another beneficiary.

§318 Downstream Estate Attribution: Example

Let’s conclude this article with an illustration of how the §318 downstream estate attribution rules actually work. The proposed hypothetical scenario is as follows: an estate owns 100 of the total 200 outstanding shares of X, a South Dakota C-corporation; A is entitled to 50% of the property of the estate and actually owns 24 shares of X; B owns 36 shares of X and has a life estate in the other 50% of the estate; and C owns 40 shares of X and only has a remainder interest in the estate after the death of B. Here is how the §318 estate attribution constructive rules would work in this case:

A actually owns 24 shares of X and constructively owns another 50 shares of X through his 50% beneficiary interest in the estate. In other words, A’s total ownership of X equals 74 shares.

B actually owns 36 shares of X and constructively owns another 50 shares of X through his life estate; his total number of shares of X equals 86.

Finally, C owns 40 shares of X only. He does not have any constructive ownership of any shares of X, because his remainder interest in the estate is not a present interest in the estate; hence, he is not a beneficiary of the estate.

Contact Sherayzen Law Office for Professional Help With §318 Downstream Estate Attribution Rules

The constructive ownership rules of §318 are crucial to proper identification of US tax reporting requirements with respect domestic and especially foreign business entities. Hence, if you a beneficiary of an estate or an executor/administrator of an estate that owns stocks in a domestic or foreign corporation, contact Sherayzen Law Office for professional help with §318 estate attribution rules.

Contact Us Today to Schedule Your Confidential Consultation!

Sherayzen Law Office Successfully Completes its 2019 Fall Tax Season

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On October 15, 2019, Sherayzen Law Office, Ltd., successfully completed its 2019 Fall Tax Season. It was a challenging and interesting tax season. Let’s discuss it in more detail.

2019 Fall Tax Season: Sherayzen Law Office’s Annual Compliance Clients

Annual tax compliance is one of the major services offered by Sherayzen Law Office to its clients. The majority of our annual compliance clients are individuals and businesses who earlier retained our firm to help them with their offshore voluntary disclosures. They liked the quality of our services so much that they preferred our firm above all others to assure that they stay in full compliance with US tax laws.

It is natural that this group of clients is the largest among all other groups, because the unique specialty of our firm is conducting offshore voluntary disclosures.

A smaller group of our annual compliance clients consists of tax planning clients who also asked Sherayzen Law Office to do their annual compliance for them.

Finally, the last group of our annual compliance clients consists of businesses and individuals who were referred to our firm specifically for help with their annual compliance. These are usually foreign businesses who just expanded to the United States and foreign executives and professionals who just arrived to the United States to start working here.

2019 Fall Tax Season: Sherayzen Law Office’s Annual Compliance Services

Virtually all of our clients have exposure to foreign assets and international transactions. Hence, in addition to their domestic US tax compliance, Sherayzen Law Office prepares the full array of US international tax compliance forms related to foreign accounts (FBAR and Form 8938), PFIC calculations (Forms 8621), foreign business ownership and Section 367 notices (Forms 926, 5471, 8858, 8865, et cetera), foreign trusts (Form 3520 and Form 3520-A), and other relevant US international tax compliance issues.

2019 Fall Tax Season: Unique Challenges and Opportunities

The 2019 Fall Tax Season was especially challenging because of the record number of deadlines that needed to be completed. During the season, Sherayzen Law Office filed hundreds of FBARs, US income tax returns and US international tax returns such as Forms 3520, 5471, 8865, 8621 and 926.

The great time pressure created opportunities for our firm to further streamline our tax preparation and scheduling processes, ultimately creating an even more efficient yet still comprehensive and detail-oriented organization.

The 2019 Fall Tax Season was unique in one more aspect – the implementation of the 2017 tax reform changes. The 2017 Tax Cuts and Jobs Act (“TCJA” or “2017 tax reform”) introduced the most radical changes to the Internal Revenue Code since 1986. Form 1040 was greatly modified and numerous other US domestic tax laws and forms were affected.

The greatest change, however, befell the US international tax law, particularly US international corporate tax law. The introduction of GILTI (Global Intangible Low-Taxed Income) tax, FDII (Foreign-Derived Intangible Income) deduction, full participation exemption and many other rules and regulations has profoundly modified this area of law.

No form felt these changes greater than Form 5471. Due to the 2017 tax reform, it has almost tripled in size and has acquired a qualitatively new level of complexity. Many new questions appeared and only some of them were definitely resolved by the IRS in the summer of 2019 when it issued new regulations.

Since Sherayzen Law Office has a lot of clients who own partially or fully foreign corporations, Forms 5471 were a constantly-present challenge during the 2019 Fall Tax Season. Nevertheless, we were able to timely complete all Forms 5471 for all of clients. We were even able to develop and incorporate important strategic and tactical tax planning techniques, such as IRC Section 962 election, helping our clients lower their tax burden.

Looking Forward to Completing Offshore Voluntary Disclosures, End-of-Year Tax Planning and 2020 Spring Tax Season

Having completed such a difficult 2019 Fall Tax Season, Sherayzen Law Office now looks forward to working on the offshore voluntary disclosures and IRS audits through the end of the year. We also have a sizeable portfolio of end-of-year tax planning cases. Finally, we look forward to the 2020 Spring Tax Season for the tax year 2019.

If you have foreign assets or foreign income, contact Sherayzen Law Office for professional help. Our firm specializes in US international tax compliance. We have helped hundreds of US taxpayers to bring themselves into full compliance with US tax laws, and We Can Help You!

Contact Us Today to Schedule Your Confidential Consultation!

Mexican Bank Accounts & US Tax Obligations | International Tax Lawyers

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In this essay, I would like to discuss three main US tax obligations concerning Mexican bank accounts: the worldwide income reporting requirement, FBAR and Form 8938. I will only concentrate on the obligations concerning individuals, not business entities.

Mexican Bank Accounts and US Tax Residents

Before we delve into the discussion concerning US tax obligations, we should establish who is required to comply with these obligations. In other words, who needs to report their Mexican bank accounts to the IRS?

The answer to this question is clear: US tax residents. Only US tax residents must disclose their worldwide income and report their Mexican bank accounts on FBAR and Form 8938. Non-resident aliens who have never declared themselves as US tax residents do not need to comply with these requirements.

US tax residents include US citizens, US Permanent Residents, an individual who satisfied the Substantial Presence Test and an individual who properly declares himself a US tax resident. This is, of course, the general rule; important exceptions exist to this rule.

Mexican Bank Accounts: Worldwide Income Reporting Requirement

US tax residents must disclose their worldwide income on their US tax returns, including any income generated by Mexican bank accounts. In other words, all interest, dividend and royalty income produced by these accounts must be reported on Form 1040. Similarly, any capital gains from sales of investments held in Mexican bank accounts should also be disclosed on Form 1040. US taxpayers should pay special attention to the reporting of PFIC distributions and PFIC sales.

It is also possible that you may have to disclose passive income generated by your Mexican business entities through the operation of Subpart F rules and the GILTI regime, but this is a topic for a separate discussion.

Mexican Bank Accounts: FBAR

US tax residents must disclose on FBAR their ownership interest in or signatory authority or any other authority over Mexican bank and financial accounts if the aggregate highest balance of these accounts exceeds $10,000. FBAR is a common acronym for the Report of Foreign Bank and Financial Accounts, FinCEN Form 114. Even though this is a FinCEN Form, the IRS is charged with the enforcement of this form since 2001.

While seemingly simple, FBAR contains a number of traps for the unwary. One of the most common trap is the definition of “account”. For the FBAR purposes, “account” has a much broader definition than what people generally think of as an account. ‘Account” includes not just regular checking and savings accounts, but also investment accounts, life insurance policies with a cash surrender value, precious metals accounts, earth mineral accounts, et cetera. In fact, it is very likely that the IRS will find that an account exists whenever there is a custodial relationship between a financial institution and a US person’s foreign asset.

FBAR is a very dangerous form. Not only is the filing threshold very low, but there are huge penalties for FBAR noncompliance. For a willful violation, the penalties can go up to $100,000 (adjusted for inflation) per account per year or 50% of the highest value of the account per year, whichever is higher. In special circumstances, the IRS may refer FBAR noncompliance to the US Department of Justice for criminal prosecution. Even non-willful FBAR penalties may go up to $10,000 (again, adjusted for inflation) per account per year.

Mexican Bank Accounts: FATCA Form 8938

The final requirement that I wish to discuss today is the FATCA Form 8938. Born out of the Foreign Account Tax Compliance Act, Form 8938 occupies a unique role in US international tax compliance. On the one hand, it may result in the duplication of a taxpayer’s US tax disclosures (especially with respect to the accounts already disclosed on FBAR). On the other hand, however, Form 8938 is a “catch-all” form that fills the compliance gaps with respect to other US international tax forms.

For example, if a taxpayer holds a paper bond certificate, this asset would not be reported on FBAR, because it is not an account. For the Form 8938 purposes, however, the IRS would consider this certificate as part of assets that fall within the definition of the Specified Foreign Financial Assets (“SFFA”).

Hence, the scope of Form 8938 is very broad. It requires a specified person (this term is almost equivalent to a US tax resident) to disclose all SFFA as long as these SFFA, in the aggregate, exceed the applicable filing threshold.

SFFA includes a huge variety of foreign financial assets which are divided into two sub-categories: (a) foreign bank and financial accounts; and (b) “other” foreign financial assets. The definition of the “other” assets is impressive in its breadth: bonds, stocks, ownership interest in a closely-held business, beneficiary interest in a foreign trust, an interest rate swap, currency swap; basis swap; interest rate cap, interest rate floor, commodity swap; equity swap, equity index swap, credit default swap, or similar agreement with a foreign counterparty; an option or other derivative instrument with respect to any currency or commodity that is entered into with a foreign counterparty or issuer; and so on.

Form 8938 requires not only the reporting of SFFA, but also the income generated by the SFFA. In essence, the worldwide income reporting requirement is incorporated directly into the form.

The filing threshold for Form 8938 is more reasonable than that of FBAR for specified persons who reside in the United States, but it is still fairly low (especially for individuals). For example, if a taxpayer lives in the United States, he will need to file Form 8938 if he has SFFA of $50,000 ($100,000 for a married couple) or higher at the end of the year or $75,000 ($150,000 for a married couple) or higher during any time during the year. Specified persons who reside outside of the United States enjoy much higher thresholds.

Form 8938 has its own penalty system which contains some unique elements. First of all, a failure to comply with the Form 8938 requirements may allow the IRS to impose a $10,000 failure-to-file penalty which may go up to as high as $50,000 in certain circumstances. Second, Form 8938 noncompliance will lead to an imposition of much higher accuracy-related penalties on the income tax side – 40% of the additional tax liability. Third, Form 8938 noncompliance will limit the taxpayer’s ability to utilize the Foreign Tax Credit.

Finally, a failure to file Form 8938 will directly affect the Statute of Limitations of the entire tax return by extending the Statute to the period that ends only three years after the form is filed. In other words, Form 8938 penalties may allow the IRS to audit tax years which otherwise would normally be outside of the general three-year statute of limitations.

Contact Sherayzen Law Office for Professional Help With the US Tax Reporting of Your Mexican Bank Accounts

Sherayzen Law Office’s core area of practice is international tax compliance, including offshore voluntary disclosures – i.e. helping US taxpayers with foreign assets and foreign income to stay in US tax compliance and, if a taxpayer fails failed to comply with US tax laws in the past, bring him into compliance through an offshore voluntary disclosure. We can help You!

Contact Us Today to Schedule Your Confidential Consultation!