A person planning to immigrate to the United States is likely already familiar with the complexities of U.S. immigration law. However, the prospective immigrant may not yet realize that he or she needs to pay attention to, and plan for, yet another complex body of U.S. law: taxes.
The U.S. government imposes an income tax on U.S. citizens and resident aliens. In addition, it imposes transfer taxes on U.S. citizens and domiciliaries for the gratuitous transfer of property during life or at death.
Each state and locality within the United States also imposes its own mix of taxes on individuals residing subject to its jurisdiction, and these vary widely. Without proper planning, an immigrant to the United States is likely to face an unexpected and severe tax burden that could have been avoided.
This article discusses how U.S. taxes apply to immigrants, and offers some pre-immigration strategies for minimizing the tax consequences of immigrating to the United States.
Pre-Immigration Planning for the U.S. Income Tax
The U.S. government taxes the worldwide income of its citizens and resident aliens at rates of up to 39.6%.1 This means that once a person establishes residence within the United States, the person will be taxed on all his or her income, regardless of where the income is earned.
Who does the U.S. income tax apply to?
As noted, the income tax applies to the worldwide income of U.S. citizens and resident aliens. For nonresident aliens—anyone who is not a U.S. citizen or a resident alien2—the income tax generally only applies to U.S.-source income.3
Accordingly, understanding when a person will become a resident alien for income-tax purposes is critical to effective tax planning. A person qualifies as a resident alien if he or she satisfies the Green Card Test or the Substantial Presence Test.4
The Green Card Test
A lawful permanent resident (i.e., green-card holder) is considered a resident alien subject to the U.S. income tax. This is so regardless of whether the permanent resident is actually present in the United States during a taxable year.
In other words, a permanent resident cannot escape the worldwide income tax imposed by the United States simply by living outside of the country. Instead, status as a permanent resident continues until it is either revoked or a court or federal agency determines that it has been abandoned.5
During the first year in which residency is established under the Green Card Test, a person is considered a resident alien beginning on the first day when he or she was present in the United States while a permanent resident.6
The Substantial Presence Test
A person will be treated as a resident alien for any taxable year in which the person satisfies the Substantial Presence Test. Under this test, the Internal Revenue Service (I.R.S.) considers a person’s presence in the United States during the taxable year and the two years that preceded it.7
Generally, a person is counted as present on any day during which the person is physically present in the United States at any time.8
For any taxable year, a person satisfies the Substantial Presence Test if the person was present in the United States for at least 31 days during the taxable year, and he or she was present during that year and the preceding two years for a total of at least 183 days, counted as follows:
- Each day of presence during the taxable year is counted as one day;
- Each day of presence during the year preceding the taxable year is counted as 1/3 of a day; and
- Each day of presence during the year preceding that is counted as 1/6 of a day.
Example: A nonresident alien was present in the United States during 2014, 2015, and 2016 for 120 days. To determine whether she meets the Substantial Presence Test for tax year 2016, the I.R.S. would add together all the days she was present in 2016 (120), 1/3 of the days she was present in 2015 (120 x 1/3 = 40), and 1/6 of the days she was present in 2014 (120 x 1/6 = 20). Because that sum (120 + 40 + 20 = 180) is less than 183 days, she will not be treated as a resident alien for 2016.
However, a person who satisfies the Substantial Presence Test may nevertheless be treated as a nonresident alien if the person was present in the United States for fewer than 183 days during the taxable year, had a regular or principle place of business or a regular abode in a foreign country for the entire year, and had a closer connection to that foreign country than to the United States.9
To determine whether a person has a closer connection to a foreign country than to the United States, the I.R.S. considers several factors described in its regulations.10 Importantly, this exception does not apply to any individual who has taken steps to apply to become a permanent resident.11
During the first year in which residency is established under the Substantial Presence Test, a person will be considered a resident alien beginning on the first day of the year in which the person was present in the United States.12
Given the high rates and worldwide scope of the U.S. income tax, proper pre-immigration tax planning is crucial in minimizing the tax effects of establishing residency in the United States. The following are some general strategies that a prospective immigrant may consider.
1. Accelerate income and defer losses
A prospective immigrant should accelerate income and defer losses and deductions.
For instance, a nonresident alien who is employed by a foreign business entity that he or she owns can accelerate the payment of wages or bonuses to him- or herself into the period before immigrating to the United States.
Likewise, a nonresident alien may sell the accounts receivable of his or her business before immigrating. In contrast, a nonresident alien should wait to pay business expenses until after he or she establishes residency in the United States.
Example: A nonresident alien operates a business outside of the United States. The business’s accounts receivable total the equivalent of $40,000. Monthly expenses for the business are $25,000. If he sells the business’ accounts receivable before establishing residency in the United States, the nonresident alien will avoid U.S. income tax on the amount received. Also, if he can wait to pay the business’s monthly expenses until after he establishes residency, then he will be able to deduct the $25,000 from the business’s income for U.S. income-tax purposes.
Additionally, a nonresident alien should sell or exchange any assets that have appreciated in value since purchase. The U.S. income tax applies to the difference between an asset’s sale price and its basis.13
The basis for an asset is generally its original purchase price. By selling the asset, the person would realize the built-in gain before becoming subject to the U.S. income tax. By exchanging the asset, he or she would establish a basis in the new asset that is equal to its fair market value on the date of the exchange.
In contrast, a nonresident alien should sell any asset with a current value that is less than its basis only after becoming a resident alien. In such circumstances, the loss from the sale of the asset can offset future income received from other sources.
Example: A nonresident alien owns stock in two non-U.S. corporations, ABC Ltd. and XYZ Ltd., both currently valued at $5,000. She purchased the ABC stock for the $10,000, and the XYZ stock for $1,000. If she sells the XYZ stock after becoming a U.S. resident, she will owe income tax on the $4,000 gain. Accordingly, she should sell or exchange the XYZ stock before establishing residency. In contrast, she should wait to sell the ABC stock until she is a resident alien for U.S. income-tax purposes, because she will be able to offset the $5,000 loss against other income.
2. Elect partnership or disregarded tax status for foreign business entities
With some exceptions, the I.R.S. generally permits business entities to choose how they will be taxed.14
Depending on the type of business entity and its number of owners, an entity may be treated for tax purposes as a corporation, which pays its own taxes at a special corporate tax rate; as a partnership, the owners of which pay taxes on the entity’s income in proportion to their ownership interests; or as a disregarded entity, in which case the individual owner pays taxes on the entity’s income as if it were his or her own income.
In some circumstances, electing to treat the entity as a partnership or disregarded entity will be a taxable liquidation of the entity. In such cases, the owner or owners of the entity will be treated for tax purposes as though they own the entity’s assets with a basis equal to the fair market value of the assets on the date of the liquidation.
If the owner or owners of the entity are nonresident aliens, and the property is non-U.S. property, then they will not have to pay any U.S. income tax resulting from the taxable liquidation.
3. Dispose of certain kinds of foreign companies
Prospective immigrants should avoid ownership interests in controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs). A CFC is any foreign corporation in which more than 50% of its stock, measured by voting power or by value, is owned or deemed to be owned by U.S. shareholders.15
A U.S. shareholder is a U.S. citizen or resident alien that owns, or is deemed to own, at least 10% of the total combined voting power of all classes of voting stock in the foreign corporation.16
A U.S. shareholder of a CFC will pay income tax on his or her pro rata share of certain kinds of income earned by the corporation, regardless of whether the corporation makes distributions to the U.S. shareholder.17
A PFIC is any foreign corporation if at least 75% of the corporation’s gross income for a taxable year is passive income or the percentage of assets owned by the corporation that produce passive income is at least 50% of all assets owned by the corporation.18
Passive income is income such as dividends, interest, royalties, rents, and annuities.19 When a taxpayer sells his or her interest in a PFIC, the gain on that sale is taxed as ordinary income, rather than at the preferential rate for long-term capital gains.20
A nonresident alien planning to immigrate to the United States should dispose of any ownership interest in CFCs and PFICs. This can be done by selling or gifting the interest to another person (other than a U.S. shareholder) prior to immigrating to the United States. Or it could be done by restructuring the assets owned, and income earned, by the foreign corporation.
Example: A nonresident alien owns 100% of the stock in a foreign corporation, 51% of the assets of which are held to produce passive income, and 60% of the income of which is passive income. If the nonresident alien were to establish residency in the United States, the foreign corporation would qualify as both a CFC, because of the individual’s 100% ownership interest, and a PFIC, because of its holdings. To minimize his U.S. income-tax liability, he should reduce his ownership in the corporation to at most 50% prior to establishing residency. In addition, the corporation’s holdings should be restructured so that less than 50% of its assets are held to produce passive income.
4. Establish a foreign trust before immigrating
For U.S. income-tax purposes, a foreign trust is treated like a nonresident alien. Accordingly, the trust’s income is not subject to U.S. income tax unless it is U.S.-source income.
By establishing a foreign trust prior to immigrating to the United States, a nonresident alien can dispose of income-producing assets that would otherwise generate income taxable to the nonresident alien after he or she becomes a U.S. resident.
However, taking advantage of this strategy requires early planning. If a nonresident alien establishes a foreign trust, and then becomes a U.S. resident within five years of establishing the trust, then the income earned by the trust will be taxed to the nonresident alien if the trust has a U.S. beneficiary.21
In other words, a nonresident alien planning to immigrate to the United States who wishes to use this strategy should establish the foreign trust more than five years before establishing residency in the United States.
Example: A nonresident alien established a foreign trust in January 2012. She then became a U.S. resident in March 2016. Because she became a U.S. resident within five years of establishing the trust, the trust income will be treated as her income if the trust has any U.S. beneficiaries.
Pre-Immigration Planning for U.S. Transfer Taxes
In addition to the U.S. income tax, the U.S. government also taxes the gratuitous lifetime and testamentary transfers of property by U.S. citizens and U.S. domiciliaries, regardless of where in the world the property is located.
These transfer taxes include the U.S. gift tax, estate tax, and generation-skipping transfer (GST) tax. The U.S. gift tax imposes up to a 40% tax on the value of property gratuitously transferred during the transferor’s life.22
Likewise, the estate tax imposes up to a 40% tax on the value of all property transferred because of a person’s death.23
The GST tax is an additional tax of up to 40% that applies in circumstances where the gift tax or estate tax applies and the recipient of the transferred property is either related to the transferor and two generations removed from him or her, or unrelated to the transferor and at least 37.5 years younger or older than him or her.24
Who do U.S. transfer taxes apply to?
The U.S. transfer taxes apply to gratuitous transfers by U.S. citizens and U.S. domiciliaries, either during life or at death. Non-U.S. domiciliaries who are not citizens are subject to the tax when they gratuitously transfer U.S.-situs property during life or at death.25
A U.S. domiciliary is a person whose domicile is the United States. The I.R.S. explains that “[a] person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom.”26
Because a person’s domicile depends, in part, on his or her subjective intent, there is no hard-and-fast rule to determine whether someone is a U.S. domiciliary.
The I.R.S. will consider objective factors that may evidence the existence (or lack thereof) of an intention to leave when determining a person’s domicile.
The following are strategies to minimize U.S. transfer taxes on an immigrant’s gratuitous transfers of property. Because determining domicile depends on a person’s subjective intent, a nonresident alien should be careful to take these steps before he or she begins to live in the United States, even with a definite present intention to leave.
1. Accelerate gifts
Gifts of non-U.S. property will not be taxed to a non-U.S. domiciliary. However, the gift tax will apply to all gratuitous transfers while a person’s domicile is the United States, regardless of where in the world the property is located. Consequently, a non-U.S. domiciliary should make gifts of non-U.S. property before establishing domicile in the United States.
Curiously, stock in a U.S. corporation is not considered U.S. property for purposes of the gift tax, but it is for purposes of the estate tax.27This means that if a non-U.S. domiciliary gratuitously transfers shares in a U.S. corporation before immigrating, he or she will not be subject to the gift tax on that transfer, and will remove the stock from his or her gross estate for purposes of the estate tax.
Example: A non-U.S. domiciliary owns 100 shares of stock in a U.S. corporation and non-U.S. rental real estate. If he becomes a U.S. domiciliary and keeps those assets until he dies, each will be included in his gross estate for estate tax purposes, subject to up to a 40% tax. However, if before becoming a U.S. domiciliary, he gratuitously transfers each asset to another person, then the assets, and the income generated by them during his life, will not be included in his gross estate.
2. Establish a foreign trust before immigrating
In addition to the income-tax benefits of a foreign trust discussed earlier, establishing a foreign trust before immigrating to the United States also has transfer-tax benefits. The gratuitous transfer of non-U.S. property to the trust will not be subject to the U.S. gift tax if completed before the transferor establishes domicile in the United States.
Additionally, the property owned by the trust will not be included in the transferor’s gross estate for estate-tax purposes. This means that the property transferred, and any income generated by it during the transferor’s life, will not be subject to the U.S. estate tax when he or she dies.
Unlike in the context of the U.S. income tax, the foreign trust does not need to be established more than five years prior to immigrating to the United States. Consequently, even if it is not feasible to establish a trust more than five years prior to immigrating, there are still advantages to doing so.
Example: A non-U.S. domiciliary established a foreign trust in January 2012 using all non-U.S. property. In March 2016, she became a U.S. domiciliary. Although the trust’s income will be taxed to her, she will not be subject to the U.S. gift tax for the initial transfer of property, and the property owned by the trust will not be subject to the U.S. estate tax when she dies.
State and Local Taxes
In addition to the federal taxes discussed above, those planning to immigrate to the United States must be mindful of the additional state and local taxes to which they will become subject. These taxes vary by state and locality, and may include income taxes, sales taxes, property taxes, gift taxes, and inheritance or estate taxes.
Because each state and locality has its own blend of taxes, the prospective immigrant should compare the tax regimes in each state and locale to which he or she is considering moving to determine where his or her taxes will be lowest.
The U.S. tax system is extremely complicated, and the consequences for improper planning or a lack of planning can be severe.
Anyone desiring to immigrate to the United States should carefully examine how U.S. taxes—including federal, state, and local taxes—will apply to him or her after immigrating.
Because of their worldwide scope, the best time to plan for U.S. taxes is before becoming subject to them. To do so, nonresidents should consult with a knowledgeable and experienced lawyer in the United States to develop a pre-immigration tax plan.
Tax Disclaimer: The information contained herein is general in nature and based on authorities that are subject to change. We do not guarantee neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. We assume no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations.
Circular 230 Disclosure: This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.