U.S. INCOME TAX AND ESTATE TAX PLANNING FOR RESIDENT ALIENS
U.S. FEDERAL INCOME TAX
Foreigner as U.S. Resident for Tax Purposes. If a foreigner is considered a U.S. resident for federal income tax purposes, they are subject to U.S. federal income taxation on their worldwide income. Generally, a foreigner is deemed to be a U.S. resident if they (1) become a U.S. citizen, (2) become a lawful permanent resident by obtaining a “green card,” or (3) meet the “substantial presence test” by being present in the U.S. (i) for at least 31 days during the calendar year, and (ii) for 183 days or more (determined by adding all the days of the current calendar year and 1/3 and 1/6 of the days of the first preceding calendar year and the second preceding calendar year, respectively). A person can avoid meeting the substantial presence test by staying in the U.S. for 121 days or less each year.
Exceptions to Substantial Presence Test. One exception is if a foreigner can establish that they have a closer connection to a foreign country. A foreigner can qualify for this exception if: (1) they were present in the U.S. for less than 183 days in the current calendar year; (2) they have a tax home in a foreign country; (3) they can establish that they have a closer connection to the same foreign country where their tax home is located; (4) they have not applied for a green card or taken any affirmative steps to obtain a green card; and (5) they file a Form 8840 with a Form 1040NR, their non-resident alien income tax return. The third element is a facts and circumstances test. Some of the facts that the IRS will consider are where the taxpayer votes, receives their health care, registers their vehicles, and operates their businesses. A foreigner’s income tax consequences may change if the U.S. has entered into an income tax treaty with the foreigner’s home country.
New laws have been passed in Puerto Rico, which have made Puerto Rico a tax haven for wealthy American investors. For example, Puerto Rico’s Export Services Act offers incentives to certain service businesses (including, investment and hedge fund managers) to relocate to Puerto Rico and export their services. The Act taxes corporate profits at a flat 4%, while making the dividends paid from profits on exported services to individual recipients exempt from tax. Also, unlike other tax havens, U.S. residents of Puerto Rico are still considered U.S. citizens even though they are subject to different tax laws. So, an American who moves to Puerto Rico does not have to renounce their citizenship or pay an exit tax when they move to Puerto Rico.
U.S. FEDERAL ESTATE AND GIFT TAX
A foreign person is subject to U.S. federal transfer taxes if they are a domiciliary of the U.S. A foreign person is deemed a U.S. domiciliary for transfer tax purposes if they are physically present in the U.S. and intend to reside in the U.S. indefinitely.
U.S. Domiciliary. If a U.S. domiciliary, the foreign person is subject to U.S. federal estate tax on their worldwide assets and U.S. federal gift tax on gratuitous transfers made during their lifetime.
Non-U.S. Domiciliary. If a foreign person is not deemed a U.S. domiciliary for transfer tax purposes, they are subject to transfer taxes on real property or tangible personal property located in the U.S. The foreign person only receives an exemption of $60,000 on death transfers. Because this exemption amount is low, modest estates can be subject to significant estate tax. A foreigner’s transfer tax exposure may change if the U.S. has entered into an estate or gift tax treaty with the foreigner’s home country.
While an estate may qualify for a marital deduction for federal estate tax purposes even if the surviving spouse is not a U.S. resident, the deduction is limited if the surviving spouse is not a U.S. citizen. The limitations are imposed to avoid the foreign surviving spouse (whose estate will not be subject to the U.S. estate tax unless they are a U.S. resident or own property located in the U.S. at the time of their death) from removing property tax-free from the U.S.
Generally, a transfer to a surviving spouse that would otherwise qualify for the marital deduction is ineligible for the marital deduction if the spouse is not a citizen of the United States. Even if the surviving spouse is a resident of the U.S. at the time of their spouse’s death, the deduction is denied because the U.S. estate tax jurisdiction terminates if one spouse simply leaves the country after their spouse's death. Section 2040(b) is similarly inapplicable if the surviving spouse is not a U.S. citizen.
A marital deduction is, however, allowed for a transfer to a non-citizen spouse if the executor makes a timely QDOT election and the transfer satisfies certain conditions. To learn more, click here.