Benjamin Franklin famously quipped, “In this world, nothing can be said to be certain, except death and taxes.” For as long as anyone claims the rights and privileges of their sovereign nation in which they are citizens, the governments of those countries reserve the right to tax their citizens in order to provide the government’s services and infrastructure. Except, sometimes, in the case of people who are citizens of one country, but live – temporarily or permanently – in another… taxation is suddenly not so certain after all.
Because the reality is that countries generally only have a right to those people who reside within their borders, and/or who generate income within their borders. While, by limitations of jurisdiction, or coordination of treaties, those who are neither citizens nor residents, generally don’t have to pay taxes on any income not earned within the country’s borders.
In this guest post, Sahil Vakil, founder of Myra Wealth, which specializes in working with immigrants to the US (who may or may not be US citizens or residents), provides guidance on what advisors need to know about navigating the rules of non-US citizens, who may or may not be residents of the US, and who may have income both within and outside the US.
When it comes to non-US citizens living in the US – known as “aliens” by virtue of being non-US citizens – the key question is whether that person at least qualifies as a “resident” of the US, either by meeting the Green Card Test or the Substantial Presence Test. Those who do are resident aliens, and must declare and pay taxes on all their income worldwide (similar to US citizens), and are also subject to special Foreign Bank Account Report (FBAR) and must follow the Foreign Account Tax Compliance Act (FATCA), which can introduce substantial additional tax reporting burdens.
By contrast, nonresident aliens are generally not subject to FBAR and FATCA, and only must report and pay taxes on their income earned in the US (either by being Effectively Connected Income to the US, or be Fixed or Determinable, Annual, or Periodic (FDAP) income (e.g., passive portfolio income). Which in turn may be eligible for special tax rates (at least on FDAP), but also special tax withholding rules.
And ultimately, these rules are important not only for the taxation of resident and nonresident aliens themselves but also the tax strategies that emerge (e.g., resident aliens contributing to US retirement accounts to receive the deduction at current US tax rates on worldwide income, but liquidating them after returning to the home country when they will only be taxed on US income as nonresident aliens). On the other hand, the limitations on tax rules for resident and especially nonresident aliens can also complicate traditional tax planning strategies (e.g., the unlimited marital deduction is not available for nonresident alien spouses, forcing the use of a Qualified Domestic Trust [QDOT] instead).
The bottom line, though, is simply to understand that, while for US citizens, there may be nothing more inescapable than death and taxes, when it comes to non-citizen “aliens,” the rules in fact are far more nuanced and the situation is less clear… presenting both opportunities, and traps, to be aware of!
With more than 41 million foreigners residing in the US, financial advisors are often approached by non-US citizens for help with their financial planning, investment management, and tax preparation needs. Non-US citizens often need advice about what their tax resident status is, how to file taxes correctly, how to handle estate taxes, and whether to take advantage of employer benefit options.
Financial advisors need to be equipped to support this underserved and growing cohort of potential clients. This article covers 4 common financial planning topics that frequently arise when working with non-US citizen clientele.
The Tax Impact Of Being A Resident Alien Vs. Nonresident Alien
Non-US citizens can either be resident aliens, or nonresident aliens, for income tax purposes. In this context, being an “alien” simply means being a non-US citizen. Thus, the key driver for non-US citizens is whether they are deemed to be residents as well.
The distinction matters, because resident aliens declare and pay taxes on worldwide income (similar to US Citizens), while nonresidents only have to report and pay taxes on income earned in the US.
In other words, resident aliens must pay taxes on any income generated from property/assets in their country of origin (or anywhere else in the world), while nonresident aliens of the US (who are still residents in some other country) only pay taxes on their actual US income (e.g., wages earned in the US) and US property (e.g., real estate physically located in the US, or investment accounts held in the US). Which means resident alien status can have huge tax consequences for a non-US citizen who is here in the US, but with income generated abroad (such as non-US business or investment income).
Determining Resident Alien Status
To determine whether non-US citizens will be treated as residents, they must meet either the Green Card Test or the Substantial Presence Test.
A foreigner meets the Green Card Test if he or she is a Lawful Permanent Resident of the United States at any time during the calendar year. He or she is a Lawful Permanent Resident of the United States, at any time, if he or she has an alien registration card, Form I-551, also known as a "green card.”
A non-US citizen without a Green Card can still be a resident alien if he or she meets the Substantial Presence Test. This test counts the number of days an individual has been physically present in the US in the current year, and over the past 3 years. To meet the Substantial Presence Test, you must be physically present in the United States (US) on at least:
- 31 days during the current year, and
- 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting: (a) + (b) + (c), where (a) All the days you were present in the current year, (b) 1/3 of the days you were present in the first year before current year, and (c) 1/6 of the days you were present in the second year before the current year.
Example 1. Your alien (non-US citizen) client has been in the United States for 120 days in each of the last 3 years (2018, 2017, 2016). To calculate his or her filing status (resident vs. nonresident alien) for 2018, first verify if they were in the United States in 2018 for more than 31 days. Yes, in this case. Then, perform the calculation as 120 days (for 2018) + 1/3 * 120 days (for 2017) + 1/6 * 120 days (for 2016) = 120 + 40 + 20 = 180 days. Since 180 days falls (just barely) below the 3-year period threshold requirement of 183 days, the alien client does not pass the Substantial Presence Test and remains a nonresident alien.
Ultimately then, non-US citizens who have either a Green Card or meet the Substantial Presence Test are treated as resident aliens. If neither the Green Card nor the Substantial Presence Test is met, they are nonresident aliens.
Taxation of Nonresident Aliens
As described above, nonresident aliens are taxed on US-sourced income only, but the exact tax treatment depends on the type or source of income.
Income that is “effectively connected” to the US (e.g., the wages they earn here) is taxed at ordinary income rates, and nonresident aliens are subject to the same tax brackets as US Citizens. However, nonresident aliens generally cannot claim the standard deduction to offset their income. Though certain (usually tax-treaty-specific) exceptions may apply to allow them to still claim a standard deduction (e.g., students on an F1 visa from India may be eligible to claim the standard deduction under Article 21 of the U.S.A.-India Income Tax Treaty).
Of course, many people don’t claim the standard deduction in the first place and instead claim itemized deductions. In the case of nonresident aliens, it is also possible to claim itemized deductions, but in order to claim them, those itemized deductions must themselves be effectively connected to the source of US Income in the first place (e.g., state and local income taxes, charitable contributions to US non-profit organizations, ordinary and necessary expenses related to a US income, and in the past US-based casualty and theft losses, miscellaneous itemized deductions, though those were eliminated starting in 2018 under the Tax Cuts and Jobs Act).
In the past, nonresident aliens could also claim one (but only one) personal exemption. Personal exemptions were also eliminated under the Tax Cuts and Jobs Act but may still be relevant for filing prior-year returns. In addition, certain nonresident aliens may also have tax treaty arrangements from their home country that allow more than one personal exemption to be claimed (e.g., residents of South Korea may be able to claim exemptions for their spouse and dependents as well).
Nonresident aliens are subject to two different tax rates, one for effectively connected income (ECI), and one for fixed or determinable, annual, or periodic (FDAP) income. ECI is earned in the US through personal service (e.g., wages, self-employment), or from the operation of a business in the US, and is taxed for a nonresident at the same progressive ordinary income tax brackets as for a US citizen. FDAP income is passive income, such as interest, dividends, rents or royalties, and is taxed at a flat 30% rate (unless a tax treaty specifies a lower rate).
For nonresident aliens, taxes are withheld directly when the income is paid or earned (i.e., withheld immediately when received into the brokerage account itself). (Notably, if someone is a US citizen or resident alien, and this tax is withheld in error from payments because of a foreign address, notify the payer of the income to stop the withholding. Use IRS Form W-9 to notify the payer.)
However, as with most other tax issues for nonresident aliens, the withholding of taxes may be modified by tax treaties between the US and the alien’s home country of citizenship. Citizens of China, for instance, are subject to only a 10% withholding rate on dividends and interest instead of the standard 30% rate. Though claiming exempted income under a treaty benefit may require filing IRS Form 8233 to support the tax treaty exemption for the lower withholding amount.
Nonresidents may also be liable to pay estimated taxes, due quarterly, unless the amount due on their tax return is less than $1,000.
When it comes to capital gains tax, though, nonresident aliens have an advantage: they are not subject to capital gains tax on non-US assets.
Notably, with respect to filing status itself, nonresident aliens cannot file as married filing jointly if either spouse was a nonresident alien at any time during the tax year. However, nonresident aliens married to a US citizen or resident alien can choose to be treated as US residents and file joint returns. In addition, if a nonresident alien is married to a non-US citizen or nonresident alien, each must file married filing separate returns. And in any case, nonresident aliens cannot file as head of household.
Taxation Of Dual Status Aliens
Another concern that some clients may bring up is that they are a dual status alien (when they have been both a US resident alien and a nonresident alien in the same tax year, for instance, if they obtained their Green Card midway through the year).
In such scenarios, the individual would pay taxes on worldwide income earned during the period when they were considered a resident alien, and pay taxes on only US-sourced income for the time period they still had nonresident alien status.
Foreign Asset Reporting Requirements For Resident Aliens
Anyone who is a resident alien and (still) has any foreign (i.e., non-US-based) accounts exceeding $10,000 during the year has to file FinCEN Form 114, also known as the Report on Foreign Bank and Financial Accounts (FBAR). The FBAR is a tool used by the United States government to track persons who have foreign financial accounts, so the government can subsequently determine if those foreign accounts are being used to circumvent United States law (e.g., for foreign money-laundering purposes, or to hide income-producing assets for tax purposes). Information contained in FBARs can be used to identify or trace funds used for illicit purposes or to identify unreported income maintained or generated abroad. Notably, FBAR reporting applies to US citizens themselves with foreign accounts, in addition to non-US citizens who are resident aliens with foreign accounts.
The challenge, though, is that FBAR reporting is burdensome for most individuals. Which is unfortunate, since most simply have overseas financial accounts for a variety of legitimate reasons, including convenience and access.
In addition to FBAR reporting, when a resident alien’s (or a US citizen’s) foreign assets are more than $50,000, complying with the Foreign Account Tax Compliance Act (FATCA) becomes mandatory as well. The resident alien needs to attach Form 8938 to his or her annual tax return. Similar to FBAR, the Foreign Account Tax Compliance Act (FATCA) is an effort to combat tax evasion by US persons holding accounts and other financial assets offshore. And again similar to the FBAR, for most individuals that simply have an overseas account for legitimate reasons, including convenience and access, this reporting requirement becomes another (unnecessary) burden.
Resident aliens who own more than 10% of a non-US business venture, including joint ventures, corporations, and partnerships, may also be subject to additional special reporting requirements. The taxpayer may also have to file Form 5471 to report non-US business income, which can apply to US persons who are officers, directors, or shareholders in certain foreign corporations.
Employer Retirement Accounts For Non-US Citizens
Some non-US citizens may not be aware that they can use retirement savings vehicles, such as 401(k) plans and IRAs, not only to receive matching contributions but also to obtain the tax deduction and tax-deferral benefits of such accounts and save in the US in a more tax-efficient manner.
Specifically, for nonresident aliens, retirement plan contributions can help offset against US sourced income. For resident aliens, retirement plan contributions can help offset against global income.
On the other hand, future distributions from US retirement accounts will be treated as taxable income earned in the US, which means it will still be taxed even if the alien is no longer living in the US at that time.
In point of fact, though, if your client is planning to return to their home country, it’s actually best to wait until they’ve returned to withdraw from US retirement accounts. As once they leave their US job, they’ll have little to no other earned income in the US before withdrawing funds in retirement accounts, which means any distributions that are subject to US taxation will be subject to the bottom tax brackets (reducing the total tax burden on the retirement account distribution).
From a retirement planning perspective, it’s also notable that nonresident aliens are not subject to FICA tax, and thus do not pay Social Security tax or Medicare tax on their US income. Resident aliens, however, are subject to the same tax laws as US Citizens and thus must pay FICA tax (including Social Security and Medicare Tax), similar to US Citizens (and may later be eligible for Social Security and Medicare benefits as tax-paying resident aliens).
Alien Status, Domicile, And Gift And Estate Tax Planning (With A QDOT)
The federal estate tax in the US is always paid by the donor (i.e., the person making the bequest), not the recipient who receives the bequest. Which means, even if money is inherited by a non-US citizen (or someone in another country altogether), the inheritance is still subject to US estate taxes if the bequest comes from someone subject to US tax jurisdiction.
In the typical scenario – where the decedent is a US Citizen – an $11.18M estate tax exemption applies. And in the case of resident aliens who are otherwise taxed as US citizens, the $11.18M estate tax exemption in the US remains available.
However, the requirements to qualify are not the same as a resident alien for income tax purpose, which is based on the Green Card Test or the Substantial Presence Test). Instead, resident aliens for estate tax purposes (to qualify for the $11.18M exemption amount) must be considered a US domiciliary. Domicile is defined as living within a country with no definite present intent of leaving. In general, Domicile means (i) having a physical presence and (ii) present intention to remain indefinitely. Determining domicile for estate and gift tax purposes is fact specific, but is still very subjective, as "intent" is a very subjective concept.
Ultimately, determining domicile for a resident alien is important because if there is a gift or estate transfer, and the resident alien’s domicile is not in the US, he/she will be treated as a nonresident alien donor. And for a Nonresident Alien donor, there is only a much-lower $60K estate tax exemption (for US-based assets that would be subject to US estate taxes).
Similarly, for any gifts from a US citizen spouse to a non-US citizen spouse (whether nonresident or resident alien), the unlimited marital deduction does not apply, and instead only a $152K exemption is available for spousal transfers.
Accordingly, planning for nonresident alien couples (including nonresident alien spouses of US citizens) commonly includes the use of a Qualifying Domestic Trust (QDOT). A Qualifying Domestic Trust (QDOT) is a trust that allows non-US Citizen spouses who survive a deceased spouse to still take the (otherwise unavailable) unlimited marital deduction on estate taxes. However, only assets that actually go inside the QDOT are considered for the unlimited marital deduction. Assets outside the QDOT will be subject to estate taxes (or at least only eligible for the lower non-citizen-spouse exemption amount).
A major limitation of the QDOT is that it serves merely as an estate tax deferral strategy, though, and simply defers the estate taxes until the subsequent death of the non-US citizen spouse. Upon the death of that non-US citizen spouse, all assets in the QDOT are subject to estate taxes. This could be extremely detrimental to any surviving trustees of the QDOT, and at a minimum should be planned for accordingly (similar to any situation where a couple is subject to estate taxes after the death of the surviving spouse).
Advising International And Multicultural Clients Is Essential
Ultimately, the key point is simply to understand that US tax laws apply in more nuanced ways to those who are non-US citizens. In general, those who become resident aliens (e.g., earn their Green Cards or otherwise remain in the US for extended periods of time and meet the Substantial Presence test) are taxed fully as US citizens (on all income worldwide), while nonresident aliens have a more limited scope of taxation (but must still pay on their US assets and US-sourced income).
Consequently, from a tax perspective, the act of earning citizenship, or at least a Green Card, or simply (by staying long enough) meeting the Substantial Presence test, can have substantial tax consequences, as the individual converts from nonresident alien status to resident alien status. Which, in general, will increase the income tax liability of the individual, as well as increasing the tax reporting requirements in the future.
But still, each year, there are over a million individuals who immigrate to the United States, and several thousand convert from nonresident alien to resident alien status. Why, given all the additional tax burdens? The answer lies in a common saying, “America is a land of opportunity.” Most of these individuals find the opportunity presented to them by becoming a resident alien far outweighs the increased tax liability or tax reporting requirements that come as a by-product of this opportunity.
Each year, America welcomes so many new arrivals, and constantly renews itself, refreshing itself with the hopes, and the drive, and the optimism, and the dynamism of each new generation of international & multicultural families. In your practice, you can expect to see an increasingly diverse set of clients. You will absolutely encounter non-US citizen clients, and you should be ready to address (or at least better understand) their unique financial and tax needs