“US taxation of foreign nationals [2nd of 2 parts]” by Jocelyn M. Magaway (April 16, 2012)

SUITS THE C-SUITE By Jocelyn M. Magaway
Business World (04/16/2012)

(Second of two parts)

In last week’s article, we provided on overview of how the US tax system addresses foreign nationals who are US tax residents, as well as the criteria for determining whether a foreign national is considered a tax resident. We will clarify the importance of the discussion on who is considered a US resident and when residency begins as we now look into how US-resident foreign nationals are taxed.

Like US citizens, US-resident foreign nationals are taxed on their worldwide income. Unlike non-residents, they can claim a standard deduction if it proves more favorable than their itemized deductions. They also qualify for a wide range of itemized deductions which include mortgage interest, state and local taxes, real property taxes, charitable contributions, and others. While their foreign income is taxed, the tax so paid can be either deducted or claimed as tax credits, subject to certain limitations. Married taxpayers can file joint returns, which is often the most favorable tax filing status, particularly if only one spouse is working and generating income.

Non-residents generally pay a flat 30% income tax, with no deductions or personal exemptions on dividends, interests and other types of “fixed and determinable periodic” US-source income, provided this income is not effectively connected with a US trade or business. In some cases, a non-resident may qualify for a lower rate based on a treaty. Interest earned on US bank accounts or on other “portfolio” type investments, is exempt from US tax.

For income that is effectively connected with a US trade or business, non-resident aliens are taxed at graduated rates. But they may not claim standard deductions and qualify for only a limited array of itemized deductions, including deductions related to their effectively connected income, state and local income taxes on their effectively connected income, casualty losses, and qualifying charitable contributions. Married non-residents are not allowed to file joint returns, unless they are married to a US citizen or resident and qualify for a joint return election. Married non-residents have to file based on the Married Filing Separate (MFS) tax rate schedule, which is the highest tax rate schedule for individuals.

A dual-status alien is a person who is considered a resident alien for part of a year and a non-resident alien for the rest of that year. This status is normally triggered in the year of arrival in, or departure from, the US. During the US residency period, a dual status alien is taxed based on worldwide income. For the period of non-US residency, a dual status alien is taxed only on certain types of US-source income. Married dual status aliens may not file joint returns or claim the standard deduction.

In the year of arrival in the US, married dual status aliens can opt to be treated as full year residents of the US and file a joint return with their spouse under one of two Code Sections, 6013(h) or Section 6013(g).
The Section 6013(h) election is for married couples with at least one foreign national spouse who qualifies as a US resident at the end of the tax year. The Section 6013(g) election is available to a married couple if, at the end of the tax year, one spouse is a non-resident and the other is a US citizen or resident.

The tax consequences of making either election (Section 6013(h) or Section 6013(g)) are virtually identical. All income, whether US or foreign-source, becomes subject to US tax. This includes income derived while a non-resident, which would otherwise be exempt or be subject to a lower rate. Foreign taxes, if any, attributable to income derived while a US non-resident, can be claimed as deductions or tax credits. Hence, while the tax base seems to increase under these elections, there may also be an opportunity to substantially reduce or even eliminate US income tax.

Another important tax consequence of making either of the above elections is the ability to claim itemized deductions during the US non-residency period. This includes foreign real property taxes, mortgage interest, and medical expenses. Finally, both elections enable the spouses to file joint returns. Hence, they will be taxed at lower rates and consequently, their US tax liability may be reduced.

The most challenging aspect of US taxation for foreign nationals is determining residency status, together with decisions about when to tie-break or make elections. A wide range of factors must be considered, including: days present in the US, level of pre-US residency income and US source income, marital status, number of dependents, US deductions available, potential favorable treatment under a tax treaty and home country tax implications.

For most taxpayers, the only way to decide with confidence is to run the numbers. On top of this complexity, note that most US states and many US cities and municipalities impose their own state and/or local income tax. Unfortunately, the rules defining taxable income and imposing tax on non-residents are not necessarily the same as federal tax rules. What may be beneficial on the federal side may not be the same for state or local tax purposes. When a foreign national is unsure about which path to take, it would be a good time to sit down with a tax advisor.

Jocelyn M. Magaway is tax senior director of SGV & Co.

Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.