Business opportunities in the US marketplace have never been better for non-US based entrepreneurs and start-ups. The US economy continues to show strong growth and economic resilience, even in the face of volatile capital markets in early 2016.
But both foreign individuals and start-ups need to be wary of the complex US tax landscape, as poor planning and even inadvertent behavior or actions can result in huge tax liabilities.
In this new series Founders Who Scale will provide insights and smart guidance for foreign individual entrepreneurs and non-US based emerging growth companies seeking to leverage the massive US marketplace for growth opportunities.
Let’s start with a look at how non-US residents are subject to US federal income tax, and how changes from their non-resident to resident status can impact their federal tax liabilities.
As a general rule, U.S. citizens and residents are subject to US federal income tax on all their worldwide income. Maximum rate is 39.6%.
Foreign national non-residents on the other hand are subject to US federal income tax only on their income generated from sources within the US and on income effectively connected with the conduct of trading or business in US. All non-US generated income is therefore exempt from US federal tax liability.
The IRS describes people who are not US citizens or US tax residents as “non-resident aliens.” An individual may face a much bigger US federal tax bill if his or her status suddenly changes from a US non-resident alien to a US resident alien.
This status change can be triggered by:
- Becoming a US Green Card holder: Individuals will be considered a US resident for tax purposes if they area Lawful Permanent Resident of the US at any time during the calendar year, having been issued a US Citizenship and Immigration Services (USCIS) alien registration card (form I-551) also know as a “green card.”
- Meeting the “Substantial Presence” test: Individuals will be considered a US resident for tax purposes if they meet this test for the calendar year, defined as being physically present in the US on at least:
a) 31 days during the current year, and
b) 183 days during the 3-year period that includes the current year and the 2 years immediately before that counting:
- All the days present in the current year, and
- 1/3 of the days present in the previous year, and
- 1/6 of the days present two years previous to the current year.
- Failure to meet the “Closer Connection” test: Even if a person meets the substantial presence test, they may under certain circumstances still be treated as a non-resident alien for tax purposes if they:
a) Are present in the US for less than 183 days during the year.
b) Maintain a tax home in a foreign country during the year.
c) Have a closer connection during the year to one foreign country in which in which the individual has a tax home than to the US.
An individual’s ‘tax home’ is the general area of the individual’s main place of business, employment or post of duty, regardless of where they maintain their family home. An individual’s ‘tax home’ is generally the place where they permanently or indefinitely work as an employee or as a self-employed individual.
In addition, in some treaties, tiebreaker rules may apply which can resolve potential conflicts.
One additional consideration for individuals whose filing status changes to US resident alien is not only the need to report all worldwide income, but the need to report foreign bank and/or investment accounts. The US Bank Security Act requires filing of this information if the aggregate value of all foreign financials accounts exceeds $10,000 USD at any time during the calendar year.
For non-US residents considering how to best limit their US federal tax liabilities and filing requirements, the key is maintaining their “non resident alien” tax status in the eyes of the IRS. These tests gets complicated in a hurry, and it is always advisable to hire a qualified CPA who can guide you through the ins and out of residency rules.
This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.