Tax implications of US residency for foreign nationals

The United States remains a destination for entrepreneurs. Foreign entrepreneurs and others entering the United States, whether for short-term visits or permanently, should be mindful of the complex U.S. income tax and foreign information-reporting rules that may apply to them.

Green-card holders and individuals who meet the substantial-presence test (i.e., individuals physically present in the United States for a period in excess of a statutory threshold) are subject to U.S. federal income tax and reporting obligations with respect to their worldwide income and assets. For example, a green-card holder may be subject to U.S. federal income tax and reporting obligations with respect to interest income on foreign bank accounts and dividend income on foreign stock investments.

Many foreign entrepreneurs have been surprised by the U.S. tax system because the United States imposes income tax or information-reporting obligations with respect to income that is not subject to tax or reporting obligations in their home country. Moreover, foreign entrepreneurs should be aware that the IRS has active enforcement campaigns in the area of information reporting and may impose significant penalties for failure to comply with information-reporting requirements. Thus, it is essential that prospective U.S. tax residents consider pre-immigration tax planning to ensure that their businesses and investments will be tax-efficient and in compliance with all reporting requirements. Failure to do so may result in unexpected tax liabilities and significant penalties.

Example: B and S are married. Both are citizens and tax residents of Country X. B is offered an opportunity to direct a film in the United States over the course of three years. The couple see this opportunity as a chance to move to the United States permanently and start their family here. They plan to move to the United States on Jan. 1, 2027, and plan to reside in New York City. The tests for U.S. residence are beyond the scope of this article, but for purposes of this example, assume that the couple will both be U.S. residents as of Jan. 1, 2027.

At the time of moving to New York City, the couple’s foreign assets include:

• Foreign brokerage accounts owned by B;
• A personal services company owned 50% each by B and S. A discussion of the default entity-classification rules for foreign entities is outside the scope of this article, so assume that the personal services company is taxed as a corporation for U.S. federal tax purposes;
• Foreign bank accounts; and
• Foreign investments.

An analysis of the potential U.S. tax treatment of these assets would provide valuable insights to the couple for consideration prior to their relocation to the United States.

Foreign brokerage accounts

A passive foreign investment company (PFIC) is a foreign corporation that meets one of two tests in a tax year:

• The income test, if 75% or more of the foreign corporation’s gross income is passive (e.g., interest or dividends); or
• The asset test, if an average (measured under Sec. 1297(e)) of 50% or more of the foreign corporation’s assets produce or are held to produce passive income.

The PFIC regime is intended to negate the benefit of deferring U.S. federal income tax by investing in foreign investment vehicles (such as offshore mutual funds) that predominantly generate passive income or hold passive assets. If the foreign corporation in which B has invested is classified as a PFIC, it will always remain a PFIC with respect to him, absent certain elections (discussed below), even if the foreign company no longer meets the income or asset test. B generally will be required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, annually for each PFIC in which he invests. In addition, the brokerage account and other specified foreign financial assets may have to be disclosed on Form 8938, Statement of Specified Foreign Financial Assets, subject to applicable thresholds (discussed below).

Default “excess distribution regime” (Sec. 1291): If B does not elect out of the PFIC regime as described below, he will be subject to what is known as the excess-distribution regime under Sec. 1291. Under this regime, B would be subject to tax on an excess distribution as though he had received the distribution ratably over his investment’s holding period. An excess distribution is defined as the portion of a distribution B receives in a tax year that exceeds 125% of the average annual distributions he received on his PFIC stock during the prior three tax years (or, if shorter, B’s holding period for his stock in the foreign investment before the current tax year). Any gain B realizes on the sale of his stock in the PFIC investment is also deemed an excess distribution.

The amounts allocated to the current year and to years before the foreign investment first became a PFIC will be taxed as ordinary income. In addition, B will be subject to a deferred tax amount in the current year. The deferred tax amount is the tax that would have been owed in prior years (after the investment first became a PFIC) had the amount allocated to those years been subject to tax in those years at the highest rate of tax, plus interest on the deferred tax amount. The effect of the excess-distribution regime is to eliminate the benefit of deferring distributions from a PFIC.

Qualified-electing-fund (QEF) election (Sec. 1293): The effect of the PFIC rules can be harsh, but the Internal Revenue Code provides some elections that may mitigate the outcome. For instance, if B made a QEF election, he would include in income annually his portion of the PFIC’s ordinary earnings and net capital gain. However, the PFIC must provide an annual information statement to support the QEF election.

B may benefit from making a QEF election, but the election should be made for the first year in which the foreign corporation becomes a PFIC. In that case, the excess-distribution regime would not apply. The election must be made by attaching Form 8621 to a timely filed U.S. federal income tax return for the election year. B may make a QEF election in a later year, but to avoid the excess-distribution regime, he must make a purging election. If he makes a deemed-sale purging election, he will be required to recognize gain on the PFIC stock, and the gain will be subject to the excess-distribution regime.

Mark-to-market election (Sec. 1296): The excess-distribution regime generally would not apply if B were to make a mark-to-market election under Sec. 1296.

The election is available only for PFICs whose shares are “marketable stock.” This election requires the U.S. person to include in income annually the change in value of the taxpayer’s PFIC stock as ordinary gain or loss; in other words, B would have to calculate the change in the market value of his PFIC shares annually and report the unrealized gain as regular income. Losses may be limited to prior gains.

If B makes a mark‐to‐market election for PFIC stock in a year other than the first year in which he holds stock in the PFIC (and a QEF election is not in effect for all years in B’s holding period), Sec. 1291 will apply to any distributions or dispositions during the year and to any amount included in income under Sec. 1296.

Personal services company

The couple’s personal services company will be considered a controlled foreign corporation (CFC) for U.S. tax purposes under Sec. 957(a) once they become U.S. residents because they collectively own more than 50% of the total value or combined voting power of its stock (the ownership threshold for CFC status). Accordingly, they will be required to report the annual activity in the foreign corporation and may have annual U.S. tax inclusions for any Subpart F income (Sec. 951) or net CFC tested income (NCTI) (Sec. 951A) of the personal services company, even if the income is not currently distributed to them.

The income of a personal services company would typically be either Subpart F income or NCTI. U.S. shareholders who are individuals must include their pro rata share of the CFC’s Subpart F income and NCTI on their individual U.S. federal income tax return as ordinary income subject to graduated rates. Individual U.S. shareholders are not entitled to foreign tax credits for the foreign income taxes paid by the CFC with respect to the inclusions or to a Sec. 250 deduction. Only U.S. shareholders that are corporations are entitled to foreign tax credits for taxes paid by the CFC or the Sec. 250 deduction. A corporation would include in income the taxes paid by the CFC that are attributable to the NCTI inclusion (deemed-paid taxes) as a deemed dividend in addition to the inclusion and would be entitled to a Sec. 250 deduction of 40% of the amount of the inclusion and the deemed dividend. The corporate shareholder would be entitled to credit the deemed-paid taxes against its tax liability (subject to the foreign tax credit limitation). However, the couple may make an election to be treated as a domestic corporation for computing their tax on their inclusion (Sec. 962), which may lower their tax liability. Modeling will be required to determine whether the election would be beneficial.

Additional reporting requirements apply to CFCs. Failing to file the required forms can result in a penalty of $10,000 under Sec. 6038 for each failure in the absence of reasonable cause and may hold the statute of limitation open for all items on the return until three years after the required forms are filed.

B and S may be able to reduce their taxes by making a check-the-box election to treat the personal services company as a partnership rather than a corporation for U.S. federal income tax purposes. As a result of the election, the couple would include the partnership’s income on their U.S. federal income tax return and would be allowed a foreign tax credit for foreign income taxes paid by the personal services company (subject to the foreign tax credit limitation). They would have other foreign information-reporting requirements, such as Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. The timing of such an election is important, because if the effective date of the election is after Jan. 1, 2027, the date B and S become U.S. residents, there would be U.S. federal income tax consequences resulting from the election.

Foreign bank accounts

The couple must report any foreign bank and brokerage accounts they have a financial interest in or over which they have signature authority if the aggregate value of those accounts exceeds $10,000 at any time during a calendar year. Under the Bank Secrecy Act, U.S. persons (including U.S. entities) must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), if this threshold is met. In addition, specified persons (including U.S. citizens and resident aliens) must file Form 8938 with their individual tax return if the total value of specified foreign financial assets exceeds the applicable thresholds. Even though no tax may be due, the information-reporting requirement can be cumbersome.

Foreign investments

If the couple are planning a near-term sale of investments such as portfolio stock or foreign real estate, they may consider selling the investments before becoming U.S. tax residents. Otherwise, they would be taxed as U.S. residents on their worldwide income, and any gain from the sale of those assets would be subject to U.S. tax. It’s possible that their current country of residence may provide tax relief or a lower rate of tax than the applicable U.S. rate of tax on any income from the sale.

In addition to the U.S. federal income tax consequences of a move to the United States, the couple will also need to consider the state and local income tax implications. Both New York state and New York City impose a significant income tax.

In conclusion, while moving to the United States may provide an important professional opportunity for the couple, they should consider beforehand the U.S. income tax consequences and foreign information-reporting requirements such a move would trigger.

— Rony Naftaly, CPA, is a tax principal with BDO USA in Los Angeles. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.