Background
While many countries levy taxes based only on income and assets earned or possessed within their borders, the United States embraces the concept of “worldwide income.” The legal status of a taxpayer determines what assets must be reported to the government, as well as the associated taxes that must be paid. Perhaps needless to say, compliance with these requirements is mandatory.
Taxpayer Categories
Broadly speaking, there are three major categories of taxpayers, each based on legal status:
U.S. citizens and nationals
“Resident aliens,” which comprises everyone who fits into one of two groups:
-A U.S. lawful permanent resident (i.e. green card holder); or
-A person whose physical presence in the United States meets the Internal Revenue Service’s (IRS) Substantial Presence formula.
The formula looks at an individual’s time spent in the United States in the last three years. An individual must have been in the U.S. the current calendar year for at least 31 days and 183 qualified days in the period spanning the current calendar and previous two years.
Only one-third of the physically present days from the prior year and one-sixth of the physically present days from the year before the prior year count towards the 183 days.
An individual was physically present in the U.S. on 115 days in each of the years 2015, 2016, and 2017. Using the formula, the individual counts the full 115 days of presence in 2017, 38 days in 2016 (i.e. about one-third of 115), and 19 days in 2015 (i.e. roughly one-sixth of 115). Since the total for the three-year period is 172 days, the individual is not considered a resident under the substantial presence test for tax year 2017.
There are also special rules for foreign governments, agricultural workers, athletes, and entertainers, in addition to special rules for cases involving expatriation, which refers to an individual abandoning U.S. citizenship or permanent resident status for tax reasons.
What is taxed and subject to reporting?
As noted above, U.S. citizens, nationals, and resident aliens must pay taxes based on their “worldwide income.” In short, this means that the government assesses taxes based on all sources of income and all assets these individuals possess around the globe. All income from all sources—whether the source is employment, real estate, investments like stocks or privately held businesses, or gifts; and whether the income is derived in the U.S. or abroad—is subject to taxation. Certain assets, such as bank accounts, are additionally subject to disclosure and reporting to the U.S. federal government.
All green card holders and most foreigners living and working in the United States should note that their foreign income and assets are subject to the same obligation because they are considered U.S. resident aliens. As referenced above, most students, diplomats, and professional athletes are exempted.
Nonresident aliens are subject to slightly different rules, namely that only U.S. source income is taxed. There are two tax rates for nonresident aliens:
Effectively Connected Income, which is based on business operations and wages earned from work
Fixed or Determinable, Annual, or Periodic Income, which is essentially investments
There is no “minimum amount” of income triggering the requirement to file taxes. As such, many nonresident aliens are not subject to having to file an income tax return. However, to enjoy benefits such as income exemption deriving from a tax treaty, many do file annual tax returns.
Ensuring Compliance
Generally speaking, most U.S. citizens, nationals, and resident aliens can ensure their compliance with tax and financial reporting obligations by performing the following:
1. Pay U.S. federal income tax.
First, report all sources of income to the IRS.
-This amount is very high and has the practical effect of eliminating taxes on foreign income for most taxpayers. For tax year 2016, for example, the excluded amount was $101,300 for a single taxpayer.
Subtract amounts permitted by tax treaties between the U.S. and other nations.
Subtract credits for foreign taxes paid to other countries (i.e. Foreign Tax Credit).
Subtract additional exclusions or deductions applicable to your situation, which may include, for instance, foreign housing exclusions or deductions.
File Form 8938 with the IRS, if foreign assets exceed a certain limit.
The limit begins at an aggregate value of specified foreign financial assets of $50,000.
Higher thresholds apply for taxpayers who are living abroad. The limit for these taxpayers starts at $200,000.
2. Pay the applicable State (or Territory) income tax.
Whether or not state taxes are due is based on an individual’s residence. The following U.S. states do not have a broad-based individual income tax.
Alaska
Florida
Nevada
New Hampshire
Tennessee
Texas
South Dakota
Washington
Wyoming
3. File a Foreign Bank Account Report (FinCEN Form 114) with the U.S. Treasury Financial Crimes Enforcement Network (FinCEN)
According to FinCEN, a U.S. person with a financial interest in or signature authority over foreign financial accounts must file a Foreign Bank Account Report (FBAR), if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year. In this context, a U.S. person refers to citizens, including minor children; U.S. residents; entities (including corporations, limited liability companies, or partnerships created or organized in the U.S., or formed under the laws of the U.S.); and estates or trusts formed under U.S. laws.
In contrast, as indicated above, nonresident aliens are only required to pay federal and applicable state taxes from U.S.-source assets and income.
Consequences
It is important for all U.S. taxpayers required to report taxable foreign-sourced income and assets to adhere to these requirements. If the IRS discovers that an individual has unreported income or undisclosed foreign financial accounts, the agency can assess penalties on top of the additional taxes owed. Punishments range from interest and fines to prosecution and imprisonment.
Potential Exceptions
Tax treaties between the United States and other countries serve to mitigate or altogether eliminate double taxation. Accordingly, these treaties may provide an individual with exceptions on what is actually taxed and at what rate it is taxed. Changing exchange rates between the U.S. dollar and relevant foreign currency can result in differences in determining when an individual’s foreign-source income and assets hit reporting limits. (Individual circumstances can vary significantly, and many answers to specific questions cannot be answered in generalized terms.)
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This article served to provide an overview on the basics of personal financial compliance. But the content included here cannot substitute for guidance about your specific situation. We strongly advise consulting with a financial planner and an experienced attorney about such issues. Zhang & Associates invites you to take advantage of a free consultation on your potential case. Click here to contact our firm today.
Created 07/28/2017
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