Passive Income Tax Consequences – Foreign Person vs. U.S. Resident
While being a Legal Permanent Resident a.k.a. Green Card Holder comes with many benefits (mainly being able to live in the United States and travel freely between the United States and a foreign country), one of the biggest detriments to being a Green Card Holder is U.S. Tax Liability.
Before a person is a Green Card Holder, they are a non-legal permanent resident/non-US citizen. As such, they are generally only taxed on their US source income.
For example, if a non-US person works in the United States for a few months, they will pay U.S. tax on the income they earned in the United States.
They would not be subject to tax on income they earn outside of the United States (unless possibly through a U.S. employer) because they are not subject to the worldwide income tax scheme as a non-US person.
Contents
Different Requirements Based on U.S. Status
When a person is a non-US citizen or non-legal permanent resident they are not considered a US person, and therefore are not required to file many of the same forms as a US person. These forms can be comprehensive, and the failure to file them may (but not always) result in significant fines and penalties.
For example, in addition to filing an annual tax return a U.S. person will have to report the following:
- Receipt of Foreign gifts
- Ownership of Foreign corporate interests
- Ownership of foreign partnership interests
- Interest in a foreign mutual fund
- Interest income earned in a foreign country
- Dividend earned in a foreign country
- Capital gains earned in a foreign country
- Inheritance received in a foreign country (possibly depending on the source of the inheritance)
U.S. Residents are Different
One of the biggest misconceptions we find with individuals and US tax is whether they are subject to US tax on their worldwide income. There are two main categories of individuals who are almost always subject to tax on their worldwide income – US Citizens and Legal Permanent Residents/Green Card Holders.
Unfortunately, there is a third category of individuals (not include corporate law) for non-US citizens and non-US Legal Permanent Residents who meet the substantial presence test.
Once you meet the Substantial Presence Test, you are subject to US tax on your worldwide Income. That would include passive income from a foreign country, even if that passive income is tax exempt or tax-free in the foreign country. Passive income can come in many different shapes and sizes, such as interest income, dividend income, capital gains, and even non-distributed income from a retirement plan, tax-free savings plan, or other deferred type of investment (Exceptions/Exclusion apply).
Unfortunately, even though the income is tax-free in a foreign country — chances are the United States does not recognize the specific investment as tax-free and therefore you may have to pay current tax in the United States for non-distributed income of the deferred investment overseas which is growing tax-free in that foreign country.
What is the Substantial Presence Test?
The Substantial Presence Test is a test that is utilized for a visa holder or other person who is neither a US Citizen nor Legal Permanent Resident, but has resided in the United States for a significantly long period of time – enough time to make them subject to US tax just as if they were a US Citizen or Legal Permanent Resident. This is usually common when a person resides in the United States on an H1B, L1, or E2 visa.
Not all visa holders are subject to this tax. Most commonly, a student in the United States is usually not subject to tax liability for the first five (5) years they reside in the United States.
How does the substantial presence test work?
Summary of Substantial Presence Test
As a non-US citizen and non-US green card holder, you are generally only required to pay tax on your “US Effectively Connected Income” (money you earn while working in the United States). However, if you qualify for the Substantial Presence Test, then the IRS will tax you on your WORLDWIDE income.
IRS Substantial Presence Test generally means that you were present in the United States for at least 30 days in the current year and a minimum total of 183 days over 3 years, using the following equation:
- 1 day = 1 day in the current year
- 1 day = 1/3 day in the prior year
- 1 day = 1/6 day two years prior
Example A: If you were here 100 days in 2016, 30 days in 2015, and 120 days in 2014, the calculation is as follows:
- 2016 = 100 days
- 2015 = 30 days/3= 10 days
- 2014 = 120 days/6 = 20 days
- Total = 130 days, so you would not qualify under the substantial presence test and NOT be subject to U.S. Income tax on your worldwide income (and you will only pay tax on money earned while working in the US).
Example B: If you were here 180 days in 2016, 180 days in 2015, and 180 days in 2014, the calculation is as follows:
- 2016 = 180 days
- 2015 = 180 days/3= 60 days
- 2014 = 180 days/6 = 30 days
- Total = 270 days, so you would qualify under the substantial presence test and will be subject to U.S. Income tax on your worldwide income, unless another exception applies.
Out of Compliance?
If you are out of compliance and seeking to get back into compliance-or in the compliance for the first time – one of the best and safest methods is through IRS offshore voluntary disclosure.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm today for assistance with getting compliant.