Passive Income Tax Consequences for Foreign Person vs. U.S. Resident
- 0.1 Different Requirements Based on U.S. Status
- 0.2 U.S. Residents are Different
- 0.3 What is the Substantial Presence Test?
- 0.4 Summary of Substantial Presence Test
- 0.5 Out of Compliance?
- 1 IRS Voluntary Disclosure of Offshore Accounts
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.
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. A summary is provided below:
IRS Voluntary Disclosure of Offshore Accounts
Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that if you are required to file a U.S. tax return and you don’t do so timely, then you are out of compliance.
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.” It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.
The Devil is in the Details…
If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.
It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.
Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.
What if You Never Report the Money?
If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported — then you are in a bit of a predicament, which you will need to resolve before it is too late.
As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.
Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).
Getting into Compliance
There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.
We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlikes the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.
After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.
If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.
Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.
Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver, and has also earned the prestigious Enrolled Agent credential. Mr. Golding is also a Board Certified Tax Law Specialist Attorney (A designation earned by Less than 1% of Attorneys nationwide.)
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