Tax planning is typically a year-round exercise for CPAs and their clients. One area that has gained momentum recently is preimmigration tax planning, which is relevant for nonresident aliens who are contemplating becoming either U.S. residents or U.S. citizens (collectively U.S. taxpayers). Planning focuses on the disparities in how nonresident aliens and U.S. taxpayers are taxed, both in the income tax and transfer tax context. Patrick J. McCormick, JD, LLM, a principal with Drucker & Scaccetti in Philadelphia, provides advice and strategies for practitioners in this area.
By: Jim DeLuccia, PICPA Communications Manager
Tax planning is typically a year-round discipline for our tax practitioners. And will likely be even more of a critical exercise in the future with the new tax laws. One element that may be lost in all of this is preimmigration tax planning. And joining me to discuss this area is Patrick J. McCormick JD, LLM, a principal with Drucker and Scaccetti in Philadelphia.
Patrick, you're kind of a veteran to this whole process here. I know that you've been a guest on our podcast series a few times, so I appreciate you joining me once again.
[McCormick] Jim, it's always a pleasure to speak with you all on any of these issues.
First, has this area of preimmigration tax planning become more significant in the last few years? And if so, why?
[McCormick] I think it's fair to say that it has with more people just generally coming into the United States. As a bit of background, what you're really concentrating on in the preimmigration planning context is nonresident alien; individuals who are contemplating becoming United States citizens or residents. Residency can be achieved, for lack of a better way to put it, under a multitude of circumstances, such as obtaining a green card or meeting substantial presence requirements in the United States.
As more people come to the United States, which is really a byproduct of globalized societies, there's more of a need for preimmigration planning. And more individuals to whom this is relevant.
What are a few basic items, but maybe they're items that could potentially be overlooked, that should be addressed initially before creating this nuts and bolts plan here?
[McCormick] I think really the thing that's most critical here and really, frankly, the thing Jim that gets most often overlooked is the availability of preimmigration planning. It's absolutely critical to note that you want to engage in this planning before an individual becomes a citizen or resident of the United States. Because the really big, for lack of a better way to put it, play here is to take advantage of the more limited U.S. tax code that's applicable to non-resident aliens than the tax code that's applicable to citizens and residents of the United States.
You'll look at techniques like basis step-ups, income acceleration, entity classification, elections. For high net-worth individuals, you go into trust planning as well. You want to be aware of the availability of these techniques though, while the individual is a nonresident alien. Too often, individuals ... first here to contemplate, US tax requirements after they become residents or citizens. Being proactive in this context and getting them cognizant of these issues and the opportunities that, frankly, are available in this context, is really critical.
What I like to do from a client perspective is, once we touch base with the right client, which is the first part, is to try to get essentially a ballot sheet of their worldwide holdings, listing all of their assets, the current fair market value of those assets, and the basis of those assets. It's very critical to note, it's under, I believe, Revenue Ruling 5561. It states that there's no basis step up in existing assets when you become either a United States resident or citizen.
What that means functionally is that if you have a nonresident alien who has a significantly appreciated asset that they sell shortly after becoming a United States taxpayer, they're going to be subject to United States tax on the entirety of the gain, not just the post residency, post citizenship gain. It really incentivizes you to either get a step up in basis or dispose of the asset prior to becoming a United States taxpayer, to limit the tax applicable thereto.
What are a few strategies one can employ to minimize tax exposure?
[McCormick] I think really the big things that you're looking at in the preimmigration context are trying to recognize as much income as possible before becoming a United States tax payer. As background from a United States perspective, if you're a nonresident alien for income tax purposes, the United States is going to tax you on income sourced to the United States. Primarily you're looking at tax as a nonresident alien on effectively connected income with the U.S. trade or business, what we call FDAP income, fixed or determinable annual or period income, sourced to the United States. And the gains covered under the foreign investment in real property tax act.
Aside from that though, if you don't have income that's sourced to the United States, the United States isn't going to tax that income, because they have no jurisdiction, frankly, to tax that income when it's a nonresident alien earning foreign sourced income or with foreign sourced gains.
What you want to do with that being the case is try to accelerate any foreign income. Or step up basis in foreign assets prior to becoming a United States taxpayer. Because once you're a United States taxpayer, as we're all aware, you're subject to tax on worldwide income. Like I mentioned before under the revenue rulings, under an assortment of case law that's out there, if you're having built-in gain on assets prior to becoming a United States taxpayer, if you're having income that's functionally earned, but for which there was no recognition of that prior to becoming a U.S. taxpayer, that's going to be subject to tax in the U.S. under standard U.S. rules. Thus, accelerating income, getting step up in basis, disposing of assets with significant build and gain is extremely advantageous, because then you're not subjecting those gains to U.S. tax.
Do the new tax laws have implications for those moving to the U.S.? And if so, how should our members counsel potential clients?
[McCormick] I think they do in an ancillary way. And one of the areas where there's ramifications is in regard to just the new international provisions under the tax code and jobs act. I think, frankly, functionally, one of the biggest new provisions, if not the biggest, is section 951a, which we're calling the guilty provisions, which is very aptly named once you understand the scope. What it's saying is that U.S. shareholders of controlled foreign corporations are subject to immediate tax at the shareholder level. Like with sub-part F on what exceeds essentially a 10 percent deemed rate of return for tangible business assets or a foreign corporation.
Where this gets relevant in the context of preimmigration planning is in regard to entity classification elections on foreign corporations. As a bit of background, if you have a foreign corporation, once that corporation – or a foreign entity I should say – becomes relevant for U.S. tax purposes, generally speaking that means once a federal tax return is required for the entity or an information return is required in regards to the entity, that entity, at the time of its relevance, can make an entity classification election in the United States to determine how, for United States tax purposes, it will be treated, generally subject to limited exceptions as to perceived corporations. You can elect to treat an entity as a corporation or as a pass-through entity.
The new guilty rules really create an added incentive in certain circumstances for electing flow-through treatment. That's always going to be fact specific. And I'll tell you Jim, frankly, I think in the significant majority of circumstances, it makes more sense, even giving guilty and sub-part F to treat a foreign corporation as a foreign corporation because with a pass-through, you're essentially eliminating any opportunity for deferral. These are always – I'm getting into the minutiae here – the determinations are always going to be fact specific. But that's where I see a really big change. And it's also something to really emphasize in the context of preimmigration planning, is that when you have clients with foreign entity interest, you need to ascertain how that foreign interest is going to be classified under U.S. tax rules and make a determination as to whether you want to elect an alternate classification.
You mentioned earlier in our conversation about how this applies to high net worth individuals. But I was wondering if you could expand on, or explain, this concept of preimmigration tax planning. Can it apply to other folks with different income levels? And if so, how does that come into play?
[McCormick] It's really such a great question, because planning in the context of preimmigrants can really be bifurcated. You have the high net worth individuals for whom both transfer tax and income tax planning will make sense. But really for any individuals with built-in gains on the assets with, say, deferred income. Planning makes sense in this context. Because like I'd mentioned before, in the preimmigration context, what you're trying to do is accelerate income. Step up basis, dispose of assets with significant built-in gains, whole nine yards. That can apply to anyone. That can apply to somebody with $100 million of worldwide net worth. That can apply to someone with $500,000 of worldwide net worth. It's going to be client specific. You always want to look at the balance sheet to see where opportunities lie.
Now in the high net worth context, there's a bit more that comes into play there. If you're looking at someone with the potential for transfer tax exposure in the United States, which really depends on a multitude of factors, primarily how long they're contemplating staying in the United States and what their current/anticipated worldwide net worth will be, both now and moving forward.
When you have someone for whom you want to do transfer tax planning, drop-off trusts are a really great idea. What you're essentially doing is establishing a trust. More often than not, you'll want it to be a domestic trust, because there are special rules that come into play for foreign trusts. You set up a non-guarantor trust in the United States, contribute assets to that trust prior to immigration, and then you're protecting those assets from a state tax and potentially gift tax in position, once the individual becomes a U.S. domiciliary or resident.