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Date: November 2003
Taxation of U.S. Citizens and Resident Aliens
In general, foreign nationals who are considered resident aliens are taxed on their worldwide income in the same manner as U.S. citizens. By contrast, nonresident aliens are taxed only on effectively connected income, and on fixed or determinable annual or periodical income (e.g. dividends, interest, etc...) from U.S. sources. Thus, the distinction between resident and nonresident alien status is critical for determining the U.S. tax liability of a foreign national.
Gross Income
U.S. citizens and resident aliens are taxable at graduated rates on all types of gross income derived from any source unless specifically excluded by the Internal Revenue Code. Generally, taxpayers are subject to tax on their taxable income which is equivalent to their gross income less a variety of available deductions and exclusions. Common items excluded from gross income include gifts, inheritances and interest from certain state and local governmental obligations. In addition, once every 2 years, U.S. taxpayers can exclude up to $250,000 ($500,000 for married individuals) of gain associated with the sale of their principal residence.

Ordinary income is taxed at graduated tax rates which range from 10% to a maximum federal rate of 38.6%. These rates are slated to decrease slightly in the upcoming years. The maximum rate is reached at an income level of $307,500 in 2002. State and local jurisdictions also impose taxes ranging from 0-12%. U.S. taxpayers are also subject to other tax withholdings to cover payments to the Social Security Administration and to Medicare.
Capital Gains and Losses
Capital gains of U.S. citizens and resident aliens are taxable regardless of the purpose for entering into the transaction that results in the gain. In contrast, capital losses are deductible only if incurred in the taxpayer's trade or business or a transaction entered into for profit. Thus, a gain from the sale of a taxpayer's personal residence or automobile would be taxable, but a loss from such sale would not be deductible because a residence or automobile is considered to be a personal rather than a business or investment asset.

Net capital gain income is taxed at ordinary rates except that the maximum rate for long-term gains is limited to 20% for sales of long-term capital assets after May 6, 1997. Net capital gain is equal to the difference between net long-term capital gains over short-term capital losses. Long-term refers to assets held for more than one year. Net short-term capital gains are taxed as ordinary income. This rate is further reduced to 18% for transactions after December 31, 2000 where the asset has been held for more than five years.

Capital losses are fully deductible against capital gains. However, net capital losses are deductible against other income only up to an annual limit of $3,000. Unused capital losses may be carried forward indefinitely until the losses have been fully used to offset capital gains.
Certain deductions are allowed to reduce the taxapayer's gross income subject to taxation. Deductions fall into two general categories:
  • Amounts deducted in determining adjusted gross income; and
  • The greater of the taxpayer's "standard deduction" or total itemized deductions, which is deducted from adjusted gross income in determining taxable income.
    Items deductible in determining adjusted gross income are generally deductions associated with producing gross income. These include, among others, individual retirement account (IRA) and self- employed retirement plan (Keogh) contributions and alimony payments.
    A citizen or resident is permitted either a standard deduction against taxable income fixed at a certain dollar amount each year or to itemize his deductions as specifically allowed by law. For 2002, the standard deduction is $7,850 for married individuals filing a joint return and $4,700 for single individuals.
    A taxpayer can forgo the standard deduction and elect instead to deduct claim specific itemized deductions. Itemized deductions include the following:
  • Medical expenses (subject to limitation)
  • Income and property taxes of states and localities
  • Foreign income taxes, if a foreign tax credit is not elected or unavailable
  • Mortgage interest on a personal residence and investment interest to the extent of investment income
  • Charitable contributions; and
  • Unreimbursed employee business expenses and other miscellaneous itemized deductions, to the extent that the net total exceeds 2% of adjusted gross income.
    Certain itemized deductions must be reduced where a taxpayer’s income exceeds a certain level ($137,300 for 2002). The reduction is equal to 3% of the taxpayer’s gross income that exceeds this base amount.
    Personal Exemptions
    Individual taxpayers are also entitled to reduce their taxable income by a personal exemption deduction in 2002 of $3,000 and additional exemptions of the same amount for each qualified dependent. These exemptions begin to be phased out for higher income individuals once adjusted gross income reaches specified threshold amounts.
    Alternative Minimum Tax
    The US tax system also contains a parallel tax system titled the alternative minimum tax (AMT). The AMT is intended to prevent certain deductions discussed above from reducing a taxpayers tax liability below a minimum amount. The AMT tax base is calculated on an individual's alternative minimum taxable income (AMTI), which generally equals regular taxable income with various adjustments, including an add-back for personal exemptions and certain items that receive preferential treatment in computing regular taxable income. The rate of tax applied is either 26% or 28% depending on the level of income. The AMT applies only to the extent that it exceeds the regular income tax.
    Taxation of Nonresident Alien Individuals
    Any individual who is not a U.S. citizen or resident alien is considered to be a nonresident alien for U.S. tax purposes. Nonresident aliens are generally taxed on two broad categories of income: U.S.-source fixed or determinable annual or periodical (FDAP) income and income effectively connected with a U.S. trade or business, including gains on disposition of U.S. real property interests.

    The two classifications of income are important because they determine the rate of U.S. tax that will apply. FDAP income is taxable at a flat rate of 30%, or a lower treaty rate, without the benefit of deductions and is normally collected through a withholding mechanism. In order to take advantage of lower treaty rates, foreign individuals must verify their resident status by filing the appropriate Form W-8 with the appropriate authorities. Effectively connected income is subject to U.S. tax after allowable deductions at the graduated income tax rates for resident individuals.

    Under the Foreign Investment in U.S. Real Property Tax Act of 1980 (FIRPTA), the United States treats as effectively connected income all gains and losses, of nonresident alien individuals and foreign corporations, from the disposition of U.S. real property interests. Generally, a purchaser of a U.S. real property interest from a foreign investor must withhold 10% of the sales proceeds for remittance to the IRS, regardless of the amount of the seller's recognized gain.
    Estate and Gift Taxes
    U.S. estate and gift taxes are imposed at graduated rates ranging from 18% to 55% on the value of the property transferred by reason of death or gift. Generally, citizens and residents are entitled to a limited lifetime credit (called the unified credit), which may be applied against either estate or gift taxes. For 2001, the unified credit is equivalent to the amount of transfer tax on $675,000. After 2001, the estate tax rates will be gradually reduced to a maximum rate of 45%. Beginning in 2004, the gift and estate taxes will not be unified since the exemption amounts will differ for the two taxes. In addition, estate and gift tax treaties may modify the application of the estate and gift tax rules.
    Gift Taxes
    In general, U.S. residents are subject to gift tax on the fair market value of transfers of all property, tangible and intangible, regardless of the location of the property.

    In general, each donor is entitled to an annual exclusion of up to $11,000 for gifts made to each donee. Gifts in excess of the annual exclusion are taxable at rates that range from 18% to 55. Gifts to a U.S. citizen spouse generally qualify for an unlimited marital deduction and are therefore exempt from U.S. gift tax.
    In general, foreign nationals not domiciled in the United States are subject to U.S. gift tax only on transfers of U.S. real property and tangible personal property located in the United States. They are entitled to the annual gift tax exclusion. Tax-free gifts from a nonresident spouse to a U.S.-citizen spouse may be unlimited. However, those from a nonresident spouse to another nonresident spouse are limited. Also, the unified credit is not available to nonresident foreign nationals unless a treaty provides otherwise.
    Estate Taxes
    The taxable estate of a U.S. citizen or resident includes all property, tangible and intangible, regardless of location at the time of death. In general, transfers from the estates of decedents to their U.S.-citizen spouses qualify for an unlimited marital deduction, making those transfers free of estate tax. However, property transferred at death from a U.S. citizen to a non-U.S.-citizen spouse generally is not excluded from the decedent's gross estate.
    For U.S. tax purposes, the estate of a nonresident includes only tangible, intangible and real property located within the United States at the time of death. Shares of stock in U.S. corporations and certain debt obligations of U.S. obligors are considered to be property located in the United States.

    Nonresidents are not allowed a marital deduction for transfers to their spouses who are not U.S. citizens, nor are they allowed the benefit of the unified credit unless a treaty provides otherwise. The tax rates on taxable estates are the same as those for citizens and residents.

    In addition to estate tax, estates are also subject to income tax on income earned during administration and settlement.
    Determination of Residence
    Intention to be a resident or nonresident generally has no bearing on whether an individual is treated as a resident for tax purposes. Objective tests are used to determine whether a foreign national is a resident or nonresident alien for U.S. income tax purposes. Under the rules, a foreign national who either is a "lawful permanent resident" of the United States or satisfies a "substantial presence test" is generally treated as a resident alien for U.S. tax purposes.

    Be aware that most states follow the federal rules for determining residency, but some do not. Thus, an individual may be considered resident for state tax purposes but not for federal tax purposes, and vice versa.
    Lawful Permanent Residence Test
    U.S. immigration law permits foreign nationals to enter the United States as lawful permanent residents on immigrant visas (commonly known as "green cards") or on temporary nonimmigrant visas. A green card holder is considered to be a resident during the taxable year from the first day of physical presence in the United States as a lawful permanent resident. Foreign nationals who maintain their green cards will continue to be treated as residents for each year thereafter, even if they live outside the United States.
    Substantial Presence Test
    Foreign nationals who enter the United States with temporary nonimmigrant visas may be treated as resident aliens for U.S. tax purposes if their stay is long enough to meet a substantial presence test.
    The substantial presence test is met if an individual is present in the United States for at least 31 days during the current calendar year and is present in the United States for a substantial period -- 183 or more days -- over a three-year period. To determine the days deemed present in the United States, a formula is used that weighs more heavily the days present in more recent years. The days in the three-year period are weighted as follows:
  • Current year, 100%
  • First preceding year, 33.33%; and
  • Second preceding year, 16.67%.
    For example, a presence of 122 days in each of three consecutive years will satisfy the substantial presence test.
    Current year 122 days x 100% = 122 days
    1st preceding year 122 days x 33.33% =   41 days
    2nd preceding year 122 days x 16.67% =    20 days
      183 days
    Under the weighted formula, a foreign national is considered a resident alien under the substantial presence test if physically present in the United States for 183 days or more during the current calendar year.

    Even if the tests above are met, certain exceptions can apply to allow certain foreign nationals to avoid resident alien status and the individual facts and circumstances should be reviewed by a professional tax advisor.
  • Tax Highlights for U.S. Citizens and Residents Going Abroad
  • Tax Information for Individuals