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January 19, 2021 5 minutes to read ∙ 1200 words

Tax Planning for Specified Aliens Moving to the United States

By Viatcheslav Serenkov

The last three decades not only changed our view of the world as the interconnected and “small” place where people can travel to almost any place on Earth, but also increased opportunities and ease of moving from one country to another for work, business, and family, among other reasons. Such ease of moving can come with a high tax cost when individuals with existing businesses move to the United States and become tax residents of this country. For such individuals, the question of tax planning must be one of the main priorities before they make a move to the United States.

Background on U.S. Taxation

In general, all worldwide income of U.S. persons, including U.S. citizens, U.S. residents, and domestic corporations, are subject to federal income tax under Section 61 of Internal Revenue Code (IRC). The rules for determining if an individual is a tax resident of the United States can be found in IRC section 7701. For an individual who is planning to move and stay in the United States for a long period of time, it is important to understand when he or she becomes a tax resident of the country. As a U.S. tax resident, such an individual has a duty to file an annual tax return and report all her worldwide income to the Internal Revenue Service (IRS). Also, she must keep in mind that her business in a foreign country can cause her to pay additional income tax in the United States, even though she may conduct business through a legal entity that pays taxes by itself and would be a corporation in the United States. For further explanation, we assume that our individual’s name is Amy, and she is the 100 percent owner of a foreign business entity that runs a successful restaurant in a foreign country.

Example of U.S. Taxation of a Foreign Business Entity

To understand possible tax consequences associated with the foreign business Amy owns, she has to make a projection of possible income inclusion to her individual tax return. And the starting point of such projection is identification of her entity for the U.S. federal income tax purposes. Treasury Regulations 301.7701-3 provides guidance for classification of certain business entities, including foreign business entities. It has default rules for foreign entities as well. We are assuming that Amy’s company is an “eligible entity” under Treasury Regulations 301.7701-3, and she can choose its classification by filing Form 8832, of course, if she does not like a default classification.

If Amy does nothing, her foreign business entity would be classified according to the default rules. This might not look like a big deal, but if her business entity is classified as an association (a corporation) for U.S. federal income tax purposes and later she realizes that it is better if she classifies her business entity in the United States as a flow-through entity (a disregarded entity), she most likely would be estopped from doing this by harsh tax consequences of reclassification of her foreign entity. This is because such change of classification from corporation to disregarded entity would be considered a deemed liquidation with deemed distribution of the foreign entity’s assets to Amy. And this is a taxable event for Amy, even though nothing happened with the business entity or its assets. Fed. Reg. 301.7701-3(g)(iii).

Keeping in mind “check-the-box” provisions and classification of business entities provided in Fed. Reg. 301.7701-3, Amy has to look at her foreign business entity from the point of view of the U.S. federal income tax system. She has two choices: to classify her business entity as an association (corporation) or as a flow-through entity. Both of those choices have advantages and disadvantages that must be weighed to make it as tax efficient as possible.

If she decides to classify her foreign business entity as a flow-through entity, all income of her foreign company would be reflected in her personal tax return. In this option, she can use all deductions available for individuals under IRC parts VI and VII. Also, she may claim the federal income tax credit under IRC section 901 for foreign income taxes paid by her company while doing business in a foreign country. She also could choose to deduct those foreign income taxes under IRC section 164 if she concludes that it is more advantageous for her. Amy should remember that she cannot do both in the same tax period.

If she decides to classify her company as a corporation, she may still have to include at least part of her foreign company income in her individual tax return. It can be so even if Amy does not get any distributions from her foreign company during a tax period. Because Amy owns 100 percent of the foreign company, her company would be classified as a controlled foreign corporation (CFC) under IRC section 957. The consequence of owning by a U.S. person at least 10 percent of stock in CFC by vote or value is possible inclusion of subpart F income, if any, under IRC Section 951 and, also, possible inclusion of global intangible low-taxed income (GILTI) under IRC section 951A. If Amy has to include subpart F income or GILTI in her personal tax return, she cannot claim foreign tax credit under IRC section 901 for income taxes paid by her company on income included in her tax return. On the other hand, she can use the option provided by IRC section 962 giving an individual a choice to be subject to tax at corporate rates. Such election can be made annually and gives Amy the right to claim foreign tax credit for income taxes paid by her company as deemed paid credit for subpart F inclusions. Also, Amy can use a 50 percent deduction against her GILTI inclusion under IRC section 250 that effectively reduces an amount of income tax on the GILTI inclusion.

In the most likely situation when Amy’s company does not have subpart F income and distributes profits to her as dividends, she might be able to get a more favorable tax rate for qualified dividends. But, to get preferable tax rates for qualified dividends, Amy’s company should be classified as a qualified foreign corporation under IRC section 1(h)(11)(C). And this is a separate analysis that depends on the existence of a comprehensive income tax treaty between the U.S. and a foreign country where Amy’s company is located.

After making a hypothetical tax projection, Amy most likely can decide about preferable classification of her foreign company. She also has to remember that U.S. persons might have a duty to report specified foreign financial assets on Form 8938 to satisfy Foreign Bank Account Report (FBAR) and Foreign Account Tax Compliance Act (FATCA) regulations. Violation of this requirement can cause a penalty of $10,000.

Conclusion

All information provided earlier is just a part of tax planning Amy should do before moving to the United States and becoming a tax resident. If she does not want to be unexpectedly upset by a hefty income tax due, she should seek the advice of a tax practitioner who can assist her in tax planning before she moves to the United States. In reality, the absence of tax planning by individuals before immigrating to the United States can cause a financial disaster that would be difficult to fix post-factum.

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Viatcheslav Serenkov ([email protected]) is licensed to practice law in California and Florida. He received his JD degree from the University of San Diego School of Law in May 2018 and his Tax LLM degree from the University of San Diego School of Law in May 2019. He is in the process of establishing his solo legal practice in San Diego, California, and plans to practice business and tax law.

Published in GPSolo eReport, Volume 10, Number 6, January 2021. © 2021 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association or the Solo, Small Firm and General Practice Division.

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The material in all ABA publications is copyrighted and may be reprinted by permission only. Request reprint permission here.