A foreign investor seeking to invest in the US is often motivated by factors such as transparent fiscal policies, a robust political and legal system, economic stability, and lack of currency restrictions. The same investor may want to ensure privacy, asset protection, and tax minimization. Given the sophistication of the US tax system, tax planning often drives the structure of the investment.
Privacy and Liability
Many foreign investors prioritize privacy. To achieve privacy, US assets should be acquired through a trust or an LLC. LLCs are preferred over corporations because they offer more flexible structuring options and better creditor protection, and do not require formation of a separate entity as a general partner. A foreign-owned LLC may choose to be taxed as a C corporation for federal tax purposes. If using a trust, the name of the trustee and trust must appear on the title of trust assets (e.g. recorded deed), but the investor should not be the trustee and the trust name should be generic (e.g. Blue Sky Trust). If using a legal entity, it should also have a generic name, but if the entity operates in California, it must register with the California Secretary of State. To avoid disclosure of corporate officers or LLC manager, a two-tier structure can be used – a California LLC to conduct business and a Delaware LLC as its manager. LLCs, limited partnerships, and corporations offer their owners liability protection for entity-related liabilities, but limited partnerships and LLCs have fewer formalities, affording fewer grounds for creditors to pierce the corporate veil. Limited partnerships and LLCs provide better asset protection than corporations because creditors can only place a lien on distributions from the entity (charging order) rather than seize the entity’s assets.
A foreign individual is referred to as a “non-resident alien” (NRA) for US federal tax purposes if they meet the criteria of being physically present in the US for less than 183 days in a year, 31 days in the current year, 183 total days in a three-year period (weighing formula), and do not hold permanent residency status (green card or EB-5 visa). A foreign individual receiving a green card becomes a US tax resident, and a foreign individual deemed a US tax resident based on the number of days criteria will be taxed on their worldwide income. The US tax system may tax NRAs on their US-sourced income, and a foreign corporation may also be subject to US taxation. The foreign tax credit may be available to reduce double taxation.
Withholding Tax on FDAP Income
The income tax rules for non-resident aliens (NRAs) can be complicated. NRAs are typically taxed at a flat rate of 30% on U.S.-sourced FDAP income, which is defined as income that is fixed, determinable, annual or periodical and not related to a U.S. trade or business. Rental income is taxed based on the location of the property. The payor is responsible for withholding the tax and remitting it to the U.S. Treasury. The tax rate may be reduced by a treaty between 0-15%. The tax is levied on the gross income with minimal deductions. Examples of FDAP income include interest, dividends, royalties, rents, annuity payments, and alimony.
To avoid FDAP tax on interest income, NRAs may use the portfolio interest rules, which exempt interest payable to foreigners on debt instruments from tax and withholding. NRAs may try to fit this rule by using equity participation loans or loans with equity kickers. However, the IRS has successfully argued that some of these loans were actually equity investments, making the income taxable and subject to withholding.
Capital gains from U.S. sources by NRAs are usually not taxed unless the NRA is present in the U.S. for over 183 days, the gains are related to a U.S. trade or business, or the gains are from the sale of certain assets (timber, coal, or iron ore). When the exceptions apply, the NRA is taxed at a rate of 30% on the U.S. source capital gains.
Income that is effectively connected to a U.S. trade or business by an NRA is taxed under the same rules as other U.S. taxpayers. The income may be reduced by deductions related to the U.S. trade or business and taxed at standard tax rates. The definition of “U.S. trade or business” is not defined in the tax code but has been interpreted as including personal services, direct or indirect sales, soliciting orders and exporting merchandise, manufacturing, retail, and corporate offices. The business must be active and not passive, with considerable, continuous, and regular activity in the U.S. The determination of “effectively connected” income involves dividing the income into two categories and evaluating the extent of the NRA’s commercial activity.
Branch Profits Tax
- Applies to foreign corporations operating through a U.S. branch
- Taxed at 30% (may be reduced by treaty) on “dividend equivalent amount” (effectively connected earnings and profits minus investments in U.S. assets)
- Treaty benefits are difficult to qualify for (must show not organized for tax avoidance)
- Termination of U.S. business exempts corporation from branch profits tax for the year
- Avoiding tax can be done by forming separate foreign corporations for each U.S. business
FIRPTA (Foreign Investment in Real Property Tax Act)
- Applies to the disposition of U.S. real property by non-resident aliens (NRAs)
- Taxes the transaction as if the NRA was engaged in a U.S. trade or business
- Purchasers must withhold 15% of the amount realized on the disposition
- An interest in real property includes ownership of land, buildings, crops, fixtures, etc.
Estate and Gift Tax
NRAs (non-resident aliens and not domiciled in the US) are subject to a different transfer tax regime (estate and gift taxes) than US taxpayers. Estate tax is imposed only on the part of the NRA’s gross estate that is situated in the US at the time of death. US-situs property includes shares of stock of a US corporation, real estate in the US, and tangible personal property like works of art and cars. The gross estate is reduced by deductions, but the estate tax returns must disclose all the NRA’s worldwide assets. NRAs can reduce their US estate tax obligations through advance planning, such as owning US real estate through a foreign corporation, which effectively converts the property into a non-US intangible asset. NRAs are not subject to US gift taxes on gifts of non-US-situs property, but are subject to gift tax on gifts of US-situs property.
Investment Vehicles for Foreigners
For foreign investors (Non-Resident Aliens, NRAs), there are several ownership structures to acquire U.S. assets. Each structure has its own advantages and disadvantages:
- Direct Investment: Simple and subject to only one level of tax but lacks privacy and liability protection, obligates the filing of U.S. income tax returns, and the asset may be subject to U.S. estate taxes.
- LLC/LP Structure: Provides privacy and liability protection, allows lifetime transfers that escape the gift tax but requires U.S. income tax returns and possible U.S. estate tax on death.
- Domestic Corporation: Provides privacy, liability protection, allows lifetime gift tax-free transfers, but is subject to two layers of tax, subject to 30% withholding on dividends, and the shares are included in the foreign shareholder’s U.S. estate.
- Foreign Corporation: Offers liability protection, no U.S. income tax or filing requirement, the shares are non-U.S. assets, not included in the U.S. estate, not subject to U.S. withholding, no tax or filing requirement on stock disposition, and no gift tax on stock transfer. However, it is subject to corporate level taxes and branch profits tax.
The most advantageous structure for NRAs is through the foreign corporation-U.S. corporation structure, where the NRA owns a foreign corporation, which in turn owns a U.S. LLC taxed as a corporation. This provides privacy, liability protection, escapes U.S. income tax filing requirements, avoids U.S. estate taxes, allows for gift tax-free lifetime transfers, and avoids the branch profits tax. Distributions from the U.S. subsidiary to the foreign parent are subject to the 30% FDAP withholding.
Tips Before Visiting USA
A would-be U.S. taxpayer should plan in advance to deal with worldwide income and estate taxation. Planning should include accelerating recognition of foreign source income, disposing of appreciated assets, deferring recognition of losses, receiving distributions, investing in tax-compliant investments, and establishing a pre-immigration foreign trust. The settlor of the trust should be careful to ensure the trust is properly structured and funded to avoid being treated as a grantor trust. Finally, the individual should consider gifting foreign assets or U.S. intangibles before they become subject to U.S. transfer taxes.