Tax Planning for Nonresident Aliens Moving to the United States

GENERAL COMMENTS

This article discusses some of the U.S. tax planning issues that should be considered by nonresident aliens who are contemplating a move to the United States, where the alien’s situation is such that he/she is likely to become classified as a resident alien for U.S. income tax purposes, either contemporaneously with the move or at some time thereafter. The discussion below is by no means a complete list of issues that should be considered by each such alien, but only a summary of a few of the major issues that often arise. In doing any U.S. tax planning, of course, the potential non-U.S. tax implications should always be carefully considered as well.

PERSONAL AND INVESTMENT ASSETS

Stepping Up Low-Basis Assets

As a general rule, all assets (whether personal or investment assets) that are owned by a nonresident alien have for U.S. tax purposes a tax basis that is equal to the U.S. dollar value of the asset when it was purchased by the alien.¹Section 1012 provides that “the basis of property shall be the cost of such property, except as otherwise provided” in the U.S. Internal Revenue Code (“the Code”). There are no exceptions based on the fact that the owner of the property may not have been subject to U.S. income tax jurisdiction on the purchase date. All section references (“§”) herein are to the Code, as amended. Thus, if in 1990 a nonresident alien purchased a home for 100,000 units of foreign currency (FC) in his/her home country, the U.S. tax basis of that home is equal to the U.S. dollar value of the 100,000 FC units on the purchase date. If the home is sold for 300,000 FC units after the alien has become a resident alien for U.S. tax purposes in 2015, the gain is fully subject to U.S. tax (although possibly reduced by foreign tax credits under §901), because the individual’s resident alien status results in U.S. taxation of the alien’s worldwide income. In calculating the taxable gain for U.S. tax purposes, moreover, the amount realized is converted into U.S. dollars on the date of sale. Thus, if the value of one FC unit in 1990 was US$1.00 but is US$2.00 on the date of sale in 2015, the sales price in U.S. dollars would be $600,000; as a result, the resulting $500,000 of taxable gain would include substantial foreign currency gain. By the same token, if the value of one FC unit in 1990 was $1.00 but was only $.50 on the sale date in 2015, the sales price in U.S. dollars would be only $150,000, and the taxable gain for U.S. tax purposes would be only $50,000.

Because there is no “mark-to-market” rule that steps up the U.S. tax basis of an alien’s assets to their fair market value on the date on which that person becomes a resident alien, one who expects to become a resident alien in the near future may wish to take measures to step up the basis of whatever personal and investment assets he/she anticipates selling while living in the United States and classified as a resident alien. Thus, in this example the alien may wish to accelerate the sale of the foreign home so that it takes place before he/she becomes a resident alien — particularly if the tax law in the foreign country provides that gain from the sale of an individual’s home is tax-free or subject to a reduced tax rate.²In this example, of course, the principal residence exclusion under §121 may apply so as to exclude part or all of the gain from U.S. tax if the sale takes place after the alien has become a resident alien.

If the alien owns investment assets (such as appreciated securities) that he/she does not wish to sell before moving to the United States but might wish to do so while a resident alien, there may be transactions that can step up the U.S. tax bases of the assets. With respect to marketable securities, for example, the alien may be able to sell the securities on the open market and then repurchase them in his/her own name, or in the name of an accompanying family member (assuming, of course, that no significant foreign income tax or other tax would be imposed on the sale).³The 30-day “wash sale” rule of §1091 would not apply so as to ignore the step-up, because the wash sale rules only deal with the recognition of built-in losses. More complex transactions involving marketable securities might also be effective to step up the U.S. tax bases of assets.

In determining the U.S. tax bases of an alien’s personal and investment assets, most tax practitioners believe that the rules of the Code are applied on a “hypothetical tax” basis. For example, if the alien has inherited particular property, his/her U.S. tax basis in the property would generally be the fair market value of the property (converted into U.S. dollars) on the decedent’s date of death, as provided in §1014.⁴See GCM 34572. By the same token, the U.S. tax basis of property acquired as a gift would usually be the lower of the U.S. dollar value of the property on the date of the gift, or the tax basis of the donor (in U.S. dollars), as provided in §1015.

Postpone Selling Depreciated Assets

As a result of the U.S. “hypothetical tax history” rule, if an alien owns a personal or investment asset that has depreciated in U.S. dollar terms since its acquisition, and he/she expects to sell it, the alien may wish to postpone such sale until after becoming a resident alien, so that the built-in loss can be realized on his/her U.S. tax return, and possibly utilized so as to shelter other U.S. taxable income.

Pre-Move Installment Sales

A nonresident alien who sells property on an installment basis before moving to the United States and receives installment payments with respect to the sale after becoming a resident alien should be able to elect out of the §453 installment sale rules on his/her first U.S. resident alien return (Form 1040), and thereby avoid paying U.S. tax on the portion of the collections that represent taxable gain. In general, §453 provides that where an individual makes an installment sale that generates a gain, the gain is taxed only as the installment payments are received — unless the taxpayer “elects out” of installment sales treatment on his/her tax return for the year of the sale. However, if an alien makes an installment sale while still classified as a nonresident alien living abroad, in most cases he/she will not be required to file a U.S. income tax return for the year and may not even be aware of the §453 rules until after moving to the United States and becoming a resident alien.

In this situation, the Internal Revenue Service has adopted a “pro-taxpayer” position in PLR 8708002 and PLR 9412008, where it ruled that a nonresident alien who sold property on the installment basis and later moved to the United States and became a resident alien could elect out of installment treatment on his/her first U.S. tax return, in order to avoid U.S. tax on the installment payments received after the move. In so ruling, the IRS emphasized that Congress in the 1980 legislative history of §453 specifically asked it to issue regulations to permit such an election by a former nonresident alien.⁵Although no regulations on this issue have yet been issued, presumably the IRS would rule the same way if the issue were to arise today, on the basis of the 1980 legislative history. Notwithstanding the two private letter rulings just cited, there is dictum in CCA 003750 to the effect that a nonresident alien who wishes to elect out of the §453 default treatment must do so on a timely filed U.S. tax return.

Although the IRS position is apparently that a newly arrived resident alien may in fact elect out of §453 treatment on his/her first Form 1040, if the alien realized a loss in U.S. dollars on the installment sale of the property, presumably he/she would not want to elect out of the §453 treatment, so that the loss would be realized for U.S. tax purposes as the installment payments are collected, and could thus be utilized to shelter other U.S. taxable income.

FOREIGN TAX CREDIT PLANNING

U.S. tax planning may be available where a newly arrived resident alien moves to the United States from a foreign country where personal income taxes are higher than in the United States, and where the alien expects to make foreign business trips during the period of resident alien status. If, during an alien’s first year in the United States, he/she can arrange to be classified as a resident alien on or before the date on which the taxable year closes in the country from which he/she came, it may be possible to claim a foreign tax credit for all the taxes paid to that country with respect to that fiscal year.

For example, assume that Ms. Z moves to the United States from a foreign country where the effective tax rate on her earnings is 40%, and the effective federal income tax rate on her earnings is 25%. If she moves into the United States in mid-year but can arrange to be classified as a resident alien for the entire year (perhaps as the result of one or more IRS elections, discussed below), her foreign-source earnings prior to the move will be subject to U.S. tax but will be fully sheltered from U.S. tax because of foreign tax credits for the foreign income tax. At the same time, the excess 15% foreign income tax will generate excess foreign tax credits that can be used to reduce or eliminate the U.S. tax on her earnings allocable to foreign business trips later during that year, and during the 10-year foreign tax credit carryover period. If full-year resident alien status in effect is “elective,” however, she should take into account (i) the possibility that including the foreign-source earnings in her gross income for the year of the move could increase the effective U.S. tax rate on her U.S.-source post-move earnings for the same year, and (ii) the likelihood that she will actually make sufficient foreign business trips after the move in order to fully utilize her excess foreign tax credits. She should also consider the possibility that including the pre-move foreign earnings in her gross income could expose her to the “net investment income tax” under §1411, or increase the amount of that tax if it would already be imposed on her without including the pre-move foreign earnings in her gross income. The possible impact on her state and local income taxes (if any) should also be considered.

TIMING OF RESIDENT ALIEN STARTING DATE

An individual who moves to the United States and expects to become a resident alien at some point after the move may have flexibility to plan for his/her residency starting date. U.S. and/or foreign tax savings may be available even if the alien does not have significant personal or investment assets — for example, if the alien has a substantial salary. Because there are numerous fact patterns in which various types of planning could result in tax savings, before moving to the United States an alien should consider a number of U.S. and foreign tax issues — including whether a resident alien election may be available under §7701(b)(4) in order to avoid full-year nonresident alien status, whether (in the case of a married couple) a full-year resident alien election may be available under §6013(g) and/or §6013(h), whether a treaty tie-breaker rule may be available to reclassify the individual as a nonresident alien despite his/her resident alien status under the Code, and whether foreign tax credit planning, described above, may be advisable. Some of the factual issues that should be taken into account are whether the alien will make substantial foreign business trips after moving to the United States, whether the alien is likely to incur substantial non-business expenses that may be deducted by resident aliens but not by nonresident aliens (such as home mortgage interest expense and real property taxes), and (as discussed above) whether the alien is likely to sell appreciated personal or investment assets where the gain may be taxed to a resident alien but not to a nonresident alien.

U.S. ESTATE AND GIFT TAX PLANNING

If the alien anticipates remaining in the United States for more than a few years as a non-immigrant or anticipates applying for a U.S. permanent residence visa (green card) and possibly eventual U.S. citizenship, he/she should consider the potential U.S. estate and gift tax cost of becoming classified at some point as a resident for estate and gift tax purposes. Because the question of an alien’s “domicile” is a question not of U.S. income taxes but rather estate and gift taxes, the alien should consider the potential U.S. estate and gift tax cost of eventually becoming “domiciled” in the United States. For example, an alien with a substantial net worth may consider creating a so-called “drop-off trust” before moving to the United States, so as to reduce the risk of eventual estate and gift tax on the family’s personal and investment assets.⁶See Bissell, Some Cautionary Comments on ‘Drop-Off Trusts’ for Incoming Aliens, 42 Tax Mgmt. Int’l J. 697 (Nov. 2013). For a detailed discussion of U.S. estate and gift tax planning for aliens moving to the United States, see 903 T.M., Tax Planning for Portfolio Investment into the United States by Foreign Individuals.

ADVANCE PLANNING WHEN MOVING OUT OF THE UNITED STATES

Although this article deals primarily with tax planning for aliens moving to the United States, advance planning can be equally important when an alien anticipates moving out of the United States and becoming a nonresident alien once again. Although there are often fewer options available to an alien who is moving out of the United States with respect to resident or nonresident alien status (in most cases, the individual will be classified as a resident alien up to the date of the move, and as a nonresident alien thereafter), it may still be possible to extend the individual’s resident alien status to a later date, or possibly until the end of the year. For example, if the alien is married and the couple made a §6013(g) election with respect to their first year in the United States, they will be classified as resident aliens up to the end of their last year in the United States, unless they revoke the election for such last year. Even in the absence of such an election, it may be possible to prolong resident alien status by returning to the United States for more than 10 days later in the year.

As is true for the year of the move into the United States, all the elements of the alien’s factual situation should be considered before the alien moves out of the United States. Thus, there may be planning opportunities with respect to the possible sale of U.S.- or foreign-situs personal or investment assets (including sale of the alien’s principal residence in the United States),⁷See Bissell, Nonresident Aliens, ‘Covered Expatriates,’ and the §121 Principal Residence Exclusion, 43 Tax Mgmt. Int’l J. 349 (June 2014). and/or with respect to salary, fringe benefits (including reimbursed moving expenses), and pending bonuses. Of course, as is true for the alien’s first year in the United States, the non-U.S. tax implications of any planning should always be carefully considered as well.