What are the key tax considerations for private clients in USA?

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Tax

i Income tax

US citizens (regardless of where they reside) and residents (collectively, US persons) are subject to US income tax on worldwide income.² On the other hand, individuals who are neither citizens nor residents of the United States (non-resident aliens) are subject to US income tax only on certain types of US-sourced income, income effectively connected with a US trade or business and gains on the sale of US situs real property.³

A non-citizen of the United States is considered a resident of the United States for income tax purposes if the individual:

1. is admitted for permanent residence (i.e., holds a green card);
2. elects to be treated as such; or
3. has a substantial presence in the United States in a given calendar year.⁴

An individual satisfies the substantial presence test and is deemed a resident if he or she has been present in the United States for at least 31 days in the current year and for at least 183 days during a three-year period that includes the current year, determined based upon a weighted three-year average.⁵

The use of this weighted average can become a trap for individuals who focus only on the total day count and who believe that they can spend up to 182 days each year in the United States without having a substantial presence that will cause them to be considered a US resident for income tax purposes. Under the weighted average test, a person may spend, on average, up to 120 days in the United States each year without being treated as a US income tax resident under the substantial presence test. An individual who meets the substantial presence test but spends less than 183 days in the United States in a year can still avoid being treated as a US income tax resident if he or she can establish that the individual maintains his or her tax home in another jurisdiction and maintains a ‘closer connection’ to such foreign tax home by filing a Form 8840 (Closer Connection Exception Statement for Aliens) with the IRS.⁶ It is also important to consider whether a non-US citizen may be entitled to protection under a tax treaty between the United States and the jurisdiction the individual considers to be his or her home.

ii Gift, estate and generation-skipping transfer tax

There are three types of US federal transfer taxes: estate tax, gift tax and generation-skipping transfer (GST) tax (collectively referred to as transfer taxes). US citizens and US residents are subject to transfer taxes on worldwide assets.⁷ The test to determine whether an individual is a US resident for transfer tax purposes is different from the test to determine whether an individual is a US resident for income tax purposes. Whereas the residence test for income tax purposes, as discussed above, is an objective test, residence for the purpose of transfer taxes is determined by a subjective domicile test, turning on the individual’s intentions. A person is a US resident for transfer tax purposes if he or she is domiciled in the United States at the time of the transfer.⁸ A person can acquire domicile in a place by living there, for even a short period of time, with the intention of remaining there indefinitely.⁹

Subject to provisions of an applicable treaty, a non-US citizen who is not domiciled in the United States is subject to US transfer taxes only on property deemed situated in the United States (US situs assets), including US real estate (which includes condominium apartments) and tangible personal property located in the United States. Shares in US corporations, debt obligations of US persons (subject to important exceptions for certain portfolio debt and bank deposits), and certain intangible property rights issued by or enforceable against US persons are subject to US estate tax but not US gift tax.

Current income and transfer tax rates

The Tax Cuts and Jobs Act (TCJA) passed under the Trump administration modified the income limits and respective rates of the seven individual income tax brackets, mostly with the effect of decreasing the tax rate for each bracket. The top marginal rate was decreased from 39.6 to 37 per cent, and in 2023 applies to single filers with income in excess of US$578,125, and married couples with income in excess of US$693,750. The TCJA also nearly doubled the standard deduction, which is adjusted annually for inflation and in 2023 is US$13,850 for single filers and US$27,700 for married couples.

While the aforementioned changes implemented by the TCJA may reduce the federal tax liability of many taxpayers, other changes, such as the elimination of deductions previously available to taxpayers who itemise deductions, may increase federal taxes, especially for taxpayers who live in states and cities that have their own income taxes. For example, the TCJA limits the mortgage interest deduction for mortgages incurred after 15 December 2017, such that the deduction is now allowed only for the interest on up to US$750,000 of the principal, including a home equity loan used to buy or improve a qualified residence.¹⁰ In addition, whereas individual taxpayers were previously able to take a deduction against their federal income tax liability for state and local taxes paid (including property taxes), the TCJA limits the allowable deduction for such taxes to US$10,000 for both single filers and married couples.

The TCJA increased the deductions for some charitable giving to public charities. Charitable contributions of cash to a public charity may be deducted up to 60 per cent of the donor’s adjusted gross income. Non-cash contributions to a public charity may be deducted up to 50 per cent of the donor’s adjusted gross income, with the exception that contributions of capital gain property, such as appreciated stock, are subject to a 30 per cent limit. Special rules apply when a donor makes both cash and non-cash contributions to a public charity in the same year.¹¹

The lifetime exemption from US gift, estate and GST taxes for US citizens and residents was doubled by the TCJA to US$10 million (US$20 million for a married couple), indexed for inflation (for 2023, the indexed exemption is US$12.92 million for an individual and US$25.84 million for a married couple). The exemption reverts back to US$5 million (US$10 million for a married couple), indexed for inflation, after 2025. The top transfer tax rate remains at 40 per cent.

US citizens and residents for transfer tax purposes may also take advantage of portability, which permits such persons to use the unused transfer tax exemption amount of the taxpayer’s deceased spouse (if he or she died after 31 December 2010).¹² If a taxpayer is predeceased by more than one spouse, the taxpayer may use the unused transfer tax exemption of the last deceased spouse only. The executor of the deceased spouse’s estate must make an election on the deceased spouse’s estate tax return to allow the surviving spouse to use the deceased spouse’s unused transfer tax exemption. The estate of an individual who was a non-resident alien of the United States for transfer tax purposes at the time of such individual’s death is not eligible to make a portability election, and thus such individual’s lifetime exemption from US transfer taxes (which is only US$60,000) cannot be passed on to his or her surviving spouse. More significantly, a non-resident alien surviving spouse may not acquire his or her deceased US spouse’s unused lifetime exemption (except to the extent allowed under a US treaty).¹³ However, a surviving spouse who becomes a US citizen after the death of the deceased spouse may elect to use the unused transfer exemption of the deceased spouse.¹⁴

iii Medicare surcharge

The net investment income tax (NIIT) is part of the funding of the Patient Protection and Affordable Care Act enacted in 2010 and provides that citizens and residents of the United States (i.e., any individual other than a non-resident alien)¹⁵ must pay an additional 3.8 per cent Medicare tax on the lesser of the taxpayer’s net investment income, and the excess of the taxpayer’s modified adjusted gross income (as calculated for income tax purposes) for the taxable year over a certain threshold amount. Likewise, trusts and estates must pay an additional 3.8 per cent tax on the lesser of the trust’s net investment income, and the excess of adjusted gross income (as calculated by a trust or estate for other income tax purposes) over the dollar amount of the highest tax bracket for a trust or estate for the applicable tax year.¹⁶

In general, net investment income includes three broad categories of income:

1. gross income from certain interest, dividends, annuities (including annuities received from a charitable remainder trust), royalties and rents;
2. gross income derived from a business in which the taxpayer does not materially participate (income from a trade or business that is a passive activity is subject to the NIIT) or from trading in financial instruments or commodities; and
3. net gains attributable to the disposition of property, other than property held in a trade or business not described in (a).

iv Retirement plans

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law on 20 December 2019, making significant changes to retirement planning. With respect to individual retirement accounts (IRAs), the age at which required minimum distributions must start was increased from age 70.5 years to 72 years, and the restriction on making contributions after age 70.5 has been eliminated.¹⁷ Under the SECURE Act, if the original owner of an IRA dies after 31 December 2019, a beneficiary of the inherited IRA who is not an eligible designated beneficiary (i.e., a beneficiary who is not the surviving spouse or a minor child of the original owner, who is not disabled or chronically ill or who is more than 10 years younger than the original owner) must withdraw all the funds in the inherited IRA within 10 years from the original owner’s death, reducing the amount of tax-deferred growth.¹⁸ Before the SECURE Act, beneficiaries of such inherited IRAs could stretch out disbursements over their lifetimes, allowing the funds in such inherited IRAs to grow tax-deferred potentially for decades. Legislative proposals to make additional changes to retirement savings recently have been advanced. However, a detailed discussion of the SECURE Act and potential future changes is beyond the scope of this chapter.

v Investment in non-US corporate entities

US citizens and income tax residents are subject to an anti-deferral tax regime if they invest (directly or indirectly) in non-US companies that are treated as controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs).

CFCs

A foreign corporation is a CFC if, at any time during the tax year, more than 50 per cent of its stock (by vote or value) is held by US persons who directly, indirectly or by attribution hold 10 per cent or more of the voting power or value of the CFC. A CFC owned by a non-US trust is treated as owned by the trust’s respective beneficiaries, or, in the case of a grantor trust, by the trust’s grantor.

The TCJA modified the rules regarding who is considered a US shareholder of a CFC. Prior to the implementation of the TCJA, the rules only looked at voting power (as opposed to voting power or value) to determine if a taxpayer held a 10 per cent interest in the corporation. The TCJA also expanded the ‘downward attribution’ rules that must now be considered in determining whether an entity is owned 50 per cent or more by US taxpayers. These new rules may make ‘accidental’ CFCs more common.

Significant US shareholders (i.e., US shareholders who own 10 per cent or more of the vote or value) of a CFC are required to include in their gross income each year as ordinary income their pro rata share of the CFC’s passive income (generally, dividends, interest, royalties, gains from the sale of certain types of property), regardless of whether such US shareholders actually receive any distributions.

In addition, under the pre-TCJA rules, a CFC had to be considered a CFC for at least a 30-day period for significant US shareholders to be subject to the special tax charge described above. The TCJA eliminated this provision, which has had significant impact on cross-border CFC planning.

The TCJA also introduced the concept of global intangible low-taxed income (GILTI). Very generally, the GILTI regime imposes a 10.5 per cent minimum tax on substantial shareholders of CFCs.

PFICs

A foreign corporation is a PFIC if either 75 per cent or more of the gross income of such corporation for the taxable year is passive income (the income test), or the average percentage of the assets held by such corporation during the taxable year that produces passive income or is held for the production of passive income is at least 50 per cent (the asset test). For this purpose, passive income generally includes interest, dividends, rents and royalties, and similar income and net gains from the sale of property producing such income. For example, an investment in a non-US private equity fund could be treated as an investment in a PFIC.

When US shareholders of a PFIC dispose of their PFIC shares or receive an ‘excess’ distribution¹⁹ from the PFIC, any gain realised and any excess distribution received is treated as ordinary income and apportioned retroactively over the shareholder’s holding period; and an interest charge is imposed with respect to tax payable on any gain attributed to prior years. Importantly, this tax applies even where a US taxpayer holds his or her interest in a PFIC indirectly (e.g., through a US or non-US flow-through entity). For example, stock in a PFIC owned by a non-US non-grantor trust will be considered as owned proportionately by its beneficiaries.

vi Reporting requirements and penalties

This section discusses a few of the US disclosure and reporting requirements that are of particular interest to individuals with both US and international interests, but is not an exhaustive list.

IRS Forms 3520 and 3520-A

A US person (including a US trust) who engages in certain transactions with a foreign trust, including creating a foreign trust (whether or not the trust has US beneficiaries) or transferring money or property, directly or indirectly, to a foreign trust; receiving a distribution (including a loan) of any amount from a non-US grantor or non-grantor trust; or receiving more than US$100,000 in gifts or bequests from a non-US person or a foreign estate or more than a specified amount (in 2022, US$17,339) from foreign corporations or foreign partnerships in any year must report such amounts on IRS Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts).²⁰ Such US person must file a Form 3520 for the year in which any such transfer, distribution, gift or bequest is made by the due date of such person’s federal income tax return for that year, even if the individual is not subject to US income tax on the amount.²¹ An individual who fails to file a required Form 3520 may be subject to very significant penalties.

In addition, the trustee of a foreign trust with a US owner must file Form 3520-A (Annual Information Return of Foreign Trust with a US Owner) for the US owner to satisfy its annual information reporting requirements.

FBAR

If a US person has a financial interest in or signature or other authority over any bank, securities or other type of financial account outside of the United States, and if the aggregate value of all such accounts exceeds US$10,000 at any time during the calendar year, that person must report such interest for such calendar year. Such report is made on FinCEN Form 114 (referred to as an FBAR form) on or before 15 April of the succeeding year, subject to an automatic six-month filing extension. For purposes of the FBAR rules, a US person is considered to have a financial interest in an account where title to the account is held by a grantor trust and such US person is the grantor of such trust. A US person is also deemed to have a financial interest in an account owned by a trust in which such US person has a present beneficial interest in more than 50 per cent of the assets or current income of the trust. Such beneficiary is, however, not required to report the trust’s foreign financial accounts on an FBAR form if the trust, trustee of the trust or agent of the trust is a US person and files an FBAR disclosing the trust’s foreign financial accounts.

A beneficiary of a discretionary trust generally should not be considered as having a financial interest in such trust requiring an FBAR filing merely because of such person’s status as a discretionary beneficiary.

FATCA

FATCA helped accelerate the global drive towards greater transparency and scrutiny of offshore assets. Under FATCA, enacted in 2010 as part of the Hiring Incentives to Restore Employment Act, foreign financial institutions (FFIs) are required to either enter into an agreement with the IRS under which they agree to report to the IRS certain details about their accounts directly or indirectly held by US persons (US accounts)²² or become deemed compliant under the regulations. Non-financial foreign entities (NFFEs) that are publicly traded or engaged in active trading are not required to enter into or comply with an FFI agreement. However, FATCA does require certain passive NFFEs (generally, NFFEs earning mostly passive income that are not publicly traded) to report to withholding agents and participating FFIs with which the NFFE holds accounts, information on their substantial US owners (described in footnote 22), or to certify annually that they have no substantial US owners.²³ Because the United States does not have direct jurisdiction over most FFIs, FATCA compels compliance by imposing a 30 per cent withholding tax on US-sourced income and proceeds from the sale of US property on FFIs that do not agree to provide the IRS with the required information.²⁴

The definition of an FFI is broad, including any entity that accepts deposits in the ordinary course of a banking or similar business, holds financial assets for the account of others as a substantial part of its business or is engaged primarily in the business of investing, reinvesting or trading in securities, partnership interests, commodities or any interests therein,²⁵ and would include most investment vehicles unless a specific exception applies. Under this definition, foreign trusts with corporate trustees acting for different customers (including, in most cases, a private trust company that retains outside investment advisers or receives fees for its services) will be FFIs if, in general, 50 per cent or more of the trust’s gross income is attributable to investing in financial assets.²⁶ A foreign trust that is not an FFI (for instance, a trust managed by an individual trustee) will generally be an NFFE.

Since the implementation of FATCA began, the Treasury Department has entered into many intergovernmental agreements (IGAs) to facilitate the implementation of FATCA. The purpose of IGAs is to remove domestic legal impediments to compliance with FATCA requirements and to reduce burdens on FFIs located in jurisdictions that enter into IGAs (partner jurisdictions).

Despite early opposition to FATCA in many cases, FATCA has expanded and become increasingly accepted in the international sphere, with partner jurisdictions entering into bilateral IGAs whereby they agree to provide information to the United States in exchange for an agreement from the United States to provide such partner jurisdiction with FATCA-like information regarding financial accounts held by the citizens of such partner jurisdiction in the United States.

Form 8938

In addition to the reporting and withholding requirements discussed above, FATCA also requires certain individual taxpayers, including US citizens or green card holders permanently residing abroad, with interests in certain foreign financial assets with an aggregate value greater than US$50,000 on the last day of the tax year, or greater than US$75,000 at any time during the tax year, to file Form 8938 (Statement of Specified Foreign Financial Assets), reporting the interest with such individual’s federal income tax return. The obligation to file Form 8938 is in addition to, not in replacement of, any filing obligation such individual may have under the FBAR rules. Whether a US person beneficiary of a discretionary non-US trust will be required to report his or her interest in the trust on a Form 8938 will depend on many factors, including whether such individual received a distribution from the trust in a given tax year and the value of the individual’s interest in other foreign financial assets.

Form 5472

Generally, except in the case of corporations (or entities that elect to be treated as corporations), a US entity that has a single owner is disregarded as separate from its owner. However, in late 2016, the IRS finalised regulations that treat a US disregarded entity wholly owned, directly or indirectly, by a non-resident alien as a domestic corporation separate from its owner for Internal Revenue Code Section 6038A disclosure purposes.²⁷ Such entities are now required to make additional disclosures when participating in certain transactions.

Under the current rule, these entities must file IRS Form 5472 (which requires an employer identification number) when reportable transactions occur during the tax year and must maintain records of reportable transactions involving the entities’ non-resident alien owners or other foreign parties. The regulation classifies transactions such as any sale, lease or other transfer of any interest in or a right to use any property as reportable transactions. To acquire an employer identification number, the owner may have to obtain an individual taxpayer identification number (as they also would when buying property individually), which many non-resident aliens hope to avoid. These disclosure rules are particularly relevant for non-resident aliens who wish to purchase real estate through a disregarded entity for privacy reasons.

Non-resident aliens should also be aware of a revised FinCEN GTO that requires the disclosure by the title company involved in the transaction of identifying information on a FinCEN Currency Transaction Report, filed within 30 days of a qualifying transaction.²⁸ The GTO’s disclosure requirements are applicable to all residential real estate purchases by certain legal entities that are paid for, in whole or in part, by cash, cheque, money order, funds transfer or virtual currency (and without a bank loan or other similar form of financing) of US$50,000 or more in the city or county of Baltimore in Maryland or of US$300,000 or more in:

1. Bexar, Tarrant, Dallas, Harris, Montgomery or Webb counties in Texas;
2. Miami-Dade, Broward or Palm Beach counties in Florida;
3. the boroughs of Brooklyn, Queens, Bronx, Staten Island or Manhattan in New York City, New York;
4. San Diego, Los Angeles, San Francisco, San Mateo or Santa Clara counties in California;
5. Hawaii, Maui, Kauai or Honolulu counties, or the city of Honolulu in Hawaii;
6. Clark county in Nevada;
7. King county in Washington;
8. Suffolk or Middlesex counties in Massachusetts;
9. Cook county in Illinois;
10. Montgomery, Anne Arundel, Prince George’s or Howard counties in Maryland;
11. Arlington or Fairfax counties, or the cities of Alexandria, Falls Church or Fairfax in Virginia;
12. Fairfield or Litchfield counties in Connecticut;
13. Adams, Arapahoe, Clear Creek, Denver, Douglas, Eagle, Elbert, El Paso, Fremont, Jefferson, Mesa, Pitkin, Pueblo or Summit counties in Colorado; and
14. the District of Columbia.

A currency transaction report must include information about the identity of the purchaser, the purchaser’s representative and the beneficial owners, as well as information about the transaction itself, including the closing date, payment amount, payment method, purchase price and address of the real property involved in the transaction. In addition, the form requires disclosures about the entity used to purchase the property, including the names, addresses and taxpayer identification numbers for all members. The reporter must obtain copies of driver’s licences, passports or similar documents from the purchaser, the purchaser’s representative and the beneficial owners.²⁹

The purpose of the GTO is to provide law enforcement with data to improve efforts to address money laundering in the real estate sector. The GTO is a temporary measure that is effective for only 180 days, but has been extended several times, and the most recent extension will expire on 21 October 2023.

Form 5471

Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations, must be filed by, among others, US persons who own or acquire certain interests in foreign corporations, including CFCs.

Form 8621

A US shareholder who directly or indirectly owns shares in a PFIC at any time during such person’s taxable year must file a Form 8621. The filing requirement is imposed on the first US person in the chain of ownership (i.e., the lowest-tier US person) that is a PFIC shareholder (including an indirect shareholder).