Mixed nationality couples with one US citizen spouse face tough financial decisions come tax time. As their financial advisor, they may be looking to you for guidance when they’re deciding how to file taxes in the most optimal way for their financial situation.
Unfortunately, there’s no one-size-fits-all approach for mixed nationality couples, and the decisions each couple makes depend on various factors.
Below, we cover seven real-world implications of being a US tax resident that financial advisors must consider before advising their mixed nationality clients about tax planning. Among other things, the outcomes of these consequences should be examined before the couple decides how to file their taxes.
The IRS wants to know about all substantial income and assets owned by a US tax resident. This means that any foreign bank accounts owned by a US tax resident with an aggregate balance over $10,000 must be reported to the IRS using the Financial Crime Enforcement Center’s (FinCEN) Form 114, also known as the FBAR. This rule applies to joint accounts held by both spouses, even if the primary owner of the account is the non-US citizen spouse.
However, if the couple elects to file their taxes as married filing jointly, and the non-US citizen is not a lawful permanent resident, is not a resident alien of the US, and has not made a first-year election, that spouse’s individually-held bank accounts are not subject to FBAR reporting.
Similarly, Form 8938 (FATCA) requires US citizens to report certain foreign financial assets according to specified aggregate value thresholds, location of the assets, and tax filing status. Aggregate value thresholds change depending on whether the couple elects to file married filing jointly or married filing separately and where the couple are located. Additionally, couples who choose to file jointly may also subject the non-US citizen spouse to file their own Form 8938.
Passive foreign investment companies (PFICs) are foreign entities in which at least 75% of their income is generated from non-business operations such as investments, or more than 50% (≧50%) of assets produce passive income. US tax residents who own almost any foreign mutual funds or investment companies are subject to a punitive US tax regime on the income and gains from such investments.
The PFIC tax regime seeks to discourage US taxpayers from shifting their income out of the US taxation system, so the default method imposes tax rates starting at the highest marginal tax rate prevailing at the time the investment was held, plus an extra interest charge.
When all is said and done, income earned from PFICs may be taxed at a rate of 50% or above. Furthermore, the IRS assumes that for each PFIC form prepared, the prep time is estimated to be 20 hours or more. The cost of this tax preparation alone may even be more costly than the actual tax liability on the earned income.
This is important for mixed nationality couples to consider because, based on their filing status and the non-US citizen’s plans to apply for citizenship or legal residency, they may want to carefully plan for or altogether avoid investing in PFICs in their resident country.
US citizens are accustomed to enjoying significant tax advantages when contributing to a retirement account in the form of tax deductions and tax-free growth. When contributing to a foreign retirement account, US tax residents typically have to pay taxes on retirement contributions, accruals, and withdrawals from foreign retirement accounts.
Unless cross-border recognition of retirement accounts is definitively realized in an income tax treaty between the US and the couples’ country of residence (which is not common), US tax residents need to consider the tax impact of foreign retirement plans.
Couples who elect to file their taxes jointly should examine how this election will impact the non-US citizen spouse’s plans to both save for retirement and withdraw from their retirement accounts after they’ve retired. Additionally, couples should carefully consider which country they plan to primarily reside in during retirement when choosing whether to invest in the US or in their country of residence.
Net investment income tax (NIIT) is a flat 3.8% tax on investment income for US taxpayers whose income exceeds a threshold determined by their filing status. The threshold for single taxpayers is $200,000, while the threshold for taxpayers filing jointly is $250,000 and $125,000 for taxpayers filing separately.
Net investment income tax applies to all investment income regardless of the source. It cannot be offset by foreign tax credits. For those affected, this is a clear case of double taxation. As of the time of writing, it is yet unclear per the Joint Committee on Taxation or the Treasury whether NIIT is a social security tax or an income tax. Depending on what type of tax NIIT is ruled to be, expats may be able to avoid the tax in the future.
The sourcing of trust income is determined based on the type of income earned by the trust. If the trust is a US grantor trust, it is disregarded for US income tax purposes and the income is attributed directly to the trust grantor (owner).
Non-grantor trust income, on the other hand, is generally not taxed in the US unless the source of income is from the US. Of course, US beneficiaries of a foreign trust must report their share of foreign trust income over a certain threshold, regardless of whether they are the beneficiary of a grantor or non-grantor trust.
Expatriates (expats) who own a business outside of the U.S. must consider Controlled Foreign Corporation (CFC) rules. A company is considered a CFC if it meets the following requirements:
If those three requirements are met, the structure of the business has consequences for tax filing purposes. Business bank accounts are also subject to the FinCEN Form 114 (FBAR) described above. Mixed nationality couples who are also business owners will need to familiarize themselves with the tax obligations for their business revenue.
The Heroes Earnings Assistance and Relief Tax (HEART) Act that was passed in 2008 provided new rules regarding the exit tax for “covered expatriates” who leave the US global tax net (IRC §877). These tax obligations were meant to prevent wealthy US citizens and green card holders from accruing significant wealth and then renouncing their citizenship to avoid paying taxes.
Covered expatriates are, generally speaking, US citizens or green card holders who meet a particular net worth threshold or tax liability threshold. Covered expatriates also include those who cannot prove total IRS compliance within the previous five years when choosing to renounce their US citizenship or legal residency status.
This is important for mixed nationality couples if they are considering applying for a green card for the non-US spouse. If the non-US spouse ever decides to voluntarily give up their green card status, or if the green card is revoked for any reason, tax implications mandated by the HEART Act may be triggered on that person’s entire portfolio of income and assets.
At the Global Financial Planning Institute, we understand you and your clients face complex challenges in navigating the US tax system and making appropriate plans and decisions for the future. And you may not always know who to turn to for advice and guidance when you have questions about your clients’ specific situations.
Our mission is to empower more financial advisors with the education and resources they need to best serve cross-border communities. To learn more about the GFP Institute and see how we can support your practice, visit www.gfp.institute or simply click here to create your free membership account.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
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