U.S. traders move abroad; others make international investments and non-resident aliens invest in the U.S. How are their taxes handled?
- U.S. resident traders living abroad
- U.S. resident traders with international brokerage accounts
- Report of foreign bank and financial accounts
- IRS Offshore Voluntary Disclosure Program
- Foreign retirement plan elections and reporting
- Foreign assets reported on Form 8938
- U.S. traders move to Puerto Rico to escape capital gains taxes
- Renouncing U.S. citizenship or surrendering a green card
- Non-resident aliens are opening U.S. brokerage accounts, and
- Foreign partners in a U.S. trading partnership can be tax-free
U.S. resident traders living abroad
U.S. tax residents are liable for federal tax on worldwide income whether they live in the U.S. or a foreign country. If you qualify for “bonafide” or “physical residence” abroad, which is living abroad for an entire tax year, try to arrange Section 911 “foreign earned income” benefits on Form 2555. Avoid double taxation by paying tax in both a foreign country and the U.S. by availing yourself of foreign tax credits reported on Form 1116. If you live in a country which charges higher taxes than the U.S., sometimes it makes sense to skip the Section 911 exclusion and use just the foreign tax credit.
The Section 911 exclusion on foreign earned income is $101,300 for 2016, an amount the IRS raises each year. There is also a housing allowance along with maximum amount (cap) per location. The problem for traders is that capital gains and trading gains are not “foreign earned income” so they are unable to utilize Section 911 benefits. There is a solution: Traders with trader tax status (TTS) can form a Delaware S-Corp to pay officer compensation, and that compensation is foreign earned income. U.S.-based traders with TTS use an S-Corp to create “earned income” to unlock health insurance and retirement plan deductions. Add the foreign earned income exclusion and housing allowance to that list. Before committing to the S-Corp solution, compare expected net income tax savings, minus payroll tax costs vs. using a foreign tax credit.
The U.S. has tax treaties with many countries, and these agreements specify which country is entitled to collect tax on different types of items, like retirement plan distributions. Cite a tax treaty provision to override a regular tax on Form 8833. It’s important to note that tax treaty provisions are used to reduce tax liability; the IRS may not use them to increase a tax.
U.S. resident traders with international brokerage accounts
Many traders living in the U.S. have a foreign brokerage account. It’s complicated when traders open these accounts held in a foreign currency. Counterparties outside the U.S. do not issue Form 1099-B, and accounting is a challenge. Traders should separate capital gains and losses, including currency appreciation or depreciation, from changes in currency values on cash balances, which are Section 988 ordinary gain or loss.
Some foreign brokers encourage traders to form foreign entities as a requirement to get access or to set up an account. Look before you leap: Tax compliance for an international entity is significant, and there are few to no tax advantages for traders. International tax compliance is very complex, and there’s a risk of messing up tax reporting. It’s very rare to achieve material deferral on foreign income, and there are plenty of tax penalties for non-compliance. But all this being said, there are plenty of good reasons to trade foreign markets. Just get the right advice beforehand and make sure the reason to do so is compelling.
Report of foreign bank and financial accounts
U.S. residents with a foreign bank, brokerage, investment and another type of account (including retirement and insurance in some cases) who meet reporting requirements must e-file FinCEN Form 114, Report of Foreign Bank and Financial Account (known previously as Foreign Bank Account Reports or “FBAR”). If your foreign bank and financial institution accounts combined are under $10,000 for the entire tax year, you fall under the threshold for filing FinCEN Form 114.
Filing due date changed: A new law enacted on July 31, 2015, changed the due date from June 30 to April 15 starting with 2016 filings in 2017. Congress added an automatic extension for six months to Oct. 15 to coordinate FinCEN Form 114 with individual income tax returns.
In recent years, we have learned that many taxpayers omitted foreign bank account reports when they should have filed them. Many taxpayers just didn’t realize it. Some had financial interests in family accounts offshore if they were foreign nationals before moving to the U.S. Or some taxpayers married a foreign person gaining that financial interest. Others may have international retirement or insurance accounts that they never realized were subject to FBAR reporting.
The FBAR rule states “a financial interest in, signature authority or other authority over foreign financial accounts.” Traders and executives of hedge funds and other financial institutions and trustees typically have signature authority or other authority over foreign financial accounts triggering FBAR filings for them.
Most taxpayers owning foreign accounts reported their foreign income and were not trying to cheat the IRS by hiding it offshore. Because they reported foreign income correctly, many are allowed to file a late FBAR and avoid penalties. Otherwise, there is a highly complex and nuanced penalty regime in connection with late or incorrect FBAR filings.
IRS Offshore Voluntary Disclosure Program
Consider entering the IRS Offshore Voluntary Disclosure Program (OVDP), which has been extended to encourage taxpayers to come clean before getting busted by the IRS. The OVDP penalties are high (though there are exceptions). It’s not amnesty by any means and it’s an expensive undertaking with tax attorneys and accountants. But if you wait to get busted by the IRS, your foreign bank or anyone else, the penalties are far higher. Criminal penalties may apply too unless you join the program first. The current OVDP program has no end date, but the IRS has explicitly stated it may revoke it at any time. On July 1, 2014, the IRS created a “streamlined” program for those taxpayers who were negligent in not filing FBARs (but did not do so on purpose). U.S. resident taxpayers pay just a 5% penalty with this streamlined program.
While OVDP is a good plan for some (such as tax cheats in serious potential trouble), it’s often not appropriate for those discussed earlier who reported their income but just missed an FBAR filing.
It’s wise for American taxpayers to turn themselves in before getting busted. It can make a significant difference in treatment and penalties.
Foreign retirement plan elections and reporting
Don’t assume international retirement plans are like U.S. pension plans with tax deferral on income until you take taxable distributions. For U.S. tax purposes, the IRS considers many international retirement plans taxable investment accounts because they aren’t structured as qualified plans under Section 401 unless they qualify under Section 402(b) as an employees’ trust established by an employer. While that seems unfair and counterintuitive to many, it’s the rule, and it catches many unsuspecting taxpayers and accountants off guard. To the extent that Section 402(b) does not apply, you may have to pay a high Passive Foreign Investment Company (PFIC) tax. Include these retirement plans on the annual FinCEN Form 114 each year, whether or not the plan has deferral.
In October 2014, the IRS acknowledged the tax-deferral problem on Canadian retirement plans and provided assistance. In Revenue Procedure 2014-55, the IRS repealed the need for filing a tax election, which means Canadian retirement plans automatically qualify for tax deferral. These rules are retroactive, so it abates back taxes, interest, and penalties. It’s no longer needed to file Form 8891 (U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans). This relief does not apply to international retirement plans outside of Canada.
Foreign assets reported on Form 8938
Tax Form 8938 is more about giving the IRS a heads up regarding your international assets. It’s not about reporting income and loss — there are other tax forms for that. The filing threshold for Form 8938 is materially higher than the FBAR threshold, and it’s even higher for Americans living out of the country. (See Form 8938 instructions.)
U.S. traders move to Puerto Rico to escape capital gains taxes
Puerto Rico (PR) is not a state or foreign country; it’s a “possession” with a government and tax system (Hacienda). Residents of PR report particular types of income to Hacienda and other forms of revenue to the IRS. Trading gains are capital gains on “personal property” taxed where the seller’s tax home is.
PR enacted tax incentive acts that are tailor-made for traders/investors, investment managers, and financial institutions. Passed in 2012, PR Act 22 allows investors and traders with bona fide residence in Puerto Rico to exclude from PR and U.S. taxes under Section 933 100% of all short-term and long-term capital gains from the sale of personal property accrued after moving there. Personal property includes stocks, bonds, and other financial products. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can be made with a U.S. broker or on any exchange around the world. This capital gain tax break applies to professional traders using the default realization method, or Section 475 MTM.
There is a different PR tax incentive act for investment managers, who charge advisory fees. They sell their services to investors outside of PR and hence they can qualify for PR Act 20 tax incentives for “export service businesses.” The Act 20 tax incentive is a 4% flat tax rate on net business income. The owner also receives Act 22 100% exclusion on dividends received from the PR business entity, and exclusion from U.S. tax, since Section 933 excludes PR-sourced dividends.
On Nov. 30, 2015, PR enacted Act 187-2015 amending Acts 22 and 20 to stiffen the requirements. For Act 22 incentives, PR requires new applicants after Dec. 1, 2015, to purchase residential property in PR within two years and open a deposit account. For Act 20 incentives, PR requires gradually hiring five full-time employees in PR.
These PR tax benefits are not easy to arrange. Moreover, the political and economic conditions are uncertain, to say the least. Traders and investment managers need to move their family and operations to PR to get these tax breaks while they retain the benefit of U.S. citizenship with a passport.
Renouncing U.S. citizenship or surrendering a green card
Some countries have much lower tax rates than the U.S. and a few countries exempt capital gains from tax. Increasingly, traders, investment managers, and other taxpayers are surrendering their U.S. resident status (citizenship or green card), which requires potentially paying a Section 877A expatriation tax. The expatriation tax only applies to “covered expatriates” who have a net worth of $2 million or 5-year average income tax liability exceeding $139,000. The IRS assesses the expatriation tax on unrealized capital gains on all assets — fair market value less cost-basis including debt — on the expatriation date. Only the net amount over $600,000 is taxable. Deferred compensation and IRAs are included and taxable, too.
While the expatriation tax is likely to take a big tax bite out of the wealthy, it won’t apply to the majority of online traders who may not have significant unrealized net gains and who are not covered expatriates. There are other tax issues to consider including U.S. real property and estate planning in connection with beneficiaries residing in the U.S. Learn more about the expatriation tax on IRS Form 8854. There’s an election to defer tax, and regular income tax rates apply.
Non-resident aliens are opening U.S. brokerage accounts
Non-resident aliens are subject to tax withholding on dividends, certain interest income and sales of master limited partnerships like energy companies. They have U.S. source income — effectively connected income (ECI) — on real property and regular business operations located in the U.S.
A non-resident alien living abroad can open a U.S.-based forex or futures trading account and not owe any capital gains taxes in the U.S. U.S. tax law has long encouraged foreign taxpayers to invest and trade in U.S. financial markets. Caveat: the exclusion does not benefit dealers. A non-resident alien living abroad can also open a U.S.-based securities account, but there could be some dividend tax withholding. If the non-resident spends more than 183 days in the U.S., he owes taxes on net U.S. source capital gains, even though he may not trigger U.S. residency under the substantial presence test. (U.S. residency is triggered with legal residence status or by meeting the substantial presence test.) There are exemptions from the 183-day capital gains tax rules for employees of foreign governments living in the U.S. and special rules for students temporarily in a school in the U.S. The non-resident alien doesn’t need a U.S. tax identification number and isn’t required to file a U.S. non-resident tax return, Form 1040NR. As a non-resident alien individual, fill out W-8BEN and furnish it to the broker.
Some U.S. brokerage firms ask non-resident aliens to establish a U.S. entity for opening a U.S.-based brokerage account. Often, the non-resident alien chooses a single-member LLC (SMLLC) formed in Delaware, and it files a W-8BEN-E with the broker. As a disregarded entity, the SMLLC activity is part of the individual’s activity, which is not U.S.-source income on trading income. Many non-resident aliens run into obstacles when trying to repatriate money to their home country, as the broker may not permit international payments. These non-resident aliens also have trouble establishing U.S. bank accounts for the entity without a U.S. presence or address.
Foreign partners in a U.S. trading partnership can be tax-free
If the non-resident is a member of a U.S.-based “pass through” taxable entity — such as a hedge fund or proprietary trading firm — that person is still exempt from effectively connected income. Typically, foreign partners in U.S. partnerships are considered to have U.S. ECI on their Schedule K-1 income. But if the partnership is a trading company — in financial markets, not goods — the income is considered portfolio income, including the partner’s share. Typically, U.S. partnerships withhold taxes on foreign partners, but that is not required if the foreign partner only has portfolio income not subject to U.S. tax. It gets more complicated with dividends in the partnership since dividends tax isn’t withheld for the share owned by the foreign partner.
International tax matters are complicated and often involve tax planning between the U.S. and one or more foreign countries or possessions. There are significant international opportunities for income and tax savings, but many pitfalls and compliance rules, too. Don’t try to cheat on your taxes by hiding assets and income offshore; the IRS has extensive operations around the world to bust tax cheats. Engage tax attorneys and CPAs with extensive international experience, so it works out well.
GNMTraderTax attorneys Mark Feldman and Roger Lorence, and CPA Deborah King contributed to this content.
This content is an updated version of International Tax Matters in “Green’s 2016 Trader Tax Guide.”
Webinar/Recording: If You Trade Around The World, You Need To Know IRS Rules.