The U.S. stock markets have been stellar, and many non-U.S. persons have been accessing them from their home country. Other foreign individuals and entities prefer to open U.S.-based brokerage accounts for lower commissions, and better trading platforms.
In either case, the foreign individual or foreign company is subject to U.S. tax withholding on U.S. dividends and certain other U.S. passive income. The default withholding tax rate is 30%, and income tax treaties provide for lower rates, usually around 15% or less. U.S. brokers handle this tax withholding and pay those taxes to the Internal Revenue Service (IRS). The foreign investor does not have an obligation for U.S. tax compliance if withholding is done correctly.
The critical point is that capital gains are not taxable in the U.S. if the nonresident alien does not spend more than 183 days per year in the U.S. Most active traders don’t generate significant dividend income paid by U.S. companies, so tax withholding is not a problem. Many of them get a foreign tax credit for U.S. tax withholding in their resident country.
Some nonresident aliens establish a spousal-member LLC in the U.S. and file a U.S. partnership tax return. The LLC/partnership opens a U.S.-based brokerage account as a domestic entity. The LLC files a W-9 with a U.S. tax identification number. The broker treats the U.S. LLC/partnership as a U.S. account, which means the broker does not handle the tax withholding on dividends and other passive income for the foreign owners of the LLC.
Therefore, the nonresident alien owners must file a W-8BEN with the U.S. partnership. The U.S. partnership assumes responsibility for tax withholding on dividends and other portfolio income, and payment of those taxes to the IRS on a timely basis. It’s extra tax compliance work, but it’s not too complicated.
U.S. estate tax might come into play. Estate tax treaties may exempt brokerage accounts for nonresident aliens or provide higher exemptions from the tax. U.S. partnership interests are likely not includible in an estate for a nonresident alien. Brokers are not responsible for estate tax compliance, so it’s a tax matter for nonresident aliens and their tax advisors. Brokers require a conclusion of IRS estate proceedings before releasing assets from the account of the deceased.
Nonresident alien U.S. income tax treatment
In this scenario, nonresident aliens are subject to U.S. tax withholding on dividends paid by U.S. companies and on other “fixed or determinable, annual, or periodic” (FDAP) income. Per IRS Taxation of Nonresident Aliens: “FDAP income is passive income such as interest, dividends, rents or royalties. This income is taxed at a flat 30% rate unless a tax treaty specifies a lower rate.” Many countries have a tax treaty with the U.S. providing for 15% or lower withholding tax rate on FDAP income. Interest income on bonds and commercial paper issued by U.S. companies, by the U.S. Treasury, and by U.S. government agencies is generally exempt from U.S. tax withholding, although it’s reportable on Form 1042-S.
Nonresident alien individuals fill out W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting – Individuals) and furnish it to the broker. Don’t overlook Part II to claim tax treaty benefits. The broker then withholds taxes on U.S.-source dividends and other FDAP income at the appropriate tax treaty rates, or 30% if there is no tax treaty, and pays those taxes to the IRS directly. As a withholding agent, the broker is required to report all U.S.-source FDAP to the IRS and the client on Form 1042-S. There are other types of W-8 forms including W–8BEN–E (entities), W–8ECI (ECI from U.S. business), W–8EXP (foreign government or organization), and W–8IMY (foreign intermediary or branch).
Capital gains 183-day rule
If the nonresident alien 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. The IRS taxes U.S. residents on worldwide income.)
“Nonresident alien students and scholars and alien employees of foreign governments and international organizations who, at the time of their arrival in the United States, intend to reside in the United States for longer than 1 year are subject to the 30 percent taxation on their capital gains during any tax year (usually calendar year) in which they are present in the United States for 183 days or more, unless a tax treaty provides for a lesser rate of taxation. These capital gains would be reported on page 4 (not page 1) of Form 1040NR and would not be reported on a Schedule D because they are being taxed at a flat rate of 30 percent or at a reduced flat rate under a tax treaty.”
Income tax treaties
Per IRS Taxation of Nonresident Aliens:
“The United States has income tax treaties with a number of foreign countries. For nonresident aliens, these treaties can often reduce or eliminate U.S. tax on various types of personal services and other income, such as pensions, interest, dividends, royalties, and capital gains. Each individual treaty must be reviewed to determine whether specific types of income are exempt from U.S. tax or taxed at a reduced rate. More details can be found in IRS Publication 901, U.S. Tax Treaties.”
“Form 8833 does not apply to a reduced rate of withholding tax on noneffectively connected income, such as dividends, interest, rents or royalties.”
A nonresident alien may owe U.S. estate tax
U.S. estate tax considerations also may come into play in this situation. Nonresident aliens should learn how repatriation of funds work on death; they might have delays due to probate of the estate and getting IRS estate tax clearance. By opening a U.S.-based brokerage account, it lands the account in the U.S., which could potentially trigger U.S. estate taxes if over the estate exemption. While many types of funds like U.S. bonds are exempt from estate tax, U.S. equities are includible in an estate. (Nonresidents holding U.S. securities in a foreign brokerage account must count those U.S. securities in a U.S. estate.) The default estate exemption for nonresident aliens is $60,000; however, many estate tax treaties provide a significantly higher threshold. The estate tax rate starts at 18% and rises to 40%. An estate tax treaty beneficiary may be exempt from U.S. estate tax entirely on U.S. financial assets. (Learn more about nonresident alien accounts income and estate taxation on Schwab’s Website and Schwab’s U.S. Tax, and Estate Disclosure to Non-U.S. Persons.)
Here is an IRS list of Estate & Gift Tax Treaties (International). The U.S.–Canada Income Tax Treaty includes estate tax issues. Canadians have a $2,000,000 estate exemption instead of the default $60,000 threshold.
Some nonresident aliens open a U.S. partnership account
Some U.S. brokers are not set up to accommodate nonresident aliens or other foreign persons including foreign corporations, partnerships, and trusts. They might recommend forming a U.S. LLC entity to open a U.S. entity account instead of a nonresident alien or foreign entity account. This U.S. entity account should be treated like other U.S. persons or entities, not subject to tax withholding on dividends by the broker. The U.S. LLC entity account should receive a Form 1099-B reporting dividends, interest, sale proceeds and cost basis, and other items of income or loss. The LLC files a W-9 with U.S. tax id number, not a W-8BEN-E for foreign entity status.
There are problems using a single-member LLC (SMLLC). Without classification as a partnership or C-Corp, an SMLLC is a disregarded entity. That would mean the SMLLC disregards to the nonresident alien individual, who should then file a W-8BEN-E. Nonresident aliens may not own an S-Corp. If the broker did treat the SMLLC disregarded entity as a domestic entity, the owner would have to file a complicated Form 1040NR in the event there is a U.S. tax liability (i.e., on U.S. dividends).
As stated above, it’s better to have a spousal-member LLC to file a partnership return. The U.S. partnership takes over the role as tax withholding agent from the broker, and the U.S. partnership must issue the Form 1042-S to the nonresident alien owners. Using a company does not avoid withholding taxes on U.S.-source FDAP income for nonresident owners.
“The Chapter 3 withholding regulations on U.S. source payments to foreign persons make clear that there is no U.S. withholding on payments to U.S. persons, which includes a partnership formed under U.S. law,” says tax attorney Roger D. Lorence. “The partnership is the withholding agent, and it is required to withhold on U.S. source dividends allocable to non-U.S. partners (nonresident aliens).” (See IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.)
The Form 1065 U.S. partnership tax return can be reasonably straightforward because all owners are non-resident aliens. The partnership can report zero capital gains and losses but reconcile to the 1099-B for IRS matching purposes. The partnership can omit expenses as they do not affect U.S. income taxes. In the tax return footnotes, the partnership should explain that the nonresident owners do not owe capital gains taxes, because they are in the U.S. under 183 days per year.
Usually, the partnership can allocate dividends and portfolio income to partners on the last day of the year, so tax deposits for withholding can wait until early January of the subsequent year. It’s one accounting period, which reduces the stress of making tax payments on a timely basis to avoid penalties.
There might be challenges to establishing an LLC bank account, and repatriating funds to a foreign country.
“The U.S. partnership is not engaged in a trade or business in the U.S. with effectively connected income (ECI). It’s an investor partnership with FDAP and a Section 864 exemption,” Lorence says. “Although not free from doubt, the better view is that it is not included in a U.S. estate of a nonresident alien owner. Intangible assets like partnership interests are situated where the owner resides and dies. Legal situs is where the owner is located on death.”
Four ways nonresidents trade U.S. financial markets
1. Some foreign-based brokers offer limited access to U.S. financial markets. Even on foreign-based brokerage accounts, there is U.S. tax withholding on dividends paid by U.S. companies and other FDAP income. Foreign brokerage accounts do not issue a Form 1042-S as a U.S.-based broker does for nonresident aliens. There are U.S. estate tax considerations for U.S. securities.
2. Leading U.S. brokers open affiliate brokerage firms in some countries. There may be affiliates in Canada and some European and Asian countries. It’s the same tax treatment as the previous: tax withholding on U.S.-source FDAP income, no 1042-S issuance, and potential U.S. estate tax on U.S. securities.
3. Some U.S. brokers open accounts for nonresident aliens. The nonresident alien files a W-8BEN claiming tax treaty benefits, if applicable. The U.S. broker is an income tax withholding agent on U.S.-source FDAP with a default tax rate of 30% unless overridden by a treaty rate of usually 15% or less. The U.S. broker issues Form 1042-S reporting U.S. source income and withholding tax. There are some U.S. estate tax considerations for the nonresident so check if there is an estate tax treaty with your country, perhaps providing a higher exemption amount or exclusion. Some nonresident aliens form a foreign corporation, partnership or trust to open the brokerage account with a U.S. broker, which helps avoid potential U.S. estate taxation.
4. Some U.S.-based brokers suggest the nonresident alien open a U.S. LLC to create an account and file as a partnership. The broker treats the account like a U.S. person or entity issuing an annual tax report Form 1099-B. The broker does not withhold taxes on dividends paid by U.S. companies or on other U.S.-source FDAP income. The U.S. partnership takes over that role as tax withholding agent and issues the 1042-S to the IRS and nonresident owner of the partnership. There is probably no U.S. estate tax on a U.S. partnership interest in an investment company. There are challenges to establishing an LLC bank account, and repatriating funds to a foreign country. Consult a tax advisor.
Roger D. Lorence, JD contributed to this blog post.