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Tax Efficient Pre-Immigration Planning Takes Time by Magda Szabo, CPA, JD, LLM

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Posted on January 10, 2023 by Magda Szabo

The United States continues to be a destination for foreign citizens to invest their assets, conduct business and, in many cases, make their permanent home. Those individuals seeking U.S. residency often find the path to citizenship lined with a wealth of opportunities, a broad range of new responsibilities and costly liabilities, including U.S. income tax, estate tax and gift tax. In many situations, the best solution for preserving wealth and minimizing exposure to U.S. taxes is to engage in pre-immigration planning under the guidance of professional advisors before setting foot on U.S. soil, investing in U.S. assets or opening a business in the U.S.

Understanding U.S. Resident Tax Status 

An individual’s immigration status in the U.S. differs from his or her tax status. In most situations, once you obtain a green card or meet the “substantial presence” test, the U.S. considers you to be a resident alien (RA) or income tax resident who must report and pay taxes on your worldwide income and disclose certain offshore assets, just like U.S. citizens. Before that point, you may be considered a nonresident alien (NRA), who is responsible for paying U.S. tax only on income you derive from U.S. sources.

Unlike the bright-line statutory tests for determining residency status for U.S. income tax purposes, exposure to U.S. estate and gift tax on global assets is less clearly defined. Here, the key consideration is domicile, which is determined by an individual’s unique facts and circumstances. For individuals who are not domiciled, transfer of statutorily defined U.S.-situs property by gift or on death will trigger, as applicable, U.S. estate or gift taxes.[1] Hence, planning for the structure of ownership for U.S. situs assets prior to asset acquisition is critical to minimize exposure for both income or estate and gift taxation.

Planning Opportunities 

It is important to recognize that the U.S. can consider you a U.S. income tax resident subject to U.S. income tax laws, but not necessarily a domiciliary subject to U.S. gift and estate taxes, or vice versa. Under both circumstances, advance planning is critical for reducing your U.S. tax liabilities.

Entity Classification Elections 

The U.S. has a number of anti-deferral rules. Some of these rules apply to entities deemed controlled foreign corporations (CFCs), some are more focused on individuals (i.e., trust accumulation distributions) and some, such as passive foreign investment companies (PFICs), apply to both.

The CFC rules can give rise to double taxation of corporate income to individuals meeting certain ownership criteria for income taxed below certain thresholds or certain types of income (i.e., Subpart F income or global intangible low-taxed income (GILTI)).  U.S. tax rules uniquely allow for entity classification elections that can avoid such issues or mitigate such tax exposure. The optimal time to restructure holdings without triggering adverse U.S. income tax consequences is generally prior to the commencement of tax residency or domicile for eligible entities.

Entity classification elections also allow for a passthrough of tax credits that entities can claim against U.S. taxes for such offshore or foreign-sourced income. If the entity is in a higher tax jurisdiction, for example, this could eliminate any additional U.S. federal taxes on the income as well as eliminate any additional taxes on cash distributions from the entity.

Tax Credits and Sourcing  

Currently, the U.S. has income tax treaties with approximately 70 countries. These agreements are beneficial in a number of ways. For example, they can help determine from where income is sourced (i.e., which country is given the right to tax first) and they can provide reduced withholding rates (payments to nonresidents) for items of income such as dividends, interest and royalties.

A significant issue can exist when assets are sold, or income is realized, and a treaty does not create uniformity in terms of which country has the right to tax or source the income first.  For example, let’s assume a non-treaty country views capital gains on the sale of certain stock as sourced by that country. The U.S., by default, views such gains as taxable based on residency. Therefore, if the owner is a U.S. resident and the non-treaty country taxes those gains, the owner is left with a mismatch of income associated with the taxes paid, which may result in the taxpayer’s inability to claim any tax credit on the transaction. To avoid such issues, an appropriate structure for asset holdings should be put into place prior to immigration.

Accelerate or Defer Income and Gains 

Foreign-source income is not subject to U.S. income tax before individuals gain resident alien status. If U.S. applicable income tax rates are lower, or the transaction is not viewed as taxable, future immigrants can look to realize income and gains that would otherwise be taxable in the U.S. prior to becoming U.S. tax residents. Alternatively, if holdings have built-in losses and U.S. tax rates are higher, future immigrants may consider postponing harvesting those losses until after becoming U.S. tax residents.

Gift Assets and Restructure Estate Plans 

Estate tax exposure for future immigrants can easily be achieved by reducing the value of their taxable estate before arriving in the U.S. This can potentially be accomplished by gifting property, including stock, intangible property rights, entity interests, jewelry, art or homes, to family members prior to immigration and creating a trust or other tax-efficient vehicle to hold those assets outside the purview of the U.S. tax system.

However, with many of these estate-tax planning strategies, special care should be taken to avoid certain traps contained in the U.S. tax code. For example, if you created a trust within five years of your immigration, the U.S. may view those assets as taxable to the grantor. While the use of the trust will remove assets outside the grantor’s taxable estate, the trust will remain subject to income tax to the grantor for his or her life.

Separately, a “throwback rule” triggers additional tax assessments as to prior year undistributed net income for U.S. beneficiaries for foreign nongrantor trusts. For beneficiaries of offshore trusts, consideration can be given to distributing accumulated income in the trust prior to immigration; restructuring trusts or migrating trusts in appropriate circumstances to avoid the issue.

When developing strategies around pre-immigration, it is also important to consider the practical implications of your decisions. For example, gifting assets away and losing control over certain investments need to be evaluated irrespective of their tax benefits.  Through appropriate planning, including establishing goals and objectives and aligning them with the tax system, individuals may identify a more tax-efficient manner to accomplish their stated aims. As can also be seen from the foregoing, determinations and planning are very fact-sensitive and include issues such as the type of asset held, manner of holding, personal goals, and country with tax jurisdiction. For these reasons, as with all U.S. tax planning, individuals should meet with experienced advisors and accountants to weigh the pros and cons of each potential tax savings strategy.

Immigrating to the United States is an endeavor that individuals must undertake only with the benefit of experienced legal and tax counsel.  In addition, attention should be paid to allow ample time for clients and their counselors to address a complete range of tax-planning strategies and their consequences, including those related to business entities, insurance policies and retirement plans.  The usual approach for immigrants to focus on obtaining visas first and then seek tax advice once stateside could result in severe tax ramifications.  The preferable strategy is for these individuals to put tax planning ahead of immigration.

About the Author:  Magda Szabo, CPA, JD, LLM, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where she provides international and domestic tax and wealth planning for public and private businesses, high-net-worth individuals, trusts and nonprofits. She can be reached at the CPA firm’s New York office at (646) 213-7600 or info@bpbcpa.com.

[1] It should be noted that NRA-held property that is subject to US transfer tax rules (estate or gift) will also vary if the property is a gift vs if the property is transferred on death.  For example, corporate stock can generally be gifted and not subject to U.S. gift tax. It is, however, subject to estate tax.  (One significant exception to this rule is if the majority of assets in a corporation are real estate. In such instances, certain withholding rules are triggered on transfer and hence such transfers cannot be freely gifted generally.)