How To: Income Tax

Once more we would like to try explaining to you the complex tax system of the US with all its complicated details. We will do this in two parts, one in this issue and one in the next. Ms Ines Voigt from Berlin was so kind as to help us with this. She has been a US tax counselor for years.

Preface Are you holding a green card or are you a US citizen? Do you live and work in the US with a visa? And if you don't live and work in the US - do you have passive income in the US from interest, dividends, rent and lease? Are you living in the US as a pensioner? In these cases you will probably have to file a tax return in the US. It may be possible that you have to pay taxes in the US or are entitled to a tax refund, but don't know anything about this.

Introduction In the US, natural persons are subject to the Federal Income Tax (raised by the federal government) and to the State Income Tax (raised by the respective state). In some states, also the communities are raising a local tax. For each tax, separate tax returns must be filed. State Income Taxes and Local Income Taxes are paid to the appropriate authorities in the respective state or community. The tax rates vary, depending on the state and the height of the taxable income, between 0.36% and 11%.

Some states do not have a State Income Tax. The assessment basis of the Federal Tax is also relevant for taxation in the states and communities, there are some significant deviations, however. Therefore, this article will only be dealing with the basics of the Federal Tax system.

Tax liability US tax law differentiates between limited and unlimited tax liability.

1. Unlimited tax liability Unlimited tax liability applies to US citizens and resident aliens, irrespective of their actual permanent or usual residence. Resident aliens include foreigners holding a green card as well as foreigners who have passed the so-called Physical Presence Test.

As a simplified rule, it could be summarized like this: anyone who has spent more than 183 days of the current year in the US has passed the Physical Presence Test and is thus unlimitedly liable to pay taxes in the US. Anyone who has spent less than 183 days of the current year in the US should make a calculation according to the above mentioned formula. All persons who fall under the unlimited tax liability will have to pay taxes on their worldwide income in the US.

2. Limited tax liability Limited tax liability applies to natural persons who are not subject to unlimited tax liability in the US (nonresident aliens) with their income from US sources. Tax law differentiates between recurring income from US sources and effectively connected income in the US. The recurring income from the US sources are basically returns on interest and dividends from a US joint-stock company, as far as it is utilized in the US and is not part of a commercial activity. Taxes are automatically deducted from the recurring income, so that taxes are already taken care of. No separate tax return has to be filed in this case. The tax deduction is usually 30%, unless it is reduced due to a Double Taxation Agreement (DTA).

For Effectively Connected Income (ECI) you have to file a tax return. The ECI includes income made in the US with the intent to realize a profit and a not insignificant activity over a certain period of time. This include income form self-employed activities. According to the double taxation agreements, effectively connected income will only be subject to taxation in the US in case there is a fixed place of business or investment in the US. Income from self-employed work is treated similarly according to the double taxation agreement. Taxes will only be raised in case this income can be attributed to a fixed place of business in the US.

The latest news In 2003 the "Jobs and Growth Tax Relief Reconciliation Act of 2003," a bundle of tax cuts, was passed under President Bush. This mostly applies to: the top tax rates being cut from formerly 38.6% to 35%, a new reduced tax rate for certain dividend yields from a maximum of 38.6% to 15%, raised flat rates and reduced tax rates on capital gain and a raised "child tax credit" from $600 to $1,000. All information in this article has been compiled according to the new regulations. Please keep in mind that many of those tax relieves will become ineffective again in the following years and the old regulations will take effect again.

Calculation of income tax US income tax law doesn't know any differentiation according to the type of income. Furthermore, you have to do a self-assessment. The IRS does not issue a tax assessment note. The taxable income and the taxes to be paid will be determined according to the following calculation that can also be found on the form 1040 for unlimited liability and 1040 NR for limited liability.

1. Gross income According to US tax law, all income is taxable, unless defined by law as non-taxable income. Taxable income includes, for example, income from employed work, self-employed work, interest and dividends.

Income from employed work This includes gross wages and salaries as well as taxable payments in kind. These are subject to the Payroll Tax that will later be set off against the income tax according to the filed tax return. To summarize US income from employed work, you will be issued the form "W2" (similar to the German Lohnsteuerkarte).

Income from self-employed work Income from self-employed work is recorded in the so-called Schedule C. The most common method for determining income is the Cash Method. The cost of sales are deducted form the sales (i.e. purchase costs, costs of production for the goods). In the next step, further operating expenditures such as wages and salaries, office lease, and advertising costs will be deducted. The result is the profit of the self-employed work that will be included in gross income.

Foreign earned income Interesting for tax payers living abroad is the so-called Foreign Earned Income Exclusion (FEIE). Foreign earned income from employed or self-employed work up to $80,000 may be deducted from gross income in 2002 and 2003. The sum will be proportionally reduced in case the above mentioned income has not been made over the course of the entire year in a foreign country. Another deduction from gross income may be made for housing costs abroad, this includes rent, repairs and operating costs. In order to get the FEIE, you have to fill out a three-page form.

This article will be continued in our February edition.

You may contact the author directly under ines.voigt@cpa-berlin.com in case you need consulting.