Taxation

PREFACE

Taxation is a popular topic about which we receive a lot of questions, but it is also one of the most difficult with regard to permanent residency in the US. Especially US tax law is so complex that it is hardly possible to explain the details in simple words. We have tried to make the following text as understandable as possible. However, we know that these things are not easy to understand if you have never heard of them before. If you have specific questions about US tax law, we will be happy to refer you to a good US tax consultant. In general, it is advisable to pay your taxes in the US, even if the law there is more complicated, because the tax rates themselves are still significantly lower than those in Germany.

GENERAL FACTS

The US still raise taxes for their citizens even if they are living abroad and have no close ties to their home country anymore. They do the same with immigrants for their worldwide income, regardless of whether they have been naturalized and where that income was generated. That is one of their main differences to European countries that usually only tax income that has been generated from inland sources. Since most of you will probably not know about the complex system and the obligations that arise from it, this How To chapter will explain the US system to you. We will start with the question of when a non-immigrant in the US can be classified as resident alien or nonresident alien with regard to US tax law. An in-depth analysis would take up more time and space than we have for this newsletter section. That's why we want to come back to this in the future. We will publish part 1 here and give you part 2 in the next edition. Please note that we take no responsibility for the correctness of the following information.

As mentioned above, the US tax your worldwide income. This is in sharp contrast to the process for non-immigrants who are only liable to taxation for certain kinds of income from US sources. Immigrants and non-immigrants are subject to two different methods of taxation. Immigrants pay taxes on a net basis, that means they can profit from certain deductions for the assessment of their basis of taxation. This is different for non-immigrants. They will generally be taxed on a gross income basis, the tax for the income from inside the US - unless it is from trade or business activities - is relatively high with 30%.

PLEASE NOTE: In many cases it is advantageous to be regarded as an immigrant according to tax law. As a green card holder, this applies to you anyway, but also as a non-immigrant you can be classified accordingly. A few explanations below.

A green card holder or a holder of a temporary visa will be classified as a resident alien on the basis of the Internal Revenue Code if he or she passes the "lawful permanent resident test" or the substantial presence test" (SPT), or chooses the classification as an immigrant himself/herself. The lawful residence test is conducted quite easily. A person passes if he or she has a permanent resident status in the US that has not been revoked. In other words, you pass the test if you are a green card holder.

SUBSTANTIAL PRESENCE TEST (SPT)

This test is a little more complicated. The holder of a temporary visa qualifies as an immigrant under tax law if he or she has, first of all spent at least 31 days of the current fiscal year in the US, and at least 183 days of the two preceding years. For technical reasons, one day during the current year counts as one whole day. One day in the preceding year only counts for 1/3, and one day in the year before that only as 1/6. One example:

Ms Mueller has spent a total of 122 days each in the US in the years of 2000, 2001 and 2002.

This means that Ms Mueller has not been a US resident in any of those and also not before that. Why? Ms Mueller cannot be a resident, because in 2000 and the two preceding years, she has been in the US for only 122 days. She also isn't a resident in 2001. Because the sum for both stays from 2002 and 2001 is 162 1/3 days (122 for 2001 and 40 2/3 for 2002). She is, however, an immigrant for 2002, because she has spent at least 31 days in the US in 2002 and 183 days in 2002 and the two preceding years (122 entire days in 2002, 40 2/3 in 2001 and 20 1/3 in 2000). In order to count the days you have been in the US, your physical presence is important, irrespective of how this was during one day. In addition, days you have been present in the US will be counted as 1/3 and 1/6 for the preceding year and the year before, not rounded up to an entire day. By the way, even times you have spent in or above territorial waters or in US airspace will be counted.

EXCEPTION: "CLOSER CONNECTION"

A person that has been classified according to the SPT has only three options of still qualifying as a non-immigrant. First off, the person must have spent less than 183 days a year in the US and have maintained a tax home in another country, also during the current fiscal year. Last but not least you should have proof of your closer connection to your home country than to the US. Unfortunately, this closer connection exception is not available for persons with a pending adjustment of status application or green card application for the US.

The tax home has to exist during the entire calendar year the exception is to apply to. The tax home is to be where the person has his or her main residence. Other indicators leading to the closer connection exception are real estate property, family ties and addresses the applicant has so far stated on official (US) documents. Since the questions whether you actually have closer ties to your home country is very subjective for everyone, you should be prepared for the fact that you may not be able to avoid paying taxes as a US resident. Nevertheless, if you are interested in trying, send the form 8840 (www.irs.gov/pub/irs-pdf/f8840.pdf) to the Internal Revenue Service Center, Philadelphia, PA 19255.

EXCEPTIONAL DAYS

Other kinds of days are excluded from the assessment process, e.g. days during which you cannot leave the US for medical reasons, are in transit between two points outside the US or working as a flight attendant on board a plane from another country. One example for this as well:

Mr. Thomson has his main residence in Toronto, Canada. On January 1, 2002 he starts working in Niagara Falls, New York and commutes between home and work six days a week. Even though Mr. Thomson spends ca. 300 days in the US, none of these counts for the SPT criteria. That means, Mr. Thomson is not an immigrant according to the US tax code. Regular commuting is if a person travels between home and work for more than 80% of his or her work days during the current year. Commuting between two points is given if the person travels there and back within a 24-hour period. You may regard yourself as being not present in the US if you are in the US for less than this time and are in transit between two point outside the US. Transit, in this case, means traveling from one point to another. In case you participate in a business meeting, this day will no longer count as an exception. The same applies to crewmembers of international airlines who are in the US on other business.

CHOICE: CLASSIFICATION AS RESIDENT

In case you fail both the green card test and the SPT test, you can still choose to do this another way. In order to qualify, you don't have to have been an immigrant according to the tax code the previous year and qualify for the SPT again in the next year. In addition, you have to meet a few minimum SPT requirements for the year of the application. If your resident status changes during the year, you will effectively have two fiscal years, one as an immigrant and one as a non-immigrant. If you receive your green card during the year (but fail the SPT test), your tax status begins with the first day of your presence as an immigrant (under immigration law). If you choose this, you will be classified as a resident starting with that calendar in which your immigrant status begins.

PLANNING

If you are about to become a green card holder, it would make sense to speed up the process of having your income acknowledged. This would make sense if the effective tax rate in your home country as that in the US. You should especially consider to have taxable profits acknowledged, in case your home country does not tax capital gains. In that case it would be advisable to restructure your assets abroad in a way to avoid being taxed for this income in the US (see above: difference between worldwide income and territorial principle). The reversed strategy makes sense if you are giving up your permanent residence in the US.

DOUBLE TAXATION AGREEMENTS

If a non-immigrant or immigrant is classified as a US resident and there is a double taxation agreement between the US and the other country, the definition of main residence from the agreement applies. These agreements define your main residence, i.e. the country where you have to pay taxes. In case you are classified as a resident of your home country according to this agreement and want to pay your taxes there, you will automatically be classified as a non-immigrant for income taxation in the US. By the way, these agreements include special regulations for some groups of immigrants, such as athletes.

What it comes down to is that you can avoid double taxation thanks to these agreements between the US and your home country. The taxes on your worldwide income as a US resident are usually significantly lower than the taxes you have to pay with a main residence in Germany. Exceptions are, of course, always possible and - especially if your income situation is complicated - you should always get the help of a US tax consultant.

SUMMARY

Your classification into a tax status will decide to what extent the respective national applies to you. US citizens and immigrants (green card holders) will pay taxes for their worldwide income. As a non-immigrant in the US this will only apply if your activities are not connected to trade or business operations. Aliens who are holding a green card will be treated as immigrants with regard to taxation if they have spent at least 183 days of the current and the two preceding years in the US. This includes a minimum presence of 31 days in the current year. However, there are some exceptions for residency under certain circumstances. One of them is for people with a closer connection to another country. Other exceptions are for the groups of people exempt from the 183-days test.

In the second part we will tell you about taxation of non-immigrants, i.e. all persons who are in the US on a temporary visa only.