Taxation without Representation? Tax Traps for Founders Moving to the U.S.
“Entrepreneurs engaged in the global economy have found themselves scrambling to avoid a large U.S. tax bill.”
As the global economy leads to greater instances of cross-border business and expansion, it can be crucial for incoming individuals to understand the US tax system and how it applies to their income. Indeed, when faced with the world’s largest bureaucracy and a tax code exceeding 73,900 pages, individuals can often be confused as to how much they should or shouldn’t be paying. Here at Rooney PC, our global clients often ask us about this issue and so our dedicated tax lawyers have put together five key considerations which address the topical questions we’ve been seeing a lot.
1. Taxation without Representation
We’ve all heard the about the trouble that comes from taxation without representation. In a somewhat ironic twist from 1776, U.K. and Irish nationals may feel they’re being treated unfairly by the U.S. tax system. In some cases entrepreneurs engaged in the Global economy have found themselves scrambling to avoid a large U.S. tax bill. This could be on the sale of their stock in private or public companies when they exit their startup or in the event of an asset sale. While the U.K. has a 10% Capital Gains Tax Rate (up to a limit) with the Entrepreneurs Relief Scheme and Ireland is following suit with a somewhat less generous reduced 20% CGT on the first €1million in the recent budget, a U.K. or Irish national deemed to be a resident of New York City will find that ballooning up to about 35%.
2. U.S. Tax Resident
The U.S. casts a wide net to capture tax on income earned in foreign countries by any “U.S. tax resident.” This covers U.S. citizens working abroad, but it also may cover a foreign national regularly traveling in and out of the U.S. (whether for business purposes or otherwise).
You are a “U.S. tax resident” and subject to U.S. taxation on your worldwide income (“US Worldwide Taxation”) if you are one of the below –
- U.S Citizen
2. Permanent resident aliens and immigrants
3. Resident aliens for tax purposes
For foreign citizens, trying to understand if category (3) applies to them. They must employ the “Substantial Presence Test”.
3. The Substantial Presence Test
A foreign citizen passes the Substantial Presence Test if he or she is:
- Physically present in the USA for 183 days or more in the current tax year;
- Physically present in the USA for a “deemed total of 183 days or more” during the current year and the two years immediately prior thereto (“Three-Year Period”) – The Look Back Rule!
4. The Look Back Rule
For purposes of the Three-Year Period, the number of days you are deemed present incorporates a “Look Back” rule and therefore is determined as follows:
- For the current year, count all of the days that you are physically present in the USA;
- For the year immediately prior to the current year, count one-third of the days of physical presence;
- For the second prior year, count one-sixth of the days of physical presence;
- Add up the number of days in 1-3. If the sum is 183 days or more, you are a “U.S. tax resident” of the current year, despite spending less than 183 days present in that year alone.
For Example: If you were present in the U.S. for 100 days in the current year, 200 days in the year before, and for 200 days in the year before that, you will be considered a U.S. resident for tax purposes:
- Current year: 100 days x 1 full day = 100 days
- Last year: 200 days x 1/3 of a full day = 66 days
- Year before that: 200 days x 1/6 of a full day = 33 day
In total, under the look-back rule in the above scenario, you would have been present in the U.S. for a total of 199 days, which meets the requirement of substantial presence.
5. The Tie Breaker
If you are deemed a tax resident of both the USA and the UK or Ireland, it does not necessarily mean that you will be subject to double taxation. Under an applicable income tax treaty, you may be able to apply “tie-breaker” rules to determine which of the two countries may tax you as a resident (and accordingly identify what tax rate(s) applies to your income), and thus allow you to minimize potential double taxation.