The Taxation System of the U.S. Selected Topics on U.S. Taxation Munich, 29 May 2008 Lee B. Serota, Certified Public Accountant Ernst & Young AG
Outline • Overview of the U.S. Tax System • Taxation of Individuals • Definition of US Citizen/Resident • Substantial Presence Test (residency termination) • Measurement of Taxable Income and components of Income and Deductions • U.S. federal income tax rates • Non-Residents • Corporate tax rates • State tax rates • Requirements for U.S. (and State) Payroll • Social Security and Totalization Agreement • 401(k) plans
Overview of the U.S. tax system • Federal taxes- Individual income tax (graduated rates up to 35%)- Corporate income tax (graduated rates up to 35%)- Estate, gift and GST (graduated rates up to 45%, reduction to 0% 2010)- Excise taxes • State/local taxes- Individual income tax- Corporate income tax- Estate, gift and inheritance taxes- Property tax- Sales tax
Some basic terms and concepts • Inbound taxation: U.S. business/investment activities of foreign persons • Outbound taxation: Foreign business/investment activities of U.S. persons • United States person- resident alien- domestic corporation, partnership or trust • Foreign person- nonresident alien- foreign corporation, partnership or trust
Taxation of Individuals • Personal Scope- Definition of residence- Begin / end of residency- Income tax treaties • Worldwide (“unlimited”) taxation of US citizens / resident aliens- All income from whatever source derived- Tax rates (reduced for certain categories of income)- Avoidance of double taxation (foreign tax credit, foreign earned income exclusion) • Source-based (“limited”) taxation of nonresident aliens- Gross and net-based taxation- Source rules, withholding tax- “trade or business”
US Citizen / Resident • US citizens • “All persons born or naturalized in the United States”US Constitution, XIV Amendment • Born outside the U.S. – statutory requirements (e.g., US citizen parent)http://www.uscis.gov/graphics/services/natz/English.pdf • Naturalization: Immigration and Nationality Act (INA)http://www.uscis.gov/graphics/services/natz/index.htm • Resident alien defined in U.S. Internal Revenue Code (IRC) Sec. 7701(b) • permanent resident visa (“green card”)or • substantial presence
Resident alien: Definition (IRC Sec. 7701(b)) • Permanent resident visa = “Green card” test- Starting date: first day present in the US with green card- Ending date: rescission of visa (final determination necessary) • “Substantial presence” test- 183 day rule – weighted over a three year period: 100% of current year days 1/3 of days in preceding year 1/6 of days in second preceding- minimum of 31 days of presence in current year
Example: Substantial presence test • Aufenthalts- • Jahr tage GewichtungErgebnis • 2007 120 1 120 • 2006 150 1/3 50 • 2005 60 1/6 10 • 180
Example: Substantial presence test • Aufenthalts- • Jahr tage GewichtungErgebnis • 2007 120 1 120 • 2006 150 1/3 50 • 2005 60 1/6 10 • 180 • As the formula totals less than 183 days, the individual is considered a nonresident of the US.
Example: Substantial presence test Aufenthalts- • Jahr tage GewichtungErgebnis • 2007 122 1 122 • 2006 122 1/3 40 2/3 • 2005 122 1/6 20 1/3 • 183 • As the total is 183 days, the individual is considered a resident of the US. • Residence begins in 2007 with the first day present in the US in 2007(Exceptions)
Exceptions: Substantial Presence • Presence in the US for certain individuals is disregarded (IRC Sec. 7701(b)(5))- Diplomats- Teacher, trainee, student (subject to time limitations)- Professional athletes competing in a charitable sports event- “Get sick in the US” – US presence extended for medical reasons arising in US • Closer connection exception (IRC Sec. 7701(b)(3)(B))- Current year presence in the US is less than 183 days,- “Tax home” is in a foreign country (cf. IRC Sec. 911, 163 and treaty term “permanent home”) and- Closer connection to such foreign country than to the US (cf. Reg. § 301.7701(b)-2(d) and treaty term “center of vital interests”)Limitations, e.g., in case of pending green-card application;timely-filed US tax return
Taxable income – US citizen / resident • Income – US taxation of worldwide income using US income tax principles • Deductions (Adjustments) & Itemized Deductions- historical distinction to achieve tax policy goals- Adjustments: usually fully deductible expenses incurred in connection with a trade or business or the production of income (exceptions: e.g., certain medical expenses, IRA)- Itemized Deductions: limited deductibility of expenses that include items incurred for personal purposes (e.g., deduction of qualified residence interest or medical expenses) • Standard Deduction:- minimum allowed deduction in lieu of itemizing- 2007: $ 10.700 (MFJ) $5.350 (single) & (MFS) • Personal exemption:$ 3.400 (2007)- available for taxpayer and certain dependents (e.g., dependent children) • Form 1040 used by US citizen/resident; No final assessment notice from the Internal Revenue Service (IRS)
Federal Income Tax – Individuals (2007) • Dividends – reduced rates through 2010- 15 % (taxpayers in 10% or 15% bracket)- “qualified dividend”: derived from domestic and certain foreign corporations • Capital gains – reduced rates through 2010- long-term capital gains (held for more than one year)- 15 % (taxpayers in 10% or 15% bracket)- 25 % tax imposed on depreciation recapture (real property)- “capital asset”- IRC Sec. 1221- Deductibility of losses up to $3,000 (MFJ) or $1,500 (MFS)- Special treatment of property used in a trade or business (IRC Sec. 1231)
Federal Income Tax – Individuals (2007) * • 10 % ledig Single(S) - $ 7.825 • zusammen Married filing jointly (MFJ) - $ 15.650 • getrennt Married filing separately (MFS) - $ 7.825 • 15 % Single from $ 7.825 to $ 31.850 • Married filing jointly from $ 15.650 to $ 63.700 • Married filing separately from $ 7.825 to $ 31.850 • 25 % Single from $ 31.850 to $ 77.100 • Married filing jointly from $ 63.700 to $ 128.500 • Married filing separately from $ 31.850 to $ 64.250 • 28 % Single from $ 77.100 to $ 160.850 • Married filing jointly from $ 128.500 to $ 195.850 • Married filing separately from $ 64.250 to $ 97.925 • 33 % Single from $ 160.850 to $ 349.700 • Married filing jointly from $ 195.850 to $ 349.700 • Married filing separately from $ 97.925 to $ 174.850 • 35 % Single over $ 349.700 • Married filing jointly over $ 349.700 • Married filing separately over $ 174.850 * Additional tax tables apply to an individual „head of household“ and to trusts/estates
Nonresident aliens – Taxable Income • US Nonresidents are taxable in the US on their US source income • Two categories – IRC Sec. 871(a) and (b)1. non-ECI: „income which is not effectively connected with the conduct of a trade or business in the United States“ IRC Sec. 871(a) → gross tax of 30%2. ECI: „income which is effectively connected with the conduct of a trade or business in the United States“ IRC Sec. 871(b)→ net-based tax (gross income less deductions) same tax rates generally applicable to US residents
State taxes • Separate state sovereignty to tax - no binding uniform system • states are not parties to U.S. tax treaties • Examples of tax rates: State Highest individual tax ratesCalifornia 9,3 % Illinois 3 % Texas 0 % Georgia 6 % New York 6,85 % + City Florida 0 %
U.S and State „Payroll“ • Payroll is required to be initiated by an employer for the following employees working within the U.S.: • Employees who are residents of the U.S. (U.S. citizens, Green Card Holders, Resident Aliens who qualify under the Substantial Presence Test). • Non-Residents who receive compensation for which no exemption from U.S. tax exists under a tax treaty (e.g. those employees who compensation is paid or borne by U.S. companies without „charge-back“ or other allocation to a to non- U.S. entity). • Most States within the U.S. have similar payroll rules as above. • Note: underpayment penalties exist which can be charged to the individual for inadequate withholding on wages. Penalties also exist for the Employer if the payroll withholding is not recorded in a timely fashion and paid-in to the tax authorities.
Special Topics—Social Security • U.S. system—maximum amount assessed but no maximum for the 1.45% medicare portion (e.g. Unlimited medicare tax on worldwide compensation subject to the rules). Other elements: • Totalization Agreement between Germany and the U.S. • Certificate of Coverage to maintain coverage in „home country“ • Avoidance of double coverage/taxation • Does not cover U.S. Federal Unemployment Tax (FUTA) or State equivalent (SUTA). FUTA/SUTA generally assessed at the Employer level. • Limited period of time for certificates of coverage • Payroll withholding issue similar to income taxes on wages
Special Topics: IRC §401(k) • A U.S. qualified pre-tax plan at the employer level which provides for a reduction of U.S. (and State) taxable compensation for the employee. Issues: • Allows an employee to reduce his/her taxable compensation on a yearly basis. Example: Gross compensation of $100,000 and amount contributed to the 401(k) is $15,000. Taxable compensation is $85,000. • Restrictions as to when the employee or former employee is allowed to withdraw $ from the 401(k) plan. • Taxation issues when the employee returns to home country and eventually withdraws the amount. • Income tax treaty issues (Article 18: Pensions).