The Taxation System of the U.S. Selected Topics on U.S. TaxationMunich, 29 May 2008
Lee B. Serota, Certified Public AccountantErnst & Young AG
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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
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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
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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
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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”
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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
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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
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Example: Substantial presence test
Aufenthalts-
Jahr tage Gewichtung Ergebnis
2007 120 1 120
2006 150 1/3 50
2005 60 1/6 10
180
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Example: Substantial presence test
► As the formula totals less than 183 days, the individual is considered a nonresident of the US.
Aufenthalts-
Jahr tage Gewichtung Ergebnis
2007 120 1 120
2006 150 1/3 50
2005 60 1/6 10
180
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Example: Substantial presence test
Aufenthalts-Jahr tage Gewichtung Ergebnis
2007 122 1 1222006 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)
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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
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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)
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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)
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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 $ 31.850Married filing jointly from $ 15.650 to $ 63.700Married filing separately from $ 7.825 to $ 31.850
25 % Single from $ 31.850 to $ 77.100Married filing jointly from $ 63.700 to $ 128.500
Married filing separately from $ 31.850 to $ 64.250
28 % Single from $ 77.100 to $ 160.850Married filing jointly from $ 128.500 to $ 195.850Married filing separately from $ 64.250 to $ 97.925
33 % Single from $ 160.850 to $ 349.700Married filing jointly from $ 195.850 to $ 349.700Married filing separately from $ 97.925 to $ 174.850
35 % Single over $ 349.700
Married filing jointly over $ 349.700Married filing separately over $ 174.850
* Additional tax tables apply to an individual „head of household“ and to trusts/estates
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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
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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 rates
California 9,3 % Illinois 3 % Texas 0 % Georgia 6 % New York 6,85 % + City Florida 0 %
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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.
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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
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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).