Tax Reform’s Impact on Inpatriates and Expatriates
With hundreds of pages of tax reform legislation affecting taxpayers across the board, what does this mean to the typical non-U.S. individual who was already new to the U.S. tax system (i.e., inpatriates) as well as to U.S. citizens and Green Card holders living and working abroad (i.e., expatriates)? Unless otherwise noted, the following changes are effective for years beginning after December 31, 2017, and before January 1, 2026.
New Income Tax Rates and Brackets
The Tax Cuts and Jobs Act retains seven tax brackets for individuals: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Effectively, the highest marginal tax rate has been reduced from 39.6% to 37%. The new brackets below broaden where the next marginal rate begins—meaning more income is taxed at a lower rate. However, the net investment income tax of 3.8% and additional Medicare tax of 0.9% remain.
The tax brackets may come as a shock to many foreign nationals now subject to the U.S. tax system. When originally used to a more simplified method, the foreign nationals are now subject to a matrix of federal, state, and, in some cases, local tax systems. For the year of arrival and year of departure from the U.S., their available filing status options are limited.
For Married Individuals Filing Joint Returns and Surviving Spouses
|If taxable income is:||The tax is:|
|Not over $19,050||10% of taxable income|
|Over $19,050, but not over $77,400||$1,905 plus 12% of the excess over $19,050|
|Over $77,400, but not over $165,000||$8,907 plus 22% of the excess over $77,400|
|Over $165,000, but not over $315,000||$28,179 plus 24% of the excess over $165,000|
|Over $315,000, but not over $400,000||$64,179 plus 32% of the excess over $315,000|
|Over $400,000, but not over $600,000||$91,379 plus 35% of the excess over $400,000|
|Over $600,000||$161,379 plus 37% of the excess over $600,000|
For Single Individuals (Other Than Heads-of-Households and Surviving Spouses)
|If taxable income is:||The tax is:|
|Not over $9,525||10% of taxable income|
|Over $9,525, but not over $38,700||$952.50 plus 12% of the excess over $9,525|
|Over $38,700, but not over $82,500||$4,453.50 plus 22% of the excess over $38,700|
|Over $82,500, but not over $157,500||$14,089.50 plus 24% of the excess over $82,500|
|Over $157,500, but not over $200,000||$32,089.50 plus 32% of the excess over $157,500|
|Over $200,000, but not over $500,000||$45,689.50 plus 35% of the excess over $200,000|
|Over $500,000||$150,689.50 plus 37% of the excess over $500,000|
Standard Deduction Increased
The standard deduction has increased to $24,000 for married individuals, $18,000 for heads-of-households and $12,000 for all other taxpayers. These increases help taxpayers who previously did not have enough deductions to itemize but could hurt some taxpayers who did. As certain deductions have either been eliminated or reduced, many who itemized deductions will be taking the standard deduction. The legislation did not change the additional standard deduction for those over age 64 or who are blind.
Personal Exemptions Suspended
The deduction for personal exemptions is effectively suspended at the federal level; most taxpayers can claim a personal exemption at the state level. If someone has recently moved to the U.S. with their family and they do not have or are not eligible for a Social Security Number (SSN), they may be eligible for an Individual Taxpayer Identification Number (ITIN), which is required to claim a personal exemption for the spouse and children who are qualified dependents. The ITIN application process may require an inpatriate to obtain certified copies of their dependents’ passports from their country’s embassy or local office. This becomes an added step when working with a certified acceptance agent in obtaining the necessary tax identification numbers.
Child Tax Credit Increased
In order to claim the child tax credit, a qualifying child will need an SSN and must be physically present in the U.S. Qualified dependents with an ITIN will no longer be allowed the credit. The credit has been increased to $2,000 and an additional $500 nonrefundable credit is provided for certain non-child dependents. This ultimately effects the previous benefits for ITINs, which have been limited from a federal point of view. In addition, any children born in the U.S. while a parent is on assignment are automatically U.S. citizens and become subject to the same tax reporting. Upon departure from the U.S., the inpatriate and their newly born child may face U.S. tax compliance issues from their home country.
State and Local Tax Deduction Limited
Deductions for state and local property and income taxes not related to a trade or business are limited to an aggregate itemized deduction of up to $10,000. Foreign real property taxes may not be deducted.
State, local, and foreign property sales taxes are fully deductible only when paid or accrued in carrying on a trade or business. There is no limitation on the taxes paid or accrued in this regard. For example, taxpayers owning a home in the U.S. or a foreign country will be allowed to deduct the property taxes associated with that home in computing net rental income or loss from the rental activity.
Many inpatriates will rent their principal residence while away on assignment. During the rental period, foreign property taxes will be allowed as a deduction against the rental income; however, if the property is not rented, the foreign property taxes will no longer be allowed as an itemized deduction.
Mortgage and Home Equity Indebtedness Interest Deduction Limited
The deduction for interest on home equity indebtedness is suspended, and the deduction for mortgage interest is limited to debt of up to $750,000 ($375,000 for married taxpayers filing separately).
The reduced amounts apply to homes acquired after December 14, 2017. Any home mortgage that was entered into prior to December 15, 2017, or a contract that was binding and signed prior to that date is allowed the prior $1,000,000 amount. Refinancing is also still allowed as long as the loan was originated prior to December 15, 2017, and the refinancing does not exceed the original amount of refinanced indebtedness.
Medical Expense Deduction Threshold Temporarily Reduced
For tax years beginning after December 31, 2016, and before January 1, 2019, the threshold for medical expense deductions is reduced to 7.5% of adjusted gross income (AGI) for all taxpayers.
Charitable Deduction Limitation Increased
The 50% limitation for cash contributions to public charities and certain private foundations increased to 60% of the taxpayer’s AGI. Any contributions exceeding the 60% limit are carried forward for five years. In order to be a qualified charitable donation, the organization must be located in the U.S., Canada, Mexico or Israel. In certain cases, donations to a U.S. charity which, in turn, transfers the funds to foreign charities are deductible and vice versa.
Moving Expense Deduction Suspended
The deduction for moving expenses is suspended, except for members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station. When an individual moves to a new country for work, unreimbursed moving expenses will no longer be allowed. This should be negotiated in employment contracts before making the move overseas, as the costs can be burdensome for shipping personal items overseas.
Miscellaneous Itemized Deductions Suspended
The deduction for miscellaneous itemized deductions subject to the 2% AGI limitation is suspended. Items no longer deductible include tax return preparation fees, unreimbursed employee business expenses, temporary living expenses, portfolio expenses and certain brokerage fees. When inpatriates arrive in the U.S. on a less-than-one-year contract, they will no longer be allowed a deduction for temporary living expenses, such as rent and utilities, while on assignment.
Transition Tax on Move to Participation Exemption
The U.S. is transitioning to a participation exemption regime. In order to move to this new system, the U.S. imposes a mandatory one-time transition tax on deferred foreign income earned by specified foreign corporations (SFCs). An SFC is defined as any controlled foreign corporation (CFC) or any foreign corporation that has at least one domestic corporate U.S. shareholder that owns at least 10% of the SFC.
All U.S. shareholders with an interest in that same SFC must include their pro rata piece of the deferred foreign income. The portion of the deferred earnings that are attributable to the U.S. shareholder’s aggregate foreign cash position receives a 55.70% reduction, which is then taxed at the U.S. shareholder’s ordinary income tax rate. The remaining portion receives a 77.10% reduction, which is also taxed at the U.S. shareholder’s ordinary income tax rate. For 2017, the highest tax rate for a corporate shareholder is 35% and an individual shareholder is 39.6%. The tax liability may be paid over an eight-year period at the election of the taxpayer.
New Foreign Tax Credit Basket for Foreign Branch Income
The Tax Cuts and Jobs Act adds a separate basket for foreign branch income. The term foreign branch income includes the business profits of a U.S. person attributable to one or more qualified business units in one or more foreign countries. Foreign branch income does not include passive income. This also includes any U.S. person who has made an entity classification election to treat the foreign entity as disregarded for U.S. tax purposes.
There are many more changes to the U.S. tax system because of the Act. Over the next year, the IRS will issue guidance with respect to many new provisions. It will take time for taxpayers and their accountants to prepare and plan for the new rules. To understand the new law and to see what planning opportunities may be available, contact your advisor in order to minimize tax exposure and leverage the new laws to your advantage.