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).