EB-5 Visas have been widely promoted as a legal basis for foreign business owners to gain conditional residency followed by permanent residency in the United States. Nothing hard to understand about that. The combination of economic and political freedom in the United States is unsurpassed. Rich folks are not trying to emigrate to Tehran or Moscow. However, unlike other countries, the decision to become a permanent resident or U.S. citizen has some draconian tradeoffs from a tax perspective. These tradeoffs should make a wealthy foreigner think twice about becoming a U.S. permanent resident or citizen particularly if other ways to emigrate to the U.S. without being locked into permanent residency or U.S. citizenship from a tax perspective. The cost of residency may prove to be too steep!
It is my view that the tax consequences of U.S. residency are not adequately discussed when business immigration options are being considered. Some of the subtleties of being an American taxpayer are often overlooked including the tax consequences of forfeiting U.S. residency or citizenship in the future after obtaining residency. The civil and criminal penalties of foreign bank account reporting and compliance may come as a complete shock.
In many cases, the foreign business owner only needs to be in the U.S. for a short time until the political and economic situation in the home country approves. It is not uncommon that the foreign business owner becomes aware of these adverse tax consequences after he becomes a U.S. resident.
The desire to become a U.S. resident or citizen for reasons of patriotism or political freedom is a completely different rationale than a scenario where the foreign business owner as a non-immigrant is looking for the flexibility to spend large blocks of time in the U.S. for both personal and business reasons rather than political reasons. The business non-immigrant depending upon their amount of time in the U.S. avoids tax residency.
This article is a summary of the downside risks from a tax perspective of becoming a U.S. resident for tax purposes and some of the other options that exist in lieu of EB 5.
Congress established the EB 5 program in 1990 as a way to stimulate the U.S. economy through job creation and capital investment by foreign investors. The program is administered through USCIS. The program sunsets every three years and requires renewal by Congress in order to continue.
EB-5 Visas foreign investors who make a direct minimum investment of $1,000,000 in an ongoing business, or start a new business in the U.S. which preserves or creates ten or more jobs for U.S. workers. The direct investment requirement is reduced to $500,000 if the investment is made in a targeted employment area. Investment through a private or public economic entity known as an EB-5 Regional Center devoted to increased domestic capital promotion, job creation, and improved regional productivity.
Upon making an EB-5 investment and upon approval of the application, a foreign investor (and immediate family including children under age 21) will be granted conditional permanent residence. If the foreign investor can show that the investment satisfies the EB-5 job creation requirements after two years, the foreign applicant will be granted permanent residence.
Foreign investors are only entitled to permanent residency under the EB -5 program only if the foreign investor puts the minimum-required investment ($1 million under the Investor Program or $500,000 under the Pilot Program) “at risk.” Capital is “at risk” only where there is a chance for a loss or a gain. Generally, EB-5 investments are structured a debt or equity investments.
Under the debt model, two enterprises are created: a “new commercial enterprise” (“NCE”) and a “job creating enterprise” (“JCE”). Foreign investors make a capital investment in the NCE. The NCE, in turn, loans the JCE capital raised from the foreign investors, which the JCE uses to create the requisite jobs. The JCE repays the NCE typically at 5-8% interest. Once the JCE repays the loan from the NCE, the NCE can be liquidated.
Under the equity model, the foreign investor is given either true or preferred equity in the JCE in exchange for his or her capital investment. The JCE can issue the equity directly to the foreign investor or it may issue it to an NCE. Most investors and developers prefer the preferred equity model since investors are generally not interested in maximizing their rate of return (they are more concerned with obtaining a green card) and developers would prefer to share their upside with investors.
In 2014, Chinese applicants accounted for more than 85 percent of the EB 5 applications with 9,128 applicants. The second largest group of applicants were South Koreans with 225 applications and Mexicans with 129 applications. Brazil accounted for 30 applications.
One other practical consideration is the fact that the foreign investor is an entrepreneur who is accustomed to management and control over his own investments. The EB-5 investment may limit the foreign business owner’s management and control over the investment. As a practical matter, the grapevine suggests that many EB-5 investments have been mediocre investments at best. Most business owners, foreign or domestic, would rather follow the business rule that suggests that if the business owner is going to lose money on a business investment, he would prefer to lose the money himself!
Tax Consequences of U.S. Tax Residency
The U.S. may be one of the only country that requires resident and citizens to pay tax on their worldwide income. Additionally, the wealthy permanent resident and taxpayer will have their worldwide assets subject to federal gift and estate taxation as well. Considering that many foreign investors end up in high tax jurisdictions such as New York and California, the combined tax effect is no small matter.
One of the objectives of foreign tax structuring is the avoidance of the foreign individual falling within the jurisdiction of the IRS. U.S. individual residency for tax purposes is a major tradeoff. Many foreigners come from foreign jurisdictions where the fiscal authorities lack the enforcement capability of the IRS. As a result, many foreigners do not appreciate or underestimate the full enforcement capability of the federal government for tax compliance purposes. The “quid pro quo” between wealthy foreigners and their governments for tax purposes does not exist in the U.S.
A second component of the tax compliance issue is the requirement for foreign bank account reporting (FBAR) and foreign investment account reporting for permanent residents and U.S. citizens. I have often heard from tax attorneys in Miami that the national debt could easily be satisfied if every Latin American in Key Biscayne was fully FBAR compliant.
The qualitative point here is that many foreign investors come from a background where not only do they not trust their government in their home jurisdiction, and may not fully trust every member in their extended family. Financial disclosure is limited to a very small group of personal advisors. It is an assumption that these foreigners are not fully tax compliant in their home jurisdictions.
The problem with U.S. residency or citizenship is the need to disclose their stockpile of cash in Switzerland, Panama or The Cayman Islands. The current number of countries that have tax information treaties with the U.S. and that have signed onto to FATCA now includes most of the tax haven jurisdictions. There is not where left to ride and hide!
The wealthy foreign investor needs to come to terms with the idea of annual FBAR reporting, Schedule B of Form 1040 and Form 8938. A willful intent to disregard these requirements is to face the unpleasantness of the criminal side of the IRS. Maybe it is better to stay home and visit the U.S. whenever the foreigner wants and for as long as he wants without residency.
There is no doubt that the $1 million or 500,000 minimum investment under EB-5 for many Chinese investors is “chump” change. The ultra-high Chinese investor may view this level of investment is the equivalent of the purchase of a ticket to the Chinese New Year’s Party. Other business immigration visas such as the L-1 visa or E-1 or E-2 provide a much lower cost threshold of investment with a much quicker approval.
The expedited processing request for the L-1 visa may cost $1,500 in filing fees with no minimum investment with a determination by USCIS which is much quicker than the EB-5 petition. The expedited filing of the E1 or E2 visa request also has a similar cost and quick time threshold for determination. In either case (L1 or E1 or E2), the foreign investor is not locked into residency for tax purposes.
Relinquishing Permanent Residency or U.S. Citizenship
One of life’s great lessons is that things are not always what they seemed to be at the outset. Increasingly I hear stories from other attorneys about clients who did not fully appreciate the intricacies and tradeoffs of becoming a U.S. resident or citizen and want to relinquish their U.S. status. In all cases, they are very surprised to heart that there is an “exit” tax.
The Heroes Earning Assistance and Tax Relief Act of 2008 repealed the former ten year look back period and instead introduced a deemed disposition on worldwide assets. The new rules are applicable to taxpayers who expatriate after June 17, 2008. IRS Notice 2009-85 supplemented IRC Sec 877A with fifty eight pages of guidance for taxpayers.
These gains are taxed at capital gains rates without any of the exclusions available for a principal residence under IRC Sec 121. The tax only applies if the amount of gain exceeds $690,000 in 2015. The gain may be delayed on a property-by-property basis until the property is actually sold.
The expatriation rules apply to U.S. citizens or long term residents that have a Green Card in eight of the last fifteen years preceding the application for expatriation. The expatriation rules are applicable if the taxpayer meets one of two test. A "covered expatriate" is a taxpayer that meets the Net Worth Test of IRC Sec 877A(g)(1) of $2 million or more.
Alternatively, under the Tax Liability Test, the expatriation rules apply if the taxpayer's tax liability for the five years preceding the year of expatriation exceeds $160,000 in 2015. Regardless of the application of the preceding two rules, under a third test, the Certification Test, the expatriation rules apply if the taxpayer fails to certify that the taxpayer is compliant with all of his federal tax obligations on Form 8854. The non-compliant foreign investor who become a U.S. resident or citizen and is hiding a mountain of cash in the Cayman Islands may have a difficult time certifying compliance.
The rules are not applicable to taxpayers who became dual citizens at birth. The taxpayer must have remained a dual citizen of both countries. The second exemption applies to taxpayers who expatriate before age 18 1/2 who did not qualify as a U.S. resident under the substantial presence test for more than ten years prior to the year of expatriation.
IRC Sec 877A subjects a covered expatriate to an exit tax on the net unrealized gain with respect to all worldwide property when the taxpayer terminates U.S. citizenship or permanent U.S. residency. The property is deemed sold on the day before expatriation occurs and exceeds an exemption threshold of $690,000 in 2015. In the case of a grantor trust, trust assets are subject to the mark-to-market rules. Beneficial interests in a non-grantor trust are exempt from taxation.
The exit tax base is predicated on the fair market value of all property. The taxpayer is able to adjust his tax basis on each item subject to the deemed sale to its FMV on the expatriation date. A covered expatriate may defer the payment of the exit tax in exchange for providing security to the IRS that satisfies IRC Sec 877A(b)(4). The taxpayer irrevocably waives any treaty benefits that might otherwise preclude a tax assessment. Interest accrues at the normal underpayment rate of IRC Sec 6621.
Deferred compensation items such as an interest in a qualified plan or non-qualified stock options are subject to the exit tax. "Eligible" items such as an interest in a qualified plan is subject to a 30 percent withholding tax at the time of payment. The taxpayer must make an irrevocable waiver of any tax treaty benefits. Deferred compensation items that do not fall within these parameters are taxed as an exit tax on the date preceding expatriation.
A topic for another article on a different day is the use of Puerto Rican residency to mitigate the tax consequences of expatriation for EB-5 visa holders who change their minds in order to avoid the exist tax.
Who wouldn’t be proud to be an American or enjoy permanent residency in the “Home of the Brave and the Land of the Free!” My point to the wealthy foreign investor is that there is a better way of enjoying America without getting caught in the onerous U.S. system of worldwide taxation of income and assets; tax compliance with the “bite of a shark” for FBAR non-compliance” or a costly exit tax in case the EB-5 visa holder changes his mind and wants to go home.
I am not concluding that EB-5 is a bad choice in very case, but rather than it has been over-promoted leaving many foreign investors with reduced flexibility for tax planning purposes. I would rather have a foreign investor come to America as a non-immigrant using other business immigration visa programs (L-1; E-1; and E-2) to “kick the tires” before adjusting his status to become a permanent resident. The cost of the EB-5 can be far greater than the initial investment if the Eb-5 visa holder has to pay the exit tax on worldwide assets as a result of relinquishing his U.S. residency.