Individuals who are citizens or residents of the U.S. are taxed on their income from all sources, both within and outside of the U.S. Form 1040 (U.S. Individual Income Tax Return) must be filed with the Internal Revenue Service, each year by April 15, for the prior calendar year. Unlike taxation in Canada, form 1040 may be filed either by an individual separately, or by a married couple on a joint basis. Income tax rates are graduated, and different rate schedules are used for returns with different filing status. In this way, income tax rates are adjusted to account for differences in circumstances for persons filing as single, married filing jointly, married filing separately, qualifying widow(er), or as head of household (HOH).
For tax years ending in 2018, the maximum tax rates for non corporate taxpayers' net capital gains are as shown on the table below:
|Start 10%||$ 9,525||$19,050||$13,600|
Generally, a U.S. citizen living anywhere in the world, must file a return if the minimum income indicated for the filing status below is met in 2018:
|Single (over 65)||$13,600|
|Head of household||$ 18,000|
|Head of household, over 65||$19,600|
|Married filing jointly||$24,000|
|Married filing jointly, one over 65||$25,300|
|Married filing jointly, both over 65||$26,600|
|Married filing separately||$ 0|
|Qualified widow(er)||$ 12,000|
|Qualified widow(er), over 65||$13,600|
(b) Itemized Deductions and Standard Deduction
Individuals filing as U.S. residents must choose whether to claim the standard deduction, or whether to itemize deductions. Itemized deductions include such items as medical expenses, state and local taxes, charitable contributions and investment expenses.
For 2018 itemized deductions are severely restricted while the standard deduction has been increased (to the levels shown above under filing thresholds.) Most notably, real estate tax and state tax deductions are limited to $10,000 and home mortgage interest is restricted to the interest on the first $750,000 of debt for a married couple. Further, personal exemptions have been eliminated.
The phase out of itemized deductions at higher income levels has also been eliminated.
The result of these changes will likely reduce the number of taxpayers who itemize deductions.
If all taxes due are paid by April 15, an application may be made for an automatic extension of the filing deadline of form 1040 to October 15, and further extensions may be available in certain circumstances. U.S. citizens (or permanent residents) living outside the U.S. (and with no U.S. source employment income) have until June 15 each year to file their returns and pay taxes, without filing an extension.
Additional filings are required with the 1040 return for holdings of controlled foreign corporations (form 5471). Foreign grantor trusts such as Canadian Tax Free Savings Accounts (TFSA) and Registered Education Savings Plans (RESP’s) must file form 3520 with the 1040 return, and form 3520A by March 15 unless an available six month extension to September 15 is applied for before the initial due date.
U.S. citizens are also required to disclose foreign financial assets on U.S. Treasury form FINCEN 114, electronically by the (extended) due date of the 1040 return and form 8938, which is filed with the 1040 return.
Net Investment Income Tax
A new Net Investment Income Tax (NIIT) of 3.8% will be payable on investment income in excess of the following filing thresholds. This new tax will be reported on form 8960 and will affect U.S. citizens and residents only, where income exceeds 200,000 (single), $250,000 (married filing jointly) or $125,000 (married filing separately).
Net investment income will include gains from property held for investment, such as stocks, bonds, mutual funds, etc., including gains on the sale of a principal residence in excess of the exemption amount, less expenses related to investments. For NIIT purposes, net losses from property dispositions cannot be less than zero (and therefore cannot offset other investment income), and are not available for carry forward to future periods.
Medicare Tax on Earned Income
A new medicare tax of 0.9% of earned income in excess of the same income thresholds as for NIIT, and will be reported on new form 8959. Generally, employers are required to withhold the additional tax from pay exceeding $200,000 per year, but a problem may result from combining income from separate jobs, or spouse’s income on a joint return.
Persons carrying on an unincorporated business as a sole proprietor or disregarded entity (such as a single member LLC, for example) in the U.S. are generally subject to income tax on their gross income less allowable deductions attributable to that income, and must file Schedule C with their form 1040 for each business, each year. Self employed persons are also subject to the Self Employment Tax, which amounts to 15.3% of self employment income up to $128,400 (for 2018), and is imposed in addition to any income taxes payable. The Self Employment Tax is used to fund social security taxes, and is the equivalent of the self employed Canada Pension Plan amount payable in Canada. One half of self employment tax is deductible from income prior to the calculation of tax liability.
Generally, under the terms of Binational Social Security Agreements (or Totalization Agreements), self employed persons who are subject to dual taxation are only required to pay social security taxes or their equivalent in the country in which they reside. Accordingly, U.S. citizens resident in Canada are required to pay Canada Pension Plan (CPP) premiums and are therefore exempt from Self Employment Tax.
A U.S. citizen providing personal services in Canada. as a self-employed individual falls under Article VII(1) of the Treaty – Business Profits. Under this provision, taxation is limited to the profits earned within a “Permanent Establishment” and only to the extent earned in Canada.
Permanent Establishment Defined:
The definition of “permanent establishment” was subject to much interpretation in the former Treaty. Under the new rules, the application of benefits in many cases is tied to whether a person or company has a permanent establishment in a contracting state. A permanent establishment is now created where an individual spends more than 183 days in the other state in any 12 month period and during that time more than 50% of the gross revenue generated by the business is derived from services rendered in the other state by that individual. A permanent establishment may also be created where services are provided in the other state for more than 183 days in any 12 month period with respect to a project for a resident of the other state.
Consistent with changes in the definition of “permanent establishment” mentioned above, the blanket exemption from taxation available to individuals or businesses providing business services in the other state (but not through a permanent establishment) has been repealed. Now, “business profits” are taxable in each state on a basis proportional to the activity carried out through a permanent establishment in each state.
This now means that any self U.S. employed individual or corporate entity which meets the above definition of “permanent establishment” will not be exempt from taxation but will be proportionally taxable in Canada on the net income earned while conducting business in Canada.
Although partnership income is reported on form 1040 - Schedule E each partnership operating in the U.S. must file a separate tax return each year on form 1065. The partnership distributes its income, expenses and other items to partners on form K-1.
Rental and royalty income are also disclosed on Schedule E. A U.S. resident who files Schedule E which discloses rental income from sources in Canada or elsewhere must use U.S. rules in the determination of income and expenses, which in many cases can be significantly different from the rules used in Canada.
Whereas losses from real estate rentals are generally deductible against other income in Canada, Canadian rules prohibit the claiming of capital cost allowance (depreciation) to create or increase a loss from real estate. In the U.S., losses may be created by claiming depreciation, (and depreciation calculations are mandatory rather than elective) but the deductibility of the losses may be limited or deferred by the "passive activity loss" rules.
Net income from rental, royalty or other passive (i.e. interest, dividends, investment) activities may give rise to the requirement to pay quarterly installments of federal (and/or state) tax in advance for the next taxation year.
Corporations carrying on business in the U.S., whether incorporated in the U.S. or elsewhere, must file a return of income each year within four and one half months for “C” corporations after their fiscal year end (unless extended), and two and a half months after the year end for other entities and must use the appropriate form depending on whether the entity is a Limited Liability Company (LLC), Subchapter S corporation or other entity. Corporations (except flow through entities) pay income tax at a flat rate of 21% commencing in 2018.
Non U.S. corporations that are controlled by “U.S. persons” must be reported on form 5471 on the personal income tax returns of certain shareholders.
Corporate tax planning in the United States is considerably different than that in Canada, since rules are in place to prevent the accumulation of income in excess of $150,000 for corporations engaged in technical, scientific or professional activities or $250,000 for others.
To level the playing field and to provide unincorporated entities with a similar tax rate as that available for C corporations, sole proprietors, partnerships, S corporations and REIT’s may deduct 20% of qualified business income.
The QBID is available to any business which is not a “Specified Service Business”. A Specified Service Business is any business involving the performance of services in the fields of health, law, accounting, actuarial services, performing arts, consulting, athletics, financial services, brokerage services where the principal asset is the reputation or skill of one or more of its employees or owners.
Commencing with the 1996 taxation year, every individual who files a U.S. income tax return must have a valid identification number issued by the Social Security Administration and acceptable to the IRS. For U.S. residents, citizens, and visa holders entitled to work in the U.S., a Social Security Number (SSN) is required, and is available by completing form SS-5 (Application for a Social Security Card). For spouses, dependents and non-residents who file a U.S. tax return or are claimed as dependents on a U.S. tax return but are not permitted to work in the U.S., an Individual Taxpayer Identification Number (ITIN) is required, and is available by completing form W-7 (Application for IRS Individual Taxpayer Identification Number). Effective in 2012, the Certifying Acceptance Agent program has been eliminated, and all new applications must be accompanied by an original certified copy of a passport, issued by the home country passport office. Tax forms which do not have the appropriate identification numbers will not be accepted by the IRS, and claims for dependents without appropriate numbers will be disallowed. ITINs issued before 2013 and not used in three years may need to be re-applied for starting in 2016.
Partnerships, corporations and self employed persons should apply for an Employer Identification Number (EIN) by filing form SS-4 (Application for Employer Identification Number).
Many states in the U.S. have independent income tax systems applicable to persons living in or earning income from within the state or corporations doing business in the state. Although many states that impose an income tax use the federal taxable income as a starting point, rates, methods of taxation, rules of computation and filing requirements vary from state to state and from entity to entity.
Many states do not recognize foreign tax credits for taxes paid to foreign countries or provinces. As a result, proper tax planning should be undertaken prior to establishing residence in a state to take into account the implications of state taxation as it is complicated by federal and international taxation.