The origins of the US tax laws begin with the Sixteenth Amendment of the United States Constitution. Historically, the U.S. government had relied on tariffs as a source of revenue since the country saw income taxes as controversial at that time. Congress had two significant constitutional issues to overcome before authorizing a federal income tax: first, what is the source of taxation and second, should the revenues be apportioned among the states based on population. However, on February 3, 1913, the Sixteenth Amendment was Ratified; “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”. Shortly after being ratified, Congress passed the Revenue Act of 1913, which ultimately eliminated both problems and allowed federal income taxes.
Legislative/Statutory Source of Taxes
After the Revenue Act of 1913, US Tax Laws began to be codified and compiled into the first Internal Revenue Code of 1939. This was later overhauled in 1954 and 1986. The Internal Revenue Code (IRC) of 1986 is the current statutory tax rules enacted by Congress. This is a dynamic document that Congress adds to, deletes from, or modifies provisions at least once a year. Since it is Congress that we are talking about, there is a legislative process behind all IRC modifications. First, a new tax bill would be drafted by the House Ways and Means Committee, which would then be considered by the whole House. If approved, it moves to the Senate Finance Committee, where the Committee can do revisions, additions, and/or deletions before presenting to the whole Senate. Suppose the bill happens to be substantially different from that original one from the House. In that case, both versions are sent to the Conference Committee (composed of both House and Senate members), where a compromise bill gets drafted. If both the House and Senate approve the Conference Committee’s bill, they send it to the President. The President can either veto it or sign it, redesigning it as a tax act and becoming law. The IRC consists of sections (Section 1 – Section 9834). These sections are divided into subsections, paragraphs, subparagraphs, and clauses. The IRC constitutes Title 26 of the U.S. Code (U.S.C.) which is administered by the Internal Revenue Service (IRS – the US tax authority) through its Regulations Rulings.
Administrative Source of Taxes
Treasury Regulations are the most common source of administrative tax authority. These are the Treasury Departments and the IRS’s statements of law. The Internal Revenue Service (IRS) is the US tax authority responsible for enforcing tax law and collecting taxes. A Revenue Ruling explains how the IRS applies the law in certain situations while a Revenue Procedure advises taxpayers on how to comply with the IRS on procedural and administrative matters. These provide instruction guidance to taxpayers. They are not laws in and of themselves, but rather interpretations that help illustrate the IRC rules. Although they are not binding on the Courts, they inform the taxpayers how the IRS addresses certain situations. Nonetheless, it is common for the courts to often follow the IRS position on these documents. It is not common for taxpayers to convince the federal courts that a regulation was an incorrect interpretation of IRC rules.
Judicial Source of Taxes
The judicial source of United States laws is based on the common law system that evolved from British tradition. This is true for 49 states with the lone exception of Louisiana, which is the only civil law jurisdiction in the United States. In simple terms, common law is derived from judicial decisions instead of from statutes. That is, laws are interpreted by judges and quasi-judicial tribunals and their written opinions on cases.
These cases help establish legal precedents, which carry weight for future decisions on similar situations. The same goes for tax law. When questions and issues arise regarding the interpretation or application of tax law, the tax courts (judicial system) steps in. Court decisions are official interpretations and applications of the IRC. Additional tax law is generated and carries the same weight as a statute itself.
DESCRIPTION AND TYPES OF TAXES FOR INDIVIDUALS
Personal Income Taxes (PIT – Form 1040)
Individuals are subject to a progressive personal income tax (PIT) based on their personal taxable income. The applicable tax rates are determined based on the marital and family status of the individual. This is best illustrated in the following table. Numbers inside the table represent Taxable Income (USD).
These are the 2022 PIT rates:
|10 %||0 – 10,275||0 – 20,550||0 – 10,275||0 – 14,650|
|12 %||10,275 – 41,775||20,550 – 83,550||10,275 – 41,775||14,650 – 55,900|
|22 %||41,775 – 89,075||83,550 – 178,150||41,775 – 89,075||55,900 – 89,050|
|24 %||89,075 – 170,050||178,150 – 340,100||89,075 – 170,050||89,050 – 170,050|
|32 %||170,050 – 215,950||340,100 – 431,900||170,050 – 215,950||170,050 – 215,950|
|35 %||215,950 – 539,900||431,900 – 647,850||215,950 – 539,900||215,950 – 539,900|
|37 %||539,900+||647,850 +||539,900+||539,000+|
Depending on where taxpayers reside, there will also be state and local income taxes. Seven states have no state income tax (Alaska, Florida, Nevada, Texas, South Dakota, Washington, and Wyoming). Forty-one states tax wage and salary income, two states (New Hampshire & Tennessee) only tax dividend and interest income. Nine states have a single-rate tax structure, and the rest have gradual-rate income taxes with the brackets varying widely between. Hawaii has 12 brackets, the most in the country. Tax rates go all the way from 2.9% in North Dakota to 13.3% in California, but the average is around 5%.
Alternative Minimum Tax
The Alternative Minimum Tax (AMT) ensures that high economic income individuals pay at least a minimum amount of tax. The United States AMT is based on the generation of economic income, rather than taxable income itself. AMT eligibility and computation is extremely complicated.
Capital Gains Taxes (CGT)
A capital gain is the growth in value of an investment. There are two different types of Capital Gains. Long-term Capital Gains (LTCG), which are incurred when you hold an asset longer than 12 months. And Short-term Capital Gains (STCG) which are incurred when you hold the asset for less than 12 months. Capital Gains and losses are carried to Schedule D from the Form 1040.
Individual Capital Gains: Short-term capital gains for individuals are taxed as ordinary income rates of up to 37%. Long-term capital gains are taxed at preferential tax rates of 0%, 15%, or 20%. Long-term capital gains on “collectibles” (baseball cards, sneakers, wine, etc.) are taxed at a maximum rate of 28%. The preferential tax rates table goes as follow (as of 2022):
|Tax Rate||Single Taxpayers (ST)||Married Filing Jointly (MFJ)||Married Filing|
|0 %||0 – $ 41,675||0 – $83,350||0 – $ 41,675||0 – $55,800|
|15 %||$41,675 –||$83,350 –||$ 41,675 –||$55,800 –|
|20 %||Over $459,750||Over $517,200||Over $258,600||Over $488,500|
Inheritance and Gift Taxes
Inheritance and gift taxes are adjusted each year due to inflation, so the numbers that we will be reviewing are likely to increase (not considering a potential tax reform). In the United States, there is no inheritance tax; however, there is an Estate & Generation- Skipping Transfer Tax (GST). For 2022, the first $12.06 million is exempt ($60,000 for nonresident aliens) from GST and gift tax and anything more than the exemption is taxed at 40%. Estate taxes in the United States are considered to be transfer taxes since the donor pays the tax, generally on their final 1040.
Key points on estate taxes: The estate tax applies to all financial and real assets. Estates can deduct debts, funeral expenses, legal and administrative fees, charitable bequests, and estate taxes paid to states. Inheritances are not taxable income to the recipients.
Unrealized capital gains on assets are not subject to income tax. The exemption level is portable between spouses, so the exemption of a married couple will be double that of a single. There are also other special provisions to reduce taxes or spread payments over time for family-owned farms and closely held businesses.
Key points on gift taxes: In 1932, Congress enacted a gift tax to prevent donors from avoiding estate taxes by transferring their wealth before they died. Therefore, gifts fall under the same exemption of $12.06 million in 2022. That is, gifts reduce the exemption amount available for estate tax purposes. However, there is an annual exclusion of $16,000 in 2022, which is indexed for inflation on increments of $1,000. If a married couple with two children could give their children a total of $60,000 ($15,000 from each parent to each child) each year without owing taxes or counting towards the lifetime exemption, that have the overall effect of reducing their taxable estate for the estate tax purposes and gives their children non-taxable income.
The overall net of estate taxes differs for nonresident aliens. United States residents and citizens are subject to estate taxes on their global estate. That means if a US resident has property in Spain and he/she wishes to transfer it to his/her kids, that estate is subject to US tax. On the other hand, nonresident aliens’ estate is only subject to US taxes if such estate is in the United States (i.e. real or personal property that is physically located in the United States). Intangible property, such as stock or membership interest, is not treated as being in the United States.
Withholding Tax (WHT)
Withholding Taxes (WHT) are a concept that nonresident aliens should be aware of. Under the Internal Revenue Code, a foreign person is subject to a 30% tax on US-source non-business income (FDAP) which is essentially a flat tax on passive income. Therefore, if a person makes US-source non-business payments (like Dividends, Interests, and Royalties) to a foreign person, they are subject to report and withhold 30% of the gross US-source payments. Foreign persons, or Withholding Agents, can reduce the 30% rate if the beneficial owner certifies their eligibility based on the operation of the US Tax Code or a Tax Treaty.
National Agency – Internal Revenue Service (IRS)
The Internal Revenue Service is the nation’s tax collection agency. The IRS also administers the Internal Revenue Code that Congress enacts. The IRS releases Revenue Regulations & Revenue Procedures to guide taxpayers about how the IRS might interpret certain facts and how to comply with them on procedural and administrative matters. Let’s remember that the IRS’s statements of law do not carry the weight of law, so they are not binding to courts. Nonetheless, federal courts tend to side with the IRS on tax matters.
The IRS falls under the Department of the Treasury. There are only two positions appointed in the organization, the Commissioner of the Internal Revenue Code and the Chief Counsel. The president makes such appointments, and the Senate confirms. The Commissioner is the head of the IRS and serves a renewable 5-year term. The Chief Counsel advises the IRS on legal matters like interpreting and enforcing tax laws. An IRS Oversight Board exists to ensure that the agency treats taxpayers fairly and reviews IRS plans. However, as of January 2021, the IRS Oversight Board does not have enough members confirmed by the Senate to make a quorum. Therefore, operations are suspended until a quorum is reached.
The IRS is commonly known for being the agency in charge of Criminal Investigations of the Internal Revenue Code and related financial crimes. Their program emphasis in the following areas: Abusive Return Preparer Enforcement, Abusive Tax Schemes, Bankruptcy Fraud, Corporate Fraud, Employment Tax Enforcement, Financial Institution Fraud, Gaming, General Fraud Investigations, Healthcare Fraud, Identity Theft Schemes, International Investigations, Money Laundering & Bank Secrecy Act (BSA), Narcotics- Related Investigations, Non-filer Enforcement, Public Corruption Crimes, and the Questionable Refund Program (QRP).
Audits are probably the most common tax controversy the IRS is known for. As part of their enforcement mission, the IRS audits a selected portion of income tax returns each year. Reasons for an audit vary, but there are some factors that can increase your chances.
Common red flags for an audit include failing to declare the right amount of income, claiming rental real estate losses, making disproportionately large charitable donations compared to income, and claiming higher-than-normal amounts of deductions (particularly business-related ones). Surprisingly, high income is also another attention grabber for the IRS. Individuals with income of more than $1 million have a 3.2 % chance of getting audited compared to a 0.6% chance of those making between $200,000 and $1 million.
Taxation of resident aliens vs. nonresident aliens
A foreign individual is taxed in the United States when he or she is considered a tax resident (or resident alien in IRS terms) and are subject to income tax on all his worldwide income. To be regarded as a resident alien for tax purposes, a foreign individual must meet one of two tests:
The Green Card Test – if an individual holds a Form I-551, he or she qualifies as a resident alien.
Substantial Presence Test – An individual has to be physically present in the US for at least 183 days; OR, present at least 31 days of the year in question, and present for 183 days summing from days of the target year, plus days in the first preceding year counted as one-third days, plus days in the second preceding year counted as one-sixth days.
The Substantial Presence test holds several exemptions to which days can be counted as presence in the United States. Additionally, several types of visas are also exempted from this test.
A foreign individual classified as a nonresident alien can only be taxed on US source income, unless a tax treaty can be claimed.
Foreign Tax Credit
A Foreign Tax Credit (FTC) is a form of relief from double taxation on foreign earned income. An FTC only applies to income taxes; foreign excise taxes, sales taxes, transfer taxes, and property taxes are not creditable. An FTC is subject to a significant limitation. The annual credit cannot exceed a specific percentage of the precredit U.S. tax for the year. This percentage is the taxpayer’s foreign source income divided by taxable income.
A Passive Foreign Investment Company (PFIC) is a corporation located abroad that meets one of two conditions:
- At least 75% of their income is passive.
- At least 50% of the company’s assets are investment.
United States investors that own shares of a PFIC must file a Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, with the IRS.
In 1986, Congress wanted to close tax loopholes that allowed US taxpayers to shelter offshore investments from taxation. Congress not only wanted to bring such investments under US taxation, but they also wanted to discourage taxpayers from this practice.
Sections 1291 through 1298 of the US Income Tax Code define PFICs. Form 8621 is intricate; it is estimated to take around 40 hours to fill out.
A Controlled Foreign Corporation (CFC) is a corporate entity that is registered or conducts business in jurisdictions or countries different than the residence of their controlling owners. Under IRC § 957, the term controlled foreign corporation means any foreign corporation if more than 50 percent of the total combined voting power of all classes of stock or the total value of the stock of such corporation is owned or considered as owned by United States shareholders. United States shareholders means a United States person who owns 10 percent or more of the total combined voting power (or value) of all classes of stock. A US person with more than 10% ownership of a CFC must attach to his US Individual Tax Return, a Form 5471, which is considered by the IRS the most complicated form to be prepared.
Treaty between the U.S.A. and the Kingdom of Spain to avoid double taxation.
We have gone over how the US is a Worldwide Regime tax system. Since the US doesn’t surrender its jurisdiction of US nationals’ income tax, a problem of potential double taxation arises.
Each tax treaty is unique; rates and exemptions vary among countries. Currently, the US has bilateral income tax treaties with more than 60 governments. By filing a W-8BEN, the taxpayer claims the benefits provided to their country nationals under the US tax treaty, reducing the rates of income taxes, withholding taxes, and any other additional benefits provided.
The Income Tax Convention with Spain was signed in 1990. Additionally, a protocol that modified the convention was signed in January 2013, with its technical explanation.
Both Spain and the U.S.A. are considered Worldwide Tax Regime systems, with the difference that the U.S.A. taxes their citizens on their worldwide income, while Spain does it with his residents.
The existing taxes, to which this Agreement shall apply, are in Spain, the Income Tax on Individuals (IRPF); in the U.S. the Federal income taxes imposed by the Internal Revenue Code. The agreement does not cover the transmission tax in Spain (Donaciones and Sucesiones) or the State taxes un the U.S.A.
A natural person is fiscal resident in Spanish when any of the following occurs circumstances:
- Staying more than 183 days, during the calendar year, in Spanish territory. To determine this period of permanence, absences will be computed sporadic unless the taxpayer proves his tax residence in another country (by means of a tax residence certificate issued by the tax authorities of that other country). In the case of countries or territories of those qualified as paradise tax, the Spanish Tax Administration may require proof of permanence in the same for 183 days in the calendar year.
- That the main core or base of their activities or financial interests, directly or indirectly, reside in Spain.
- That the non-legally separated spouse and minor children who depend on this natural person habitually reside in Spain.
Afterward, it lists some types of income and provide, with respect to each of them, the tax powers that correspond to each signatory State:
- In some cases, exclusive authority for the taxpayer’s country of residence,
- In others, exclusive authority for the country of origin of the income and,
- Finally, in some cases, shared power between both countries, both being able to tax the same income but with the obligation for the country of residence of the taxpayer to arbitrate measures to avoid double taxation.
The agreement between Spain and the U.S.A. follows the pattern of the Double Taxation Agreement Model and all of them are guided by two basic principles:
1) Exclusive taxation in the State of residence or source. In this case, as there is exclusive taxation, the doble taxation does not apply.
2) Shared taxation, in this case the doble taxation is refunded in the State of residence.
The Agreement between Spain and the U.S.A. also has what is called the “saving clause” according to which the United States reserves the right to tax its citizens and residents as if the Agreement were not in force. Taxation borne in the United States by a resident of Spain based on the citizenship criteria does not give the right in Spain to apply a deduction for double taxation in the personal income tax (IRPF). If the United States taxes on income using the “reserve clause” established for its citizens, double taxation must be avoided by the United States.
According to this, American citizens with tax residence in Spain would be taxed in the U.S.A. for two reasons (i) because the Treaty establishes it (in the articles of shared taxation) or (ii) in the cases in which the Treaty establishes the taxation exclusive to Spain, then the saving clause that allows the U.S.A. to have its citizens taxed in the U.S.A. as if the Treaty did not exist.
Edited and adapted by US Tax Consultants from a document of Flores Group. April, 2023