How are your returns on investments, as an alien in the US, taxed?


Introduction – Overseas Investments for US Aliens

It is said that the grass is always greener on the other side. But what if we told you that the grass is greener where you water it and water it correctly? Make sense? No?

The past few years have seen exponential growth in financial awareness due to social media. Podcasts, YouTube channels and Newsletters have increased the interest of not only the well-settled and well-earning strata of society, but also the ones who are just starting off in their careers. The crowd is moving on from just gold and real estate, and experimenting with SIPs, cryptocurrency, and overseas investment.

With time people have understood the benefits of taking the risk of stepping out of their comfort zone. Investors are willing to invest their money in foreign businesses. They are willing to speculate where the grass would be greener and water the ground there. The metaphorical “grass on the other side” in the US market and the US economy, where investors have either started their own businesses or partnered up with existing ones. With investments in multiple countries, the slowdown of one economy will not affect the investments in the other one, and the investor still gets pretty good returns.

And guess what? The RBI is on board as well. Recent news claims that RBI is looking to make overseas investments for angel investors and tech entrepreneurs easier. If the investments made by these tech entrepreneurs succeed, then the dollars that it would bring back would solidify the Indian forex reserves further.

Benjamin Franklin, one of the founding fathers of the US, said that there were only two things certain in life: death and taxes. He knew what he was talking about. Let’s have a look at the taxes and filings that come with such overseas investments and earnings by Indians.

I am a partner! What should I file or report? – Schedule K1

Let’s assume you are part of a business in the US that is structured as a partnership. Your contribution could be as an individual, or as a company/corporation. Regardless of that, you will be sharing the profits directly. When a partnership contract is drawn up, it will define how the partners share the profits. A partnership is also considered a ‘pass-through entity’ i.e., it does not pay a corporate tax on its income. The tax liability is passed on entirely to the partners involved. The tax basis of the partner can increase based on his/her contributions or also decrease due to withdrawals. An implication of this is that you will also be liable to the debts of the partnership to the extent defined. A General Partner is someone who is personally liable for the partnership’s debts and a Limited Partner is a partner whose liability is limited to the amount he has contributed or invested.

A Schedule K1 is a federal document that is prepared for each partner individually. It is included with their personal tax returns. So, a K1 keeps a tab on each partner’s level of involvement, or stake, in the partnership. It will report a partner’s profits, losses, and credits. The income shown in Schedule K1 can be from the partnership’s real estate rent, bond interest, or/and stock dividends.

For example, assume there are 5 equal partners in a partnership, and the total taxable income earned by the partnership is $200,000. Each partner’s K1 will show an income of $40,000 ($200,000 / 5).

Apart from these, a General Partner – the one who takes care of the day to day operations and not only invest- also gets a guaranteed payment like a salary, which is also shown on  Schedule K1. A schedule K1 applies to you if you are a partner in a Limited Liability Company (LLC), Limited Liability Partnership (LLP), or even an investor in a Limited Partnership (LP).

A Schedule K1 is issued on March 15(or the 15th day of the third month after the entity’s tax year ends), but they are more often late than on time. For a General Partner, filing a K1 is necessary. But for a Limited partner, it is not considered essential to file it. It is, however, required that the data on the K1 be included in the Limited partner’s overall taxable income. The partnership is required to file a copy of Schedule K1 along with the partnership return (Form 1065) with the IRS.

I have other investments and income in the US! What form applies to me? – Form 1099.

Now, maybe you haven’t reached a level where you can invest in a company or be a partner somewhere. You could still invest in stocks and earn passively through other methods. This is where Form 1099 enters the stage. This is applicable to you only if you are a resident alien (does not apply to non-resident aliens)

The main purpose of Form 1099 is to show the IRS the different kinds of income a taxpayer gets, excluding his routine salary. The term used is “non-employment-related sources”. This income includes income from rent, income from freelance work, returns on investments, interest on bonds, etc. The type of income helps the IRS determine the appropriate amount of tax to be collected from the taxpayer.

The issuers of Form 1099 send one copy of the form to the taxpayer, and another to the IRS. The IRS crosschecks the income reported by the taxpayer to the income shown on Form 1099 and makes sure it all ties in neatly. The 1099s forms are due on January 31 so the taxpayer receives his Form 1099 mostly by the end of February. The taxpayer need not submit or file the form, but a copy must be kept with them nonetheless.

There are different types of Form 1099, but they all ultimately serve the same purpose. Here are some common variants.

  • Form 1099-DIV – For income that is earned as a dividend
  • Form 1099-INT – For income earned as interest, if it is more than $10
  • Form 1099-R – For income received as payouts from a pension plan or annuities
  • Form 1099-G – For income received from local governments, like an unemployment benefit or a refund
  • Form 1099-B – For income due to transactions made via a broker in the sale of stocks, commodities, securities, etc.
  • Form 1099-S – For income as a consequence of real estate transactions
  • Form 1099-NEC – For income over $600 that a business pays to a non-employee, like an independent contractor or a freelancer.
  • Form 1099-MISC – Any income that falls outside the purview of the other variants of Form 1099.

For example, if you are a graphic designer and have designed a webpage for a client for $550, then the client need not issue you a Form 1099-NEC. But that income will still need to be reported by you.

If your service as a graphic designer was a contractual agreement for $10,000, then your client will issue you a Form 1099-NEC.

Even if you as a taxpayer do not receive your Form 1099 on time, it is advisable that you include that income when filing your returns. If not, you will be susceptible to an audit.

I’m receiving income as a non-resident alien. What form applies to me? – Form 1042-S.

If you are not a US citizen and are a non-resident alien who is receiving income from a US source, then Form 1042-S is applicable to you. It is a federal tax document that is given at the year-end to non-residents, foreign partnerships, foreign corporations, and foreign trusts.

Just like Form 1099, the employer or issuer needs to send a copy to the IRS, and another to the taxpayer, who is a foreign worker/entity. Each type of income also requires a separate 1042-S. The incomes could be from real estate, scholarships, dividends, royalties, interests, compensation for personal services, etc.

The employer/issuer is referred to as the Withholding Agent, as he also withholds tax on the payments made (somewhat similar to TDS in India). If there are some treaty benefits, and the withholding amount is too large, then you as the taxpayer will also get refunds while filing the tax return. If a meticulously and correctly filed Form 1042-S is attached to your return, then the refund will be timely and seamless.

There is no minimum payment to file a 1042-S. Even a $100 payment requires a 1042-S.

There are some payments that need not be reported in this form, and those are:

  • Payments are made by individuals if the individuals are not making the payment as part of their trade or business and no withholding is required to be made.
  • Insurance premium on a contract issued by a foreign insurer
  • Bank deposit interest that is not connected with a trade/business in the US
  • Non-business gambling income
  • Interest or original issue discount from a short-term obligation
  • Payments made under a grandfathered obligation
  • Amounts paid as part of the purchase price of an obligation sold between interest payment dates

One thing must have been clear so far: Mr. Franklin was right.

Taxation is inevitable, whether investments are made in the US or in India. With the tax year inching to a close, cross-border filing needs to be done with utmost care. Even more so if you are an alien, resident or non-resident, as there are different rules for each country. The correct forms must be filed and attached, with the correct and apt details. The interaction between US and Indian tax laws, along with the treaties should also be studied so that you get your appropriate refunds or deductions or credits.