The Mexico/US Tax Implications of Residency Abroad

The Mexico/US Tax Implications of Residency Abroad 

Each year, several US persons travel down to Mexico, fall in love with the country, and decide that they want to remain in Mexico — and even work or launch a business from within its borders. Conversely, it is also common for Mexican citizens to want to travel to the United States to live and work. Even though there are tax treaties between the two countries, it does not eliminate all the different reporting and income tax implications for taxpayers traveling between both countries. The rules involving the United States and Mexico can be very complicated, so let’s take an introductory look at some of the key issues:

US Person Residing in Mexico (Outbound)

Let’s first start with US Citizens and other US persons relocating to Mexico:

US Tax on Worldwide Income

The United States taxes individuals on their worldwide income. Therefore, if a US citizen relocates to Mexico, then they are still subject to US tax on their worldwide income. This is true, even if they earn all their income in Mexico — and do not have any US source income. Taxpayers may qualify for different methods of reducing their US tax liability, by way of the Foreign Tax Credit, Foreign Earn Income Exclusion, or Foreign Housing Exclusion.

Foreign Account Reporting 

US persons are required to disclose their foreign accounts, assets, and investments to the US government on various different international information reporting forms. Depending on whether the taxpayer meets the threshold requirements, they may have to file forms such as the FBAR, FATCA Form 8938, Form 8621, Form 5471, and Form 8621. Failure to file these forms may result in significant fines and penalties.

Foreign Business Structure Conundrum

When a US person launches a foreign business in Mexico it is important to determine whether or not that business is going to be disregarded or not. In addition, the taxpayer must determine whether they are going to own more than 50% of the company sufficiently so that it is considered a Controlled Foreign Corporation (CFC). If the entity is considered a controlled foreign corporation, there may be other issues as well, such as GILTI, Subpart F Income, and FDII. Taxpayers may be able to disregard the entity to avoid CFC status, but some corporations are considered per se corporations and cannot be disregarded.

Mexico Person Residing in the United States (Inbound)

With a Mexican citizen relocates to the United States to relocate for work or enjoyment, there are many factors to consider. The United States tax system operates unlike most other tax systems across the globe, in that it follows a Citizenship-Based Taxation model. With that said, the term Citizenship-Based Taxation is a misnomer because it also includes Lawful Permanent Residents and foreign nationals to meet the Substantial Presence Test.

What Type of US Person Status?

If a person becomes a US citizen, they will be limited in terms of making treaty elections. If the taxpayer is instead on an employment, travel, or investment visa — or is a lawful permanent resident — they will have other opportunities to make a treaty election that would otherwise be more difficult or impossible if they are US citizens. (Likewise, treaty elections as a lawful permanent resident residing in the United States can also be difficult) That is Mexican citizens should carefully consider their new US status before relocating to the United States on a more permanent status such as US Citizenship or Lawful Permanent Resident.

Gifts from Foreign Persons

If a person from Mexico becomes a US person and receives a large gift from a foreign non-resident alien, they are required to report the gift on Form 3520. If they fail to do, so they may become subject to significant fines and penalties, upwards of 25% value of the gift. In recent years, the IRS has moved full steam ahead on assessing and enforcing these types of penalties (it also includes foreign inheritance).

Foreign Trusts in Mexico

If a person has ownership or beneficiary status of a foreign trust in Mexico and then relocates to the United States and becomes a US person, they will have additional trust reporting requirements on 3520 and/or Form 3520-A. Especially in situations in which the trust has significant value and/or is issuing distributions to US beneficiaries, it is important for taxpayers to take heed of the reporting requirements.

First Year as a US Person and Form 5471

If a US person has ownership of a foreign corporation in Mexico and relocates to the United States, even — if it is not a Controlled Foreign Corporation — they still have to report the information on Form 5471, at least in the first year. That is because, in any year that a foreign national becomes a US person and owns 10% or more of a foreign corporation, they generally have to file for 5471 — at least in the first year. Like with most international reporting forms, the failure to file Form 5471 can come with very steep penalties.

General Tax and Reporting Rules

A few general rules that taxpayers traveling between the United States and Mexico as a resident or citizens should consider:

Closer Connection

If a person is on a visa, is not a lawful permanent resident that has not applied for lawful permanent resident status, they may qualify to be taxed as a non-resident alien even though they met the Substantial Presence Test. They do this by showing that they have a closer connection to one or more foreign countries, as well as filing the requisite forms with the IRS.

Foreign Earned Income Exclusion

For US persons who reside in Mexico, they may be able to exclude upwards of $110,000 of their income along with certain expenses they have for housing if they qualify for The Foreign Earned Income Exclusion and Foreign Housing Exclusion. For the most part, if the taxpayer can qualify for the Physical Presence Test and Tax Home Test then it is not a big problem. Alternatively, if they cannot qualify for the Physical Presence Test they may qualify for the Bona Fide Residence test.

Treaty Elections

Depending on where the taxpayer resides in either Mexico and/or the United States and/or the category of income, they may qualify to make a treaty election to reduce or eliminate certain taxes and/or withholding. To make a treaty election, the taxpayer files Form 8833 along with their tax return. The US government may disagree with the treaty election which can result in an audit, fines, or penalties—but the taxpayer has an opportunity to challenge the IRS.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to streamlined procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead of the Streamlined Procedures. But, if a willful Taxpayer submits an intentionally false narrative under the streamlined procedures (and gets caught), they may become subject to significant fines and penalties. 

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Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

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