The complexity of the U.S. income tax system is legendary. Many countries use it as a blueprint for their own tax legislation. This complexity is even more significant for foreign nationals who plan to spend time in the U.S. or become what is known as “accidental Americans” based on the U.S. tax residency rules. Here is some clarity with regard to these rules:
RESIDENT ALIEN DEFINED
In general, foreign nationals who are considered resident aliens for U.S. federal income tax purposes are taxed in the same manner as U.S. citizens — i.e., they are taxed on their worldwide income. Foreign nationals who are considered nonresident
aliens for U.S. federal income tax purposes (generally defined by narrowly crafted exceptions), on the other hand, are subject to U.S. tax only on income derived from sources within the U.S. and/or income that is effectively connected with a U.S. trade or business.
The residency rules for U.S. federal income tax purposes are found in section 7701(b) of the Internal Revenue Code. Under these rules, an individual who is not a U.S. citizen is considered a resident alien for U.S. federal income tax purposes if either of the two objective tests is met: the lawful permanent residency test or the substantial presence test.
If neither test is met for a particular year, an individual is considered a nonresident alien for U.S. federal income tax purposes for that year. As U.S. citizens are taxed as U.S. tax residents regardless of their actual physical residence, this article does not focus on the taxation of U.S. citizens.
LAWFUL PERMANENT RESIDENCY TEST
Under the lawful permanent residency test (also known as the green card test), a foreign national is considered a resident alien for U.S. federal income tax purposes from the day he or she is admitted to the U.S. as, or change status to, a lawful permanent resident under U.S. immigration laws. Such a foreign national continues to be a resident alien for U.S. federal income tax purposes (even when living outside the U.S.) until the day that his or her status is revoked or judicially found to be abandoned.
SUBSTANTIAL PRESENCE TEST
A determination of residency status for U.S. federal income tax purposes under the substantial presence test is made by using a numerical formula that measures days of physical presence in the U.S. More specifically, under the substantial presence test, a foreign national is considered a resident alien for U.S. federal income tax purposes when both of the following conditions are met:
- He or she is physically present in the U.S. for 31 days of the current year
- He or she is physically present in the U.S. for a weighted average of 183 days over a three-year testing period, which comprises the current year and the two preceding years
To determine the number of days of physical presence for these purposes, a weighting formula is used. This formula counts all of the following:
- All days in the current year
- One-third of the days in the preceding year
- One-sixth of the days in the second preceding year
A day of U.S. presence is acquired if an individual is physically present in the U.S. at any time during the day. There is no minimum threshold for this purpose. Days are excluded from the calculation referenced above for the following individuals:
- Exempt individuals — i.e., employees of foreign governments, teachers or trainees with J visas, students with F and J visas, professional athletes competing in charitable sports events
- Individuals who regularly commute for work to the U.S. from Canada or Mexico
- Individuals who, while in transit between two points outside the U.S., are physically present in the U.S. for less than 24 hours during that trip
- Individuals who are not able to leave the U.S. because of a medical condition that arose while they were present in the U.S.
Except for professional athletes, the exempt status of an individual also applies to members of his or her immediate family.
CLOSER CONNECTION EXCEPTION
A foreign national who satisfies the substantial presence test may be taxed as a nonresident alien if he or she is present in the U.S. for fewer than 183 days during the current year and can demonstrate — based on all facts and circumstances — that, during the entire year, he or she has a tax home in a foreign country and a closer connection to that country than to the U.S. For instance, factors such as the location of the individual’s permanent home, family, business and social and political relationships should be considered in this regard.
In the year that a foreign national becomes a U.S. resident (and sometimes in the year that he or she ceases to be a U.S. resident), he or she is considered a dual-status alien for U.S. federal income tax purposes. In such a year, two U.S. tax returns are generally prepared, attached to each other and filed simultaneously. One return reports income and deductions for the residency period and the other reports income and deductions for the nonresidency period.
An income tax treaty the U.S. has with a particular foreign country may override the income tax laws of the U.S. for items covered by that treaty. Any item not specifically addressed by the treaty is taxed in accordance with U.S. income tax laws.
Generally, income tax treaties do not change the U.S. taxation of a U.S. citizen. However, they may specifically define or modify residency status for purposes of the tax rules in the treaty. As a result, individuals who are considered U.S. resident aliens under either the lawful permanent residency test or the substantial presence test may be able to use treaties for a determination as to which country can treat the individual as a resident, particularly where domestic rules create a tax residence in both countries.
Individuals who are planning to spend time in the U.S., beyond brief vacations or business trips, and those applying for permanent residence should meet with their tax advisor prior to making these changes in status, as various tax-planning opportunities exist that might not be available once the U.S. tax residence has been established.
Please reach out to GHJ’s International Tax Practice for any assistance.