By Joseph R. Oliver
In Brief
Resident Aliens Are Taxed Like Citizens
More and more multinational corporations are investing in the robust U.S. economy, and many foreign nationals are finding themselves residing and working in the United States. Of immediate concern to these aliens is their status as either residents or nonresidents for U.S. tax purposes. The consequences of that distinction are significant: Resident aliens are taxed on their worldwide income and nonresident aliens are taxed only on their U.S. source income.
The rules that govern the determination of residency are complex and require keeping track of days spent in the United States. This becomes especially complicated when the alien is engaged in a significant amount of international travel.
As business expands globally and economic and social problems increase abroad, more non-U.S. citizens are living in the United States, temporarily or indefinitely. The IRC separates these individuals into two categories: resident and nonresident aliens.
Resident aliens, generally, are subject to Federal tax on their worldwide income. Nonresident aliens, generally, owe tax only on income from U.S. sources, including certain income connected with the conduct of a trade or business in the United States.
Therefore, before deciding whether part or all of an alien's income is subject to Federal taxation, a taxpayer or advisor must first determine residency status.
Distinguishing Nonresident from Resident Aliens
To exclude non-U.S. source income and certain compensation for services in the United States, an individual must retain nonresident alien status. A nonresident alien becomes a resident alien if she is a lawful permanent resident of the United States at any time during the calendar year or meets a substantial presence test. Certain tax treaties contain definitions of resident and nonresident that override the IRC.
Lawful Permanent Resident
An individual who is allowed to reside permanently in the United States under U.S. immigration laws is a lawful permanent resident. Typically, this is evidenced by INS Form I-551, Permanent Resident Card, often referred to as a green card (although it is no longer green in color). If a taxpayer is not already a resident alien under the substantial presence test, she becomes a resident upon receipt of the card.
IRC section 7701(b)(6) provides that lawful permanent resident status continues unless it is revoked or abandoned. Resident status is rescinded if a final administrative or judicial order that cannot be appealed is issued to exclude or deport the individual. Abandonment can be initiated by the alien, a consular officer, or the Immigration and Naturalization Service (INS).
Substantial Presence
Someone who is not a lawful permanent resident may still be a resident alien under IRC section 7701(b)(3) if she has been physically present in the United States (excluding U.S. possessions and territories) on--
* at least 31 days during the current year and a total of 183 days during three consecutive tax years, including the current year, or
* at least 183 days during the current tax year.
Although days of presence in the current year count as full days, each day in the preceding year counts as one-third of a day, and each day in the second preceding year counts as one-sixth of a day.
Example: Franco, who is not a U.S. citizen, was present in the United States for 90 days during 1999, 150 days during 1998, and 258 days during 1997. Franco counts all of 1999's days (90), one-third of 1998's days (50), and one-sixth of 1997's days (43), yielding a total of 183 days. He meets the substantial presence test and is a resident alien whose worldwide income generally is subject to U.S. income tax. To fail the test, Franco could cut short his U.S. presence during 1999, dropping below 183 days for the three-year period. Or, he could retain nonresident status for 1999 by being present in the United States for fewer than 31 days, regardless of how many days he was there during 1997 and 1998.
Days That May Be Excluded
In reaching the 183-day threshold, an alien can exclude, under IRC sections 7701(b)(3)(D) and 7701(b)(5) and (7), any day that she is--
* a student, trainee, or teacher who is admitted temporarily to the United States;
* a professional athlete temporarily present in the United States to compete in a charitable sports event (only days of actual competition are excluded);
* temporarily in the United States as a full-time employee of certain international organizations or by reason of diplomatic or consular status;
* prevented from leaving because of a medical condition that arose while in the United States;
* in transit between two points outside the United States; or
* commuting to and from employment in the United States, if she is a regular (more than 75% of work days) commuter who resides in Canada or Mexico.
Students, teachers, trainees, professional athletes, and persons that are unable to leave the United States because of medical conditions must file Form 8843, Statement for Exempt Individuals and Individuals with a Medical Condition.
Closer Connection Exception
Even if an alien meets the substantial presence test, she still might maintain nonresident status by proving a closer connection with a foreign country during the current tax year, according to IRC section 7701(b)(3)(B).
The individual must maintain a tax home in the foreign country during the year and must be present in the United States for fewer than 183 days. For this purpose, "tax home" includes either a place of abode or a regular or principal place of business. The tax home must be in existence for the entire year. Also, the alien must maintain more significant contacts with the foreign country than with the United States, considering facts and circumstances that include the location of the following:
* Permanent home (house, apartment, furnished room that is available at all times, continuously, and not solely for short stays);
* Automobiles, furniture, clothing, jewelry, and other personal belongings of the alien and family;
* Social, political, cultural, or religious organizations with which the individual maintains a relationship;
* Routine personal banking activities;
* Business activities other than those that constitute the tax home; and
* Jurisdiction in which the individual holds a driver's license and votes.
Facts and circumstances also include the types of official forms and documents that the alien files and the country of residence designated on them. Examples of forms and documents include the following:
* Form 1078, Certificate of Alien Claiming Residence in the United States
* Form W-8, Certificate of Foreign Status
* Form W-9, Request for Taxpayer Identification Number and Certification.
Two Foreign Countries
Generally, the closer connection exception must tie the alien to a single foreign country. This requirement may extend to two foreign countries if the individual can prove that she--
* maintains a tax home at the beginning of the current year in one foreign country;
* changes the tax home to a second foreign country during the year;
* continues to maintain the tax home in the second foreign country for the remainder of the current year;
* has a closer connection to each foreign country than to the United States during this period; and
* is subject to tax as a resident of either or both foreign countries during the period.
Closer Connection Statement
To claim the closer connection exception, an alien must timely file a statement under Treasury Regulations section 301.7701(b)-8(a)(1). (See Form 8840, Closer Connection Exception Statement for Aliens.) An individual taking steps to become a permanent U.S. resident, perhaps by filing certain INS forms, cannot use the exception. Therefore, an alien should proceed with caution when filing certain forms or having someone else, such as a relative or employer, file them on her behalf.
There may be non-tax reasons to file one or more of the following forms, but the IRS may view it as taking steps to change an alien's status to that of permanent U.S. resident, thereby blocking use of the closer connection exception:
* Form I-508, Waiver of Rights, Privileges, Exemptions and Immunities
* Form I-485, Application to Register Permanent Residence or Adjust Status
* Form I-130, Petition for Alien Relative
* Form I-140, Immigrant Petition for Alien Worker
* Form ETA-750, Application for Alien Employment Certification
* Form OF-230, Application for Immigrant Visa and Alien Registration.
Beginning and Terminating U.S. Residency
Under Treasury Regulations section 1.871-13, an alien's first or last tax year is divided into two separate periods and the tax liability is computed under two different sets of rules. For a cash method alien, income from non-U.S. sources that is not effectively connected with the conduct (by the alien) of a trade or business in the United States is treated as follows:
* Excluded from U.S. income tax if received before becoming a resident;
* Taxable if received after becoming a resident, even if earned while not a resident;
* Taxable if received while a resident, even if U.S. residency is abandoned later in the same year;
* Excluded if received after termination of U.S. residency, even if earned while a resident.
Residency Starting Date
The residency starting date for an alien who meets the substantial presence test is the first day on which she is present in the United States. The person may be in the United States for up to 10 days without triggering the residency starting date, however, by proving that her tax home was in a foreign country and that she maintained a closer connection to that country than to the United States. In addition, the 10 days may generally be allocated among several trips. Although these days do not count in determining the residency starting date, they are used in calculating the 183-day substantial presence test.
The residency starting date for an alien who meets the lawful permanent resident (green card) test is generally the first day during the year in which she is physically present in the United States as a lawful resident under IRC section 7701(b)(2)(A). An alien who meets the test during a year but is not physically present in the United States until the following year begins residency on the first day of the following year.
If an alien meets both the substantial presence test and the lawful permanent resident test during a year, the residency starting date is the earlier of the two. If an individual was a resident during any part of the preceding calendar year, residency begins on the first day of the tax year, under Treasury Regulations section 301.7701(b)-4(e), regardless of which test confers the status.
Residency Termination Date
If an individual is a resident alien because of the substantial presence test, the residency termination date is the last day of physical presence in the United States. An individual who is a resident because of the lawful permanent resident test terminates residency by no longer being a lawful permanent resident under IRC section 7701(b)(2)(B). An alien who meets both tests terminates residency on the later of the two dates.
Both termination dates depend on the alien establishing that, for the remainder of the calendar year, her tax home was in a foreign country and she maintained a closer connection to the foreign country than to the United States. Otherwise, the residency termination date is the last day of the calendar year.
As with the residency starting date, up to 10 days of travel to the United States subsequent to terminating residency may be ignored if the alien's tax home is in a foreign country and she maintains a closer connection to that country than to the United States. However, those days count toward the 183 days of the substantial presence test.
Even if the person has a closer connection to a foreign country than to the United States during the current year, residency does not terminate until the end of the current year if the alien is a resident for any part of the following year. This holds whether the status is earned under the substantial presence test or the green card test.
For example, Alexis is a citizen of a foreign country and has never been a U.S. resident for tax purposes before the current year. She was in the United States sightseeing January 610 of the current year and moved here on March 1. Alexis moved back to her country of citizenship on August 20. She took another U.S. vacation during December 1216.
She was a resident of the U.S. for the current year under the substantial presence test, satisfied as follows:
| Period | Days |
| January 6 - 10 | 5 |
| March 1 - August 20 | 173 |
| December 12 - 16 | 5 |
| Total Days | 183 |
She is not able to escape the status under any of the exceptions. However, she is able to establish a closer connection to her home country than to the United States during the January and December trips. Therefore, her U.S. resident status did not begin until March 1 and terminated on August 20. Her non-U.S. source income received before and after the period of residency is not generally subject to U.S. income tax.
Income Exempt from U.S. Income Tax
A nonresident alien files Form 1040NR, U.S. Nonresident Alien Income Tax Return, or Form 1040NR-EZ, U.S. Income Tax Return for Certain Nonresident Aliens with No Dependents, and generally excludes certain income.
Sources Outside the United States. A nonresident alien's income is generally exempt under IRC section 872(a) unless it is effectively connected with the conduct of a U.S. trade or business or is otherwise derived from U.S. sources.
For example, Bernard received $50,000 in compensation for services he rendered outside the United States. Bernard did not conduct the trade or business to which he provided the services. He was a nonresident alien during the period he rendered the services and at the time he received payment. Therefore, $50,000 is excludable from gross income for purposes of U.S. income tax.
Allocating Income. Compensation for services clearly performed in the United States is U.S. income unless specifically excludable under IRC section 861(a)(3) (see below). The U.S. source income for services performed partly in and partly outside of the United States is determined under the facts and circumstances, according to IRC sections 863(a) and (b). Often, the appropriate basis for allocation is the number of days that the individual worked in the United States compared to the total number of days for which payment is made.
For example, Pieter, a nonresident alien, earns a $90,000 salary from a foreign corporation. He was in the United States for 15% of the work days during the current tax year. Of Pieter's salary, 15%, or $13,500, is U.S. source income. The remaining 85%, or $76,500, is excludable for U.S. income tax purposes.
Transportation Exclusions. Transportation income generally includes income earned from personal services related to the use of a ship or aircraft. If such transportation begins and ends in the United States, the compensation generally is U.S. source income under IRC sections 863(c)(1) and (c)(3)(B).
If transportation begins or ends in the United States and ends or begins in a U.S. possession, tax treatment of a nonresident alien depends on whether the carrier is a plane or ship. For air transportation, half the income is generally U.S. source income. For ship transportation, compensation paid after December 31, 1997, is generally not U.S. source income under IRC sections 861(a)(3) and 863(c)(2) if the alien is temporarily present in the United States as a regular crew member of a foreign ship.
Personal services income that a nonresident alien earns from international air or ship transportation is generally not U.S. source income if the foreign country of which the alien is a resident offers the same exemption to U.S. residents, according to IRC section 872(b). Transportation income not earned from personal services is subject to additional provisions.
Pension Exclusion
A nonresident alien who receives pension payments from a U.S. employer for services rendered both within and outside the United States must generally allocate the payments between U.S. and non-U.S. source income.
Revenue Ruling 79-388, 1979-2 C.B. 270, involved an alien who initially worked for a foreign branch of a U.S. corporation and was later transferred to the U.S. office. Upon retirement, he returned to his native country and began receiving pension payments from the employer.
The revenue ruling held that U.S. source income included the portion of each pension payment that represented contributions with respect to services rendered in the United States and all earnings of the pension plan. The portion of each pension payment that represented services outside the United States was foreign source income.
The same principles were applied in Rev. Rul. 79-389, 1979-2 C.B. 281, which dealt with a U.S. citizen computing foreign source income for purposes of determining the foreign tax credit.
For example, Margaret, a nonresident alien, receives $15,000 in pension payments during the tax year. Of these payments, $5,000 is attributable to earnings of the pension plan and is U.S. source income. The remaining $10,000 represents the employer's contributions to the plan for Margaret's services. Of the employer's contributions, 60% was for her service in a foreign country. Accordingly, 60% of the $10,000, or $6,000, is non-U.S. source income. The remaining $4,000 is U.S. source income. Margaret must report $9,000 ($5,000 + $4,000) of income subject to U.S. income tax.
An annuity may be excludable under a treaty or other agreement. However, U.S. Social Security benefits that a nonresident alien receives are generally treated as U.S. source income, and 85% may be taxable under IRC sections 86(a) and 861(a)(8).
De Minimis Compensation Exception
Even if personal services are performed in the United States, IRC section 861(a)(3) exempts compensation of a nonresident alien from U.S. income tax if three requirements are met:
* The alien is temporarily present in the United States on occasions totaling no more than 90 days during the tax year;
* The compensation does not total more than $3,000; and
* The compensation is for services performed as an employee of or under contract with a nonresident alien, foreign partnership, or foreign corporation that is not engaged in a trade or business within the United States.
The employer may be a U.S. citizen or resident or a domestic partnership or corporation if the services are performed for an office or place of business maintained in a foreign country or in a U.S. possession by the individual, partnership, or corporation.
If an alien's reported compensation includes travel expenses, she may qualify for the de minimis exception even if the total exceeds $3,000. Treasury Regulations section 1.861-4(a)(4) omits advances and reimbursements for travel expenses from compensation to the extent the alien actually incurred the expenses and was required to account to the employer and properly did so. Advances and reimbursements exceeding actual expenses are included in compensation.
Disadvantages of Nonresident Alien Status
The choices for maintaining nonresident alien status and excluding income from U.S. tax entail certain disadvantages. For example, a nonresident alien generally may not do the following:
* Own shares in an S corporation;
* File a joint U.S. return or claim head of household filing status;
* Claim deductions not related to income connected with U.S. business activities;
* Claim exemptions for dependents, in some instances; or
* Claim the standard deduction.
An individual's specific circumstances may make resident alien status advantageous for a tax year. However, taxpayers and their advisors should exercise caution in this area because of potential difficulties in regaining nonresident alien status under the IRC and applicable tax treaties and possible loss of treaty benefits that the United States may accord to residents of the foreign country.
Weighing the Alternatives
Although U.S. citizens and resident aliens are subject to U.S. income tax on worldwide income, nonresident aliens generally may exclude non-U.S. source income and certain compensation for services in the United States. Aliens and their advisors must determine that the alien does not have resident status under either the lawful permanent resident or the substantial presence test. In certain instances, an individual can claim nonresident alien status (and income exclusions) for just a portion of a year.
Tax planning and compliance for a nonresident alien present challenges, but the tax savings may be worthwhile. *
Joseph R. Oliver, PhD, CMA, CFM, CPA, is a professor of accounting at Southwest Texas State University in San Marcos, Texas.
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