Taxation of resident aliens in the U.S.by Smolowitz, Sidney
Foreigners coming to the U.S. face complex rules both in determining when they become U.S. residents and when their U.S. residence ceases. The determination of residence is significant because resident aliens are taxed under a different regime than nonresident aliens. Resident aliens, like U.S. citizens, are taxed on their worldwide income, while nonresident aliens are generally taxed at regular rates on income which is effectively connected with a U.S. trade or business, and at a 30% (or less, as provided by treaty) withholding rate, on dividends, interest and other fixed or determinable periodic income. Before TRA 84
The term "residence" had been defined by Reg. 1.871- 2(b) before TRA 84, but there was no precision in defining whether an individual was a resident or nonresident alien. The status of the taxpayer depended largely on intent as to whether or not the individual was a transient. Present Law
TRA 84 added Sec. 7701(b) to the IRC. It provides a specific definition as to when an alien becomes a resident, stating that an individual so qualifies when satisfying either:
1. The lawful permanent resident (green card) test; or
2. The substantial presence test. In addition, provision is made for an alien to elect to be treated as a U.S. resident. Lawful Permanent Resident
An alien is considered a resident alien after becoming a lawful permanent resident. Such person is one who, under the immigration laws, is granted the privilege of living permanently in the U.S. (i.e., the individual is issued a green card). The individual generally continues as a U.S. resident until the green card is abandoned or revoked under the law. The lawful permanent residence test has nothing to do with the number of days spent in the U.S. An alien is subject to U.S. tax as long as the green card is retained, even if no time is spent in the U.S. Substantial Presence Test
An alien satisfies the substantial presence test if present in the U.S. for at least 183 days during the current calendar year, or under a formula method is deemed to be present in the U.S. for 183 days in the current year. Under the formula, each day in the current year is counted as one day; each day in the first preceding year is counted as 1/3 of a year; and each day in the second preceding year is counted as 1/6 of a day. However, the individual must be present at least 31 days during the current calendar year for the test to become effective even if the numerical test under the formula is satisfied.
It is important to determine what constitutes a day of presence in the U.S. Under the regulations an alien is considered to be present for a day if physically present in the U.S. at any time during that day. The Prop. Reg. Sec. 301.7701(b)-(3)(d) provides that days in transit between two foreign points may be excluded where the individual is in transit and physically present in the U.S. less than 24 hours. The regulations caution that there can be no ulterior motive by the individual; if the alien goes from one airport to another to change planes to a given destination, the alien is then considered to be in transit. However, if the alien attends a business meeting while in the U.S., even if still at the airport, the alien is not considered to be in transit. The Prop. Regs. do not, however, provide a realistic definition of what constitutes a business meeting.
The regulations do not indicate the result when the alien telephoned the home office from the airport and a conference call was arranged with U.S. and foreign business associates. Is the alien treated as present in the U.S. when in U.S. airspace, flying between two points to get to a plane to leave the U.S., and accepts a business phone call? If the alien is paged at a U.S. airport while waiting to make a flight out of the country and receives a business phone call, will this business contact be counted as a day of presence in the U.S.? Election to be Treated as a U.S. Resident
A nonresident alien can, under Sec. 7701(b)(1)(A)(iii), make an election to become a U.S. resident in the first year of presence where the alien does not meet the substantial presence test. Prop. Reg. 301.7701(b)-4(c)(3)(iv) provides the requirements for electing to be taxed as a U.S. resident. The individual:
1. Does not have a green card or does not meet the substantial presence test with respect to the calendar (election) year, or the year preceding the election year;
2. Meets the substantial presence test in the year following the election year; and
3. Is both present in the U.S. for 31 consecutive days during the election year, and is also present in the U.S. for at least 75% of the number of days during the period that begins with the first day that begins the 31-day period until the end of the year.
The purpose of the 75% test (item 3) apparently is to require a bona fide period of U.S. residence, before giving an alien the right to elect to become a U.S. resident. While it may be counterproductive to elect to be taxed as a U.S. resident where gains are to be realized, this is not the case where losses are incurred. Thus, it would often be desirable for a nonresident alien (NRA) to elect to be subject to U.S. tax where the alien can establish a capital loss carryforward which may be available in subsequent years when required to file a resident U.S. income tax return. In addition, deductions and exemptions available to resident aliens are much more liberal than those available to NRAs. Since the period required to establish U.S. residency is relatively small, many planning opportunities may be available.
Congress, by specifically defining who is a resident alien by statute, has added certainty to the law. One needs only to determine if the person is a lawful permanent resident or meets the substantial presence test under the statute. Terminating U.S. Residence
For illustrative purposes, assume "T") a British citizen, over 65 years of age, who has a green card and has been living in the U.S. for many years with his wife, wishes to retire and move to the Bahamas. He has certain attachments to the U.S.; he owns his own home, and his children and grandchildren live in and are citizens of the U.S. His largest unrealized security gain is in his employer's securities which were acquired in the open market over a number of years; he expects that his employer will soon be acquired. In addition, he also has a substantial unrealized gain in a diversified portfolio of other securities. Avoidance of U.S. tax on the appreciation of the securities presents certain problems, particularly where he wants to retain certain ties in the U.S. Resident alien "T" would like to be taxed as a NRA so that he could avoid tax on the appreciation of his securities. NRAs are taxed on their capital gains only when present in the U.S. for 183 days or more under Sec. 871(a)(2). However, NRAs are taxed on the disposition of stock of domestic corporations where U.S. real property interests constitute at least 50% or more of the assets of the corporation without regard to the number of days present in the U.S.
An individual can cease being a U.S. resident by giving up his green card. For this recision to be effective under Sec. 7701(b)(2)(B), there must be a formal proceeding before immigration authorities. If, after having spent 183 days of a year in the U.S., "T" gives up his green card and then sells his securities, he will be subject to tax as a resident alien on his capital gains. Sec. 871(a)(2) exempts from tax capital gains only of a NRA present in the U.S. for less than 1$3 days. Even if "T" had spent less than 183 days in the U.S. before surrendering his green card, he still may not be able to avoid the capital gains tax on the disposition of the securities. This could occur because "T" failed to meet the special requirements of the statute with regard to termination in his final year of residence in the U.S. Last Year of Residence
An alien, for tax purposes, may still be treated as a resident alien in his or her last year of residence, even though the alien has ceased U.S. residence. This situation applies if, during the balance of the year in which leaving the U.S., the alien fails to have a closer connection to a foreign country than to the U. S., or is a resident of the U. S. at anytime during the next calendar year.
Sec. 7701(b)(2)(B)(ii) provides that during the balance of the year in which "T" surrenders his green card, to avoid U.S. residency, he must maintain a tax home in a foreign country and must have a closer connection to that foreign country than to the U.S. Accordingly, in the year of departure the alien, who has avoided the 183 day rule of Sec. 871(a)(2) but met the substantial presence test under the formula method, can avoid the tax on capital gains in the year of departure by having a closer connection to a foreign country than to the U.S. for the balance of the year.
Apparently Congress was concerned that some longterm alien residents may not really have severed their connections with the U.S. in the year of departure. Presumably, they would realize a gain after departing the U.S., which avoided U.S. tax, without having really established a bona fide foreign residence outside the U.S. The closer connection provision with a foreign country is designed to ensure that there is a bona fide foreign residence in the year of departure from the U.S.
In addition, Sec. 7701(b)(2)(B)(iii) provides that the departing resident alien cannot be a U.S. resident at any time during the next calendar year. Therefore, if "T" becomes a U.S. resident in the year following his year of departure, he would be treated as a U.S. resident for the preceding year as well, and his income, including capital gains, would be subject to tax. Determination of Tax Home
An individual's tax home according to Prop. Reg. 301.7701(b)-(2)(c), is considered to be at the regular or principal (if more than one regular) place of business, or if the individual has no regular or principal place because of the nature of the business), then at the regular place of abode.
Reg. 1.911-2(b) provides that the term "tax home" has that same meaning as for Sec. 162(a)(2) relating to travel expenses away from home. Under the principles of Sec. 162(a)(2) dealing with business deductions (and consequently for purposes of Sec. 7701(b)) an individual's tax home is generally considered to be located at the principal place of employment.
A close reading of the Prop. Reg. 301.7701(b)-2(c)(1) does not appear to provide guidance for a retired person. It states that an employed individual will have an opportunity to have a tax home at the regular place of employment. Since a retiree has no job, his situation does not appear to fall within the scope of the Regs. Hopefully, the final regulation will address this situation, and provide guidance for a retired person, leaving the U.S., who wishes to establish a tax home in a foreign country. Prop. Reg. 301.7701(b)-(c)(2) provides that the alien's foreign tax home must be in existence for the entire current year." It appears that the regulation is improperly drafted since the statute only requires "T" to have a closer connection to a foreign country after abandoning the U.S. residence. When the Prop. Regs. are finalized, they should specify that a U.S. person abandoning a residence is only required to have a closer connection to a foreign country than to the U.S. beginning with the period subsequent to the time of abandoning the U.S. residence. Closer Connection Rules
Having established a foreign residence, the taxpayer must then prove a closer connection to that foreign country than to the U.S. Prop. Reg. 301.7701(b)-(2)(d) furnishes a list of items (not all inclusive) which may be used to determine whether "T" has a closer connection to a foreign country than the U.S.:
1. The location of the individual's permanent home;
2. The location of the individual's family;
3. The location of personal belongings, such as automobiles, furniture, clothing and jewelry owned by the individual and family;
4. The location of social, political, cultural or religious organizations to which the individual has a current relationship;
5. The location of the individual's personal bank accounts;
6. The type of driver's license held by the individual;
7. The country of residence designated by the individual on forms and documents;
8. The types of official forms and documents filed by the individual, such as Form 1078 Certificate of Alien Claiming Residence in the U.S.) or Form W9 (Payer's Request for Taxpayer Identification Number); and
9. The location of the jurisdiction in which the individual votes.
These items apply a facts-and-circumstances test so that it appears each case will be decided on its own facts, which will produce little guidance for taxpayers and substantial litigation.
For the balance of the year after he leaves the U.S., "T" must maintain a closer connection to the foreign country that he considers his primary residence than the U.S. Two of the factors that will prejudice "T's" position are that he is continuing to maintain his U.S. residence and that his children and grandchildren are located (and are citizens) in the U.S. In addition, it is expected that "T" and his wife will come to the U.S. periodically for visits. These factors indicate there is a strong tie to the U.S. Nevertheless, since his children are not dependents and since "T" is establishing a bona fide foreign residence and is living in a community (the Bahamas) with friends, (many of whom, like "T", are British citizens) there is a strong likelihood that his position as a NRA will be sustained.
There is one other thing that "T" can do to enhance his position as a NRA in the year of departure. Reg. Sec. 3901.7701(b)-(2)(d), describing the alien's home states:
"For the purpose of this paragraph, it is immaterial
whether a permanent home is a house, an apartment,
or a furnished room. It is also immaterial whether the
home is owned or rented by the alien individual. It is
material, however, that the dwelling be available at an
times, continuously, and not solely for stays of short
Based on this wording, it appears it can be applied to the U.S. residence, as well as the foreign residence. Therefore, if "T" were to rent his U.S. house for the period he does not intend to use it, his stay would be limited to a short duration and would then appear to fall within the precise meaning of the regulation, and he would not be deemed to have a U.S. home. Substantial Presence Test
Even though "T" has properly surrendered his green card, he may still be unable to avoid U. S. tax if he meets the substantial presence test. Sec. 7701(b)(2)(B)(iii) provides that the individual is not treated as a U.S. resident after he abandons his U.S. residence, provided the individual is not a resident of the U.S. at any time during the next calendar year. Thus, if "T" has spent, in the second preceding year, 300 days in the U.S., and 240 days in the first preceding year, he will have spent in that two year period (under the rules previously described) a total of 150 days in the U.S. If he spends 33 days in the U.S. in the current year, he would comply with the requirements of the substantial presence test.
Sec. 7701(b)(3)(B) provides an exception to the above rule pertaining to the substantial presence test. It provides that where an alien is physically present in the U.S. for less than 183 days in the current year, and though he meets the substantial presence test under the formula method, if he has a tax home in a foreign country, and has a closer connection to such a foreign country, he will not be deemed to be a U.S. resident.
It would appear that an alien can spend up to 182 days a year in the U.S. and fall within the substantial presence test yet avoid being treated as U.S. resident, provided there is a closer connection to a home in a foreign country. Limited Expatriation Rule
To forestall the possibility that resident aliens, after living in the U.S. for an extended period would leave for a short time, become NRAs, recognize a gain which would avoid U.S. tax and then return to U.S. residency status, Congress enacted Sec. 7701(b)(10). That section taxes an alien in a manner similar to that used by Sec. 877 to tax a U.S. citizen who expatriates himself to avoid U.S. tax. One major difference is that Sec. 877(b) only applies to a U.S. citizen where there is intent to avoid tax. Sec. 7701(b)(10) provides a mechanical test which becomes effective even where the alien inadvertently spends more than 183 days in the U.S.
Sec. 7701(b)(10) provides that if an alien was treated as a U.S. resident over a period that included parts of three consecutive calendar years (which residency period can be as little as 14 months), stops being a resident, and then becomes a U.S. resident again not having allowed three complete calendar years to lapse before he resumes his U.S. residency, he becomes subject to tax under 877(b). Sec. 877(b) applies only if that tax exceeds the tax that would be imposed as a NRA under Sec. 871. Sec. 871 taxes NRAs at 30% rate on their fixed determinable U.S. source income and excludes capital gains from tax when the NRA is present in the U.S. for less than 183 days.
Sec. 877(b) has as its objective the taxation of U.S. source income that a resident alien believed could be avoided by giving up residence. The statute accomplishes this by taxing nonresidents during the period they were absent from the U.S. on: 1) their U.S. source income which is effectively connected with U.S. trade or business; and 2) U.S. source investment income as defined in the statute, which includes gains from the sale of stock of U.S. corporations. The tax is imposed without regard to the 183 day rule applicable to NRAs. The tax will be imposed under the graduated rates of Sec. 1 of the code unless the alternative minimum tax imposed by Sec. 55 applies.
It thus appears that unless "T" inadvertently becomes subject to the Sec. 877(b) tax by becoming a U.S. resident (inadvertently meeting the substantial presence test) he may be able to avoid tax on the sale of his securities. To do it, he must set up his new residence in the Bahamas, have a closer connection to the Bahamas than to the U.S., and avoid the substantial presence test in the year after the year of departure. Residence Gain
"T's" plan, as previously stated, is to move to the Bahamas, and make his home there; to return to the U.S. in the summer months, visit with his children and grandchildren; and continue to use his old home as a residence when staying in the U.S. Under this scenario when "T", as resident of the Bahamas, sells his U.S. home, he will be subject to tax as a NRA, under Sec. 897, which taxes NRAs on the disposition of real property interests. Sec. 1445 provides that the transferee (buyer) is usually required to withhold 10% of the proceeds of the sale. Where the selling price of the house is $300,000 or less and the buyer is going to use the property as his residence, no withholding is required. Nevertheless, the seller is still subject to tax under Sec. 897. Reg. Sec. 1.897-6T(a)(5) provides that a NRA individual shall not be entitled to nonrecognition of gain (Sec. 1034 deals with rollover gain on sale of a residence) when he sells his U.S. residence and the new principal residence acquired is not a U.S. real property interest. Accordingly, when "T" sells his U.S. home, he will be subject to tax since he is a NRA without regard to the number of days spent in the U.S. Under Sec. 897, gain on the sale of real estate by a nonresident alien is treated as income effectively connected with U.S. trade or business.
However, if "T" were to retain his green card, and purchase a Bahamas home as a principal residence, it appears he would continue to be subject to U.S. tax, as a resident alien. Therefore, the rollover provision of Sec. 1034 could apply to him if he sold his U.S. home within the required statutory period. In actual fact because "T" wants to retain his U.S. home to live there during the summer months, it appears he will be subject to tax on the gain when he disposes of the property as a NRA.
Much of Sec. 7701(b) is spent defining when a resident alien becomes a NRA in terms of days. It would appear that maintenance of a principal residence in the U.S. may be inconsistent with the taxation of that NRA's home. Situations may occur where the IRS determines that an alien is still a U.S. resident (e.g., he meets the substantial presence test). If the sale of his residence would otherwise be subject to tax because of NRA status, the alien may be able to assert that he is still a resident and that the rollover provisions of Sec. 1034 apply. Estate Tax
Having extricated himself from U.S. income tax residency issues, the NRA must determine taxation for estate tax purpose. Sec. 2106 taxes NRAs' estates to the extent the property they own is situated in the U.S. TAMRA 88 increased the rate of tax on the nonresident's U.S. estate of those NRAs dying after November 10, 1986; their U.S. property will in general, be taxed at the same rates as U.S. residents. Estates of NRAs dying before November 10, 1986, had been subject to lower rates. Certain deductions including losses, debts, taxes, etc., continue in part to serve to reduce the gross estate of the nonresident in arriving at the taxable estate.
In addition to the change in rates, TAMRA created a further major change for the estates of resident aliens. Previously, the marital deduction was available where the decedent was a resident alien. Sec. 2056(d) now provides that the marital deduction is not available where the decedent's spouse is not a U.S. citizen. This change may have the unforeseen effect of causing resident aliens to become NRAs. The marital deduction will be allowed where the property is placed in a qualified domestic trust. The purpose of this trust is to make certain the assets are subject to estate tax when the wife dies or principal is distributed during her lifetime. Residence for Estate Tax Purposes
The Estate Tax Reg. 20.0-1(b)(1) defines a resident decedent as a "decedent who at the time of his death had his domicile in the U.S." Estate Tax Reg. 20.0-1(b)(2) provides that a "nonresident decedent is a decedent who at the time of his death had his domicile outside the U.S."
Domicile is a question of intent-it is the place the person regards as home, the place to which he or she always intends to return. A person can have many homes but only one domicile. Reg. 20.0-1(b)(1) states: "A person acquires a domicile in a place by living there, for even a brief period of time with no definite present intention of later removing therefrom." It would appear domicile is an entirely different concept for estate tax purposes than residence for income tax purposes. Whereas TRA 84 laid down defined standards for the determination of residence for income tax purposes, the rules pertaining to residence for the estate tax purposes remained unchanged.
Accordingly, there is a conflict between the determination of residence for income tax purposes and estate tax purposes. For income tax purposes a NRA can avoid the substantial presence test by watching the number of days (less than 183) spent in the U.S. Nevertheless, for estate tax purposes, the determination of residence is a question of intent. The courts will attempt to determine the intent of the decedent by reviewing the underlying facts.
The following illustrates the issue with regard to "T" who is now deceased, and whose family (children and grandchildren) reside in the U.S. The decedent, prior to his death, visited his children and grandchildren after having changed his status from a resident to a NRA. By limiting his stay in the U.S., he was able to avoid the substantial presence test for income tax purposes. Nevertheless, it is possible the courts will take the position that for estate tax purposes the decedent never abandoned his U.S. residence because his family remained in the U.S. He had a closer nexus to the U.S. than any other country.
A more interesting question is presented where the decedent, a NRA, spends less than 183 days in the U.S. each year over a number of years but falls within the substantial presence test because of the formula computation. However, the alien complies with the exception to the substantial presence test under Prop. Reg. 301.7701(b)-2(d) by maintaining a closer connection to a foreign country than to the U.S. Will the alien be able to claim that the same rule should be applied for estate tax purposes?
It is unlikely that the courts will abandon their analysis of the facts, in determining a decedent's intent for establishing domicile for estate tax purposes without a direct legislative mandate. Many items listed in Prop. Reg. 301.7701(b)-2(d) dealing with the determination of residence for income tax purposes are many of the same matters that will be considered by the courts for determining residence for estate tax purposes. Conclusion
There is no question that the definition in Sec. 7701(b) has added a degree of precision to the determination of an alien's residency. Hopefully, a similar rule or more precise definition will be provided for estate tax purposes. It is possible that, because the definition of residence for income tax is so precise, (and possibly easy to avoid), nonresident aliens will be spending more time in the U. S. It is therefore possible that they will be exposing themselves to estate tax as resident aliens.
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