The IRS issued final regulations that define a resident alien under IRC Sec. 7701(b). Although the final regulations largely adopted the regulations proposed on September 10, 1987, a number of revisions may change the resident status of certain alien taxpayers. The final regulations were issued retroactively and are effective for tax years beginning after December 31, 1984. Besides possibly affecting the resident status of alien taxpayers in future tax years, aliens whose resident status has changed for years still open under the statute of limitations may find it advantageous to file amended returns. At the same time the final regulations were issued on April 24, 1992, the IRS introduced proposed regulations that establish the circumstances under which a dual resident may be a shareholder of an S corporation without terminating the corporation's Subchapter S election. Additionally, a provision included in the proposed regulations may require certain dual resident shareholders claiming treaty benefits prior to July 27, 1992, to file amended returns.

To assist in determining whether an individual's resident status or residency period has changed under the final regulations, differences between the proposed and final regulations are highlighted throughout the article. Illustrative examples are also provided.

Tax Implications of Resident and Nonresident Alien Status

Individuals meeting the definition of a resident alien for Federal income tax purposes are treated similarly to U.S. citizens. Their worldwide income is subject to U.S. tax, they may take the same deductions, and their income is subject to the same progressive tax rates. In contrast, nonresident aliens are--

* Taxed on income effectively connected with a U.S. trade or business (including any net capital gain on the sale of business assets) at the normal progressive rates;

* Taxed at a flat rate of 30% on income derived from U.S. sources not effectively connected with a U.S. trade or business such as wages, salaries, interest, dividends, rents, and annuities, (an election is available under IRC Sec. 871(d) in connection with income from U.S. real property);

* Exempt from tax on net capital gains derived from U.S. sources not effectively connected with a U.S. trade or business, except when present in the U.S. for 183 days or more (this exemption does not extend to sales of U.S. real property);

* Not taxed on non-U.S. source income and are not allowed to use non- U.S. source losses to offset U.S. source income;

* Not entitled to a standard deduction (the only deductions allowed are expenses associated with the income effectively connected with a U.S. trade or business--not to exceed U.S. business income, casualty and theft losses on property located in the U.S., charitable contributions under IRC Sec. 170, and one personal exemption); and

* Not allowed to file jointly with their spouses and cannot qualify as head of household (accordingly, nonresident aliens must use either the married filing separately or single rates).

Consequently, a change in residency status can have significant income- tax consequences to an alien taxpayer. In addition, individuals not meeting the definition of a resident alien cannot be shareholders in an S corporation and are subject to special withholding requirements.

Resident Alien Defined

IRC Sec. 7701(b) defines a resident alien for purposes of Federal income tax as an individual who meets the objective criteria of either the green-card test or the substantial-presence test, or who meets the specifications contained in IRC Sec. 7701 (b)(4) and files a first year election to be treated as a resident alien. Individuals who at any time during the calendar year have been lawfully granted the privilege of residing permanently in the U.S. under the immigration laws automatically meet the definition of resident alien under the green-card test.

Individuals who are not lawful permanent residents are defined as resident aliens under the substantial-presence test if they are physically present in the U.S. for at least 183 days during the year. Alternatively, individuals who are neither lawful permanent residents nor physically present in the U.S. for at least 31 days are classified as nonresident aliens. Individuals who are not lawful permanent residents and are physically present in the U.S. for at least 31 but less than 183 days in the current year are defined as resident aliens under the substantial-presence test if they: 1) had a significant presence in the U.S. during the past three years and 2) did not have a closer connection to a foreign country in which they had a tax home. The regulations list ten objective factors that will be considered in determining whether an individual has a closer connection to a foreign country where he or she maintains a tax home.

An individual's presence in the U.S. during the past three years is deemed to be significant if the number of days the individual was present in the U.S. in the current year plus one-third of the days present in the U.S. during the prior year plus one-sixth of the days present in the U.S. during the second prior year exceeds 182.

Example 1: Ted was present in the U.S. for 105 days in 1993, 180 days in 1992, and 120 days in 1991. Ted does not have a tax home in a foreign country. Although Ted is not physically present in the U.S. for at least 183 days in 1993, he is considered a resident alien since he had a significant presence in the U.S. during the past three years and he does not have a closer connection to a foreign country in which he has a tax home.

Dayspresentin1993105

Dayspresentin1992|180x1/360

Dayspresentin1991|120x1/620

TotaldaysofU.S.presence185

Example 2: Nancy was present in the U.S. for 30 days in 1993, and all of 1991 and 1992. In 1991 and 1992, Nancy filed her income tax return as a U.S. resident since she was present in the U.S. for at least 183 days in each of those years. Nancy does not qualify as a resident in 1993 since she is not present in the U.S. for at least 31 days during the year, even though after applying the weighted formula her total days of presence equals 213 |30 + (1/3 x 365) + (1/6 x 365).

Finally, individuals not meeting the objective criteria of either the green-card test or the substantial-presence test can file a first year election to be treated as resident aliens by attaching a statement to the Form 1040, provided they--

1. Were not a resident of the U.S. in the previous year,

2. Were physically present in the U.S. for at least 31 consecutive days in the current year,

3. Were present in the U.S. 75% of the days during the testing period, which begins with the first day of the 31-day period and ends on the last day of the election year, and

4. Satisfy the substantial-presence test in the year following the election year.

Example 3: Debbie, a citizen of foreign country A, is an alien who has never been a U.S. resident for income tax purposes. Debbie is present in the U.S. from October 29, 1988, until she returns to A on December 1, 1988. Debbie returns to the U.S. on December 17, 1988, and stays for the remainder of the year. In 1989, she is a U.S. resident under the substantial-presence test. Debbie may elect to be treated as a resident of the U.S. for 1988 because she was present in the U.S. for at least 31 consecutive days (October 29 through December 1) and for at least 75% of the days during the testing period, which ran from October 29 through December 31, 1988 (49 total days of presence in the U.S./64 days in the testing period = 76.6%).

Under the final regulations, the first-year election is available only to those who substantially comply with the election procedures in the regulations. In addition, the regulations now allow individuals who qualify to make a first-year election to make an election on behalf of a dependent child who qualifies to make a first year election, provided the child is not required to file a U.S. income tax return for that year.

Differences Between the Proposed and Final Regulations

In defining a resident alien under IRC Sec. 7701(b), the regulations provide guidance regarding what constitutes a day of presence in the U.S. for purposes of determining whether an individual has met the 183- day requirement under the substantial-presence test. The regulations also clarify what constitutes a closer connection to a foreign country and what meets the definition of a tax home.

In determining a day of presence in the U.S., the final and proposed regulations differ in--

* Defining what constitutes the U.S.,

* Determining under what conditions individuals living in Canada or Mexico can exclude days spent commuting to the U.S., and

* Determining under what circumstances individuals can exclude days present in the U.S. as a result of a medical condition.

In defining the terms "closer connection" and "tax home," the final regulations differ from the proposed regulations by--

* Adding another objective factor used in determining whether the individual has a closer connection to a foreign country,

* Allowing an individual to change his or her foreign tax home and closer connections once during a calendar year, and

* Clarifying what constitutes a tax home for individuals not engaged in a trade or business.

What Constitutes the U.S.

To qualify as a day of presence in the U.S., an individual must be physically present in the U.S. at any time during the day. For purposes of the substantial-presence test, the U.S. is defined as the 50 states and the District of Columbia, but not U.S. possessions or territories. Under the final regulations, the definition of the U.S. no longer includes airspace over the U.S. Consequently, individuals qualifying as U.S. residents under the substantial-presence test because they included days flying over the U.S. en route to another country need to reassess whether they still meet the 183 day criteria under the new regulations.

Example 4: In 1991, Andrew worked 175 days in the U.S. On another 15 days, he flew over the U.S. en route to another country. In April 1992, Andrew filed his 1991 income tax return as a resident alien, since according to the proposed regulations, he was physically present in the U.S. for 190 days in 1991. However, Andrew does not automatically qualify as a resident alien under the final regulations, since his physical presence in the U.S. includes only the 175 days he actually worked in the U.S.

The IRC specifically states that days present in the U.S. do not include any day--

1. On which an individual who resides in Canada or Mexico commutes to and from full-time employment (including self-employment) in the U.S.,

2. An individual is prevented from leaving the U.S. because of a medical condition that arose while present in the U.S.,

3. An individual is present in the U.S. as an exempt individual, or

4. An individual is in transit between two points outside the U.S.

Regular Commuter

The final regulations exclude from U.S. days of presence the days in which an individual commutes, within a 24-hour period, from a permanent residence in Canada or Mexico to a U.S. location of employment, but only if the commute occurs on more than 75% of the workdays during the working period. The final regulations state that a working period begins on the first day of the current year that the individual physically works either as an employee or as a self-employed individual in the U.S. and ends on the last day the individual is present for the same purpose. Thus, a working period may extend over more than one year. For cyclical jobs, there may be several working periods in a calendar year.

The final regulations liberalized the exclusion of U.S. days for commuters, as the proposed regulations required individuals to commute on more than 80% of the workdays during the current year. Therefore, individuals who, according to the proposed regulations, were physically present in the U.S. for at least 183 days (either in the current year or during the past three years) should reassess whether the days present in the U.S. can be excluded under the regular commuter exception in the final regulations and determine whether resident alien status was retained.

Example 5: During 1990, Russell was present in the U.S. for 320 days, including 190 days in which he commuted from his principal residence in Canada to his location of employment in the U.S. During 1990, there were 250 workdays in the current year and the working period. Russell filed his 1990 income tax return as a resident alien since he was physically present in the U.S. for more than 183 days during the year. Russell was not able to exclude the 190 commuting days, since less than 80% of the 250 working days were spent commuting to the U.S. Under the final regulations, the 190 days would be excluded from U.S. days since more than 75% of the 250 working days were spent commuting from his Canadian residence to his U.S. place of employment. Consequently, if Russell's presence in the U.S. during the past three years is not significant or if he has a closer connection to a foreign country where he has a tax home, he may find it advantageous to file an amended 1990 return as a nonresident alien.

Medical Condition

To exclude days present in the U.S. due to a medical condition, the regulations require two criteria to be met. First, the medical condition must arise while the individual was present in the U.S. An individual who was aware of the condition prior to entering the U.S. is not able to exclude the days spent in the U.S. Thus, days present in the U.S. will not be excluded if the medical condition arose during a previous stay in the U.S., even if the individual returns to the U.S. for medical treatment.

Second, the individual must have intended to leave the U.S. once the condition arose, but was unable to do so because of the medical condition. The key to assessing whether the second criterion has been met is determining if, at the time the condition arose, the individual had intended to leave the U.S. Generally, an individual is presumed to have intended to leave the U.S. if he or she leaves within a reasonable period of time after becoming physically able to leave. The final regulations state that if at the time the medical condition arose the individual was present in the U.S. for a definite purpose, the individual may be able to establish that he intended to leave the U.S. once that purpose was accomplished. However, if the individual was present in the U.S. for no specific purpose, the requisite intent to leave will be determined based on the surrounding facts and circumstances.

Example 6a: Paul was seriously injured in an automobile accident in the U.S. on March 25. Paul intended to leave the U.S. on March 31 as evidenced by his airline ticket, but was unable to do so due to his injuries. Paul recovered from the injuries and was able to leave and did leave the U.S. on May 31. Paul's presence in the U.S. from April 1 through May 31 is not counted as days present in the U.S.

Example 6b: The facts are the same as Example 6a, except Paul did not leave the U.S. until June 30. Under these circumstances, it is likely that none of the days will be excluded since Paul remained in the U.S. beyond a reasonable period of time after physically being able to leave.

Exempt Individuals

Days of presence in the U.S. during which an individual is classified as an exempt individual are not included for purposes of the substantial- presence test. Exempt individuals are defined in IRC Sec. 7701 (b)(5) as--

1. Certain foreign government-related individuals temporarily in the U.S.;

2. Teachers and trainees admitted temporarily to the U.S. as nonimmigrants under Sec. 101(a)(15) of the Immigration and Naturalization Act (INA), provided that they do not engage in prohibited activities that could result in the loss of their visa status;

3. Students temporarily admitted to the U.S. as nonimmigrants under Sec. 101(a)(15)(F), (J), or (M) of the INA, provided they do not engage in prohibited activities that could result in the loss of their visa status; and

4. Professional athletes present in the U.S. to compete in a charitable sports event described in IRC Sec. 274(1)(1)(B). However, athletes are able to exclude only those days in which they compete.

IRC Sec. 7701(b)(5)(E) limits the number of years teachers, trainees, and students may retain exempt status. In general, students do not qualify as exempt individuals if they excluded U.S. days as an exempt student, teacher, or trainee for any part of more than five calendar years, beginning with 1985. Teachers and trainees do not qualify as exempt individuals in the current year if they excluded U.S. days as an exempt individual during any two of the previous six calendar years, beginning in 1985. This period is reduced to two of the previous four calendar years for individuals who were present in the U.S. either as teachers or trainees in any of the previous six calendar years and whose entire compensation during that time was from sources described in IRC Sec. 872(b)(3).

Example 7: In 1993, Carol was present in the U.S. for the entire year as a teacher. Carol taught in the U.S. in 1987 and 1991 and excluded U.S. days as an exempt individual in both years. If during 1987, 1991, and 1993 Carol's entire compensation came from sources described in IRC Sec. 872(b)(3), then Carol qualifies as an exempt individual in 1993 since she claimed exempt status only once in the last four calendar years. However, if part of Carol's compensation during 1987, 1991, or 1993 was not from sources described in IRC Sec. 872(b)(3), Carol does not qualify as an exempt individual in 1993 since she claimed exempt status in two of the previous six calendar years.

Days in Transit

To exclude days present in the U.S. as days in transit between two foreign destinations, an individual must be physically present in the U.S. for less than 24 hours. Furthermore, any activities not related to traveling to a foreign destination, such as attending a business meeting (even if the meeting is held at the airport), will prevent that day from being excluded as a day in transit.

The Closer Connection Exception

Individuals present in the U.S. for less than 183 days are not defined as resident aliens if they have a closer connection to another country where they have a tax home. A closer connection to another country can be shown by demonstrating that the individual has maintained "more significant contacts" with the foreign country than with the U.S. The regulations provide a list of factors to be considered in determining whether the individual has more significant contacts with another country. Included in this list are the location of the individual's permanent home, family, and personal belongings; where the individual votes and holds a driver's license; and the type of official forms and documents the individual files and the country of residence designated on those forms. The final regulations include as an additional factor the location where the individual conducts business activities (other than those that constitute the individual's tax home). This list, however, is not intended to be inclusive and a final determination is dependent on the individual's circumstances.

To avoid being classified as a resident alien under the doser connection exception, the individual must have maintained, for the entire year, a tax home in the same country to which a closer connection has been established. The proposed and final regulations state that a tax home for purposes of IRC Sec. 7701(b) has the same meaning it has for purposes of IRC Sec. 162(a)(2), relating to travel expenses while away from home. Therefore, an individual's tax home is where the individual's regular or principal place of business is located. If the individual is not engaged in carrying on any trade or business or if no regular or principal place of business exists because of the nature of the business, the individual's tax home is the individual's regular place of abode in a real and substantial sense.

Under the proposed regulations, individuals who moved from one foreign country to another during the year could not qualify for the closer connection exception and therefore were classified as resident aliens. The final regulations allow an alien to move his or her foreign tax home and closer connections once during the calendar year and still qualify as a nonresident under the closer connection exception. However, the individual must maintain the first tax home at the beginning of the year and move to a second foreign country where a tax home is maintained for the remainder of the year. In addition, the individual must have a closer connection to each foreign country than to the U.S. for the period during which the individual maintains a tax home in that foreign country. Finally, the individual must be taxed either as a resident of one of the foreign countries for the entire year, or as a resident of both countries during the time the individual lived in each. This new provision allows more individuals to avoid being classified as resident aliens; however, failing to meet any one of these requirements will cause the individual to meet the definition of resident alien under the substantial-presence test.

Finally, the closer connection exception does not apply to individuals who have taken affirmative steps to change their status to that of a permanent U.S. resident. Thus, an individual who otherwise would qualify for the closer connection exception will be disqualified if he or she has begun the process of immigrating to the U.S. The final regulations provide a detailed, but not exhaustive, list of actions considered affirmative steps to changing status.

TABULAR DATA OMITTED

Starting and Ending Dates of Residency

Individuals who meet the definition of a resident alien in the current year, but were not residents in the preceding calendar year, are treated as U.S. residents beginning with the residency starting date. For green card holders, the residency starting date begins on the date the individual was first physically present in the U.S. as a lawful permanent resident. For those meeting the substantial-presence test, the residency starting date generally begins on the first day during the year that the individual was present in the U.S. The residency period for individuals satisfying the green card and substantial-presence tests starts on the earlier of these two dates. For individuals making a first year election, the residency starting date is the first day of the first 31 consecutive day period in which the individual is present in the U.S.

Individuals who are resident aliens during the current year, but not residents at any time in the following calendar year, cease to be residents for income tax purposes on the individual's residency termination date. Generally, this is the last day of the calendar year. However, if the taxpayer establishes that for the remainder of the calendar year his tax home was in a foreign country to which he had a closer connection than the U.S., the residency termination date is the last day the individual is physically present in the U.S. (for purposes of the substantial-presence test) or the last day the individual is a lawful permanent resident (for purposes of the green-card test). For those satisfying the requirements of the green card and substantial- presence tests, the residency period ends on the later of the two dates. In determining the residency termination date, the proposed regulations were amended to require that the individual have a tax home in the foreign country to which he has a closer connection than the U.S. Consequently, the residency termination date of resident aliens who did not have a tax home in the foreign country subsequent to leaving the U.S. may be affected by the final regulations.

Example 8: Susan, a citizen of foreign country B, who has never been a resident of the U.S., enters the U.S. as a lawful permanent resident on January 23, 1992. On November 30, 1992, Susan ceases to be a lawfully permanent resident and returns to B. Susan is able to establish a closer connection to B for the month of December, but is unable to show that she has a tax home in B during that time. Under the proposed regulations, Susan is a U.S. resident from January 23 through November 30, 1992, and will be taxed on her worldwide income for that period. Under the final regulations, Susan is taxed on her worldwide income from January 23, 1992, through the end of the year, since she did not establish a tax home in B after leaving the U.S.

De Minimis Presence

Under the proposed regulations, individuals were able to exclude up to ten days of presence in the U.S. without triggering the starting date (for purposes of the substantial-presence test) or ending date (for purposes of either the substantial-presence test or the green-card test) if they established they had a closer connection to a foreign country during those days. It was not necessary that the ten days be consecutive, however; days from a continuous period could be excluded only if all days in the period could be excluded. The final regulations amended the de minimis presence rule by --

* Making the exclusion for the residency termination date applicable only for purposes of the substantial-presence test, and

* Requiring individuals to have a tax home in the foreign country to which they have a closer connection than the U.S.

Example 9a: Chris, a citizen of foreign country X who has never been a resident of the U.S., attends a business conference in the U.S. from February 10, 1992, until his return to X on February 24, 1992. On April 20, 1992, Chris returns to the U.S. as a lawful permanent resident. On November 10, 1992, he ceases to be a lawful permanent resident, but remains in the U.S. until November 20, 1992. Chris returns to the U.S. for a visit from December 8 until December 17, 1992. For this period, Chris can establish a closer connection to X, where he has a tax home. Chris is not a U.S. resident in 1993 and can establish a closer connection to X for that year. In 1992, Chris qualifies as a resident alien under the green-card and substantial-presence tests. Under the green-card test, Chris' residency starting and ending dates are April 20, 1992, and November 10, 1992, respectively. Under the substantial- presence test, Chris' residency starting date is February 10, 1992, since he is present in the U.S. for more than 10 days in February and cannot take advantage of the de minimis rule. His residency termination date under the substantial-presence test is November 20, 1992, since he can disregard his ten days of presence in December. Thus, for Federal income tax purposes, Chris is treated as a resident alien from February 10 through November 20, 1992.

Example 9b: The facts are the same as Example 9a, except Chris does not have a tax home in X during 1992. Under the proposed regulations, Chris' residency period is unchanged. Under the final regulations, however, since he does not have a tax home in X, Chris' residency period is extended to December 31, 1992, and he is subject to tax on his worldwide income from February 10, 1992, through the end of the year.

Dual Residents

A dual resident is an individual who meets the definition of a resident alien under IRC Sec. 7701(b) and also qualifies as a resident of another country. In instances where the other country is a U.S. treaty partner, the individual often may elect to be taxed as a nonresident of the U.S. under an income tax treaty. For tax years beginning after December 31, 1991, the final regulations require individuals filing as nonresidents under treaty provisions to attach a statement to their Form 1040NR disclosing that they are claiming treaty benefits as nonresidents. In addition to the filing requirements, the following two provisions included in the regulations could affect dual residents claiming treaty benefits to reduce their U.S. Federal income tax liabilities:

* The possible loss of lawful permanent residency, and

* The possibility of being treated as a nonresident for purposes of IRC Sec. 1361(b), which defines a small business corporation.

The final regulations added a sentence stating that, for dual residents who are lawful permanent residents of the U.S., claiming treaty benefits as nonresidents to reduce their U.S. Federal Income tax liabilities may influence the INS's determination as to whether they qualify to maintain green-card status. In addition, under the new proposed regulations, dual residents claiming treaty benefits as nonresidents to reduce their U.S. income tax liabilities are treated as nonresident aliens for purposes of IRC Sec. 1361(b), thus terminating the corporation's Subchapter S election effective the first day of the taxable year in which the dual resident claims a treaty benefit. Dual residents not claiming treaty benefits can be shareholders of an S corporation without terminating the corporation's S election. However, when the following three conditions are met, the regulations allow dual residents claiming treaty benefits to be shareholders in an S corporation. These conditions ensure at least one level of U.S. tax on a dual resident's share of an S corporation's income.

1. The S corporation was never a C corporation or another S corporation that was previously a C corporation;

2. The shareholder agrees to include in income his pro rata share of S corporation income as if such income were realized by a resident alien;

3. The S corporation agrees to withhold taxes on the nonresident alien's share of S corporation income and any gain the nonresident realizes on the disposition of S stock as if the shareholder was a foreign partner in a partnership.

The proposed regulations are effective for S corporation tax years beginning after July 27, 1992; however, dual resident shareholders who previously claimed a treaty provision as nonresidents on a U.S. return are required to either--

1. Waive their treaty benefits and file amended returns as resident aliens, or

2. Determine the character of their pro rata share of income in accordance with a reasonable method that is consistent with IRC Sec. 1366.

The proposed regulations, however, did not specifically state the consequences to S corporations for years prior to July 27, 1992, if a dual resident shareholder fails to meet either of these two requirements.

EXHIBIT 3 PROPOSED RULES REGARDING DUAL RESIDENTS THAT ARE S CORPORATION SHAREHOLDERS

PROPOSED RULE: An individual who is a dual resident and who claims treaty benefits as a nonresident to reduce his or her U.S. inocme tax liability will be treated as a nonresident alien for purposes of determining the Subchapter S status of a corporation.

EFFECTS OF PROPOSED RULE: If a shareholder in a Subchapter S corporation is a dual resident and claims treaty provisions to reduce his or her Federal income tax liability, the corporation's Subchapter S election will be terminated, effective on the first day of the dual resident's taxable year.

PROPOSED RULE: A dual resident that does not claim treaty benefits to reduce his or her income tax liability will not be treated as a nonresident alien for purposes of determining the Subchapter S status of a corporation.

EFFECT OF PROPOSED RULE: An S corporation may have as a shareholder a dual resident of the U.S. and another country, without terminating its subchapter S election, provided the dual resident shareholder does not claim treaty benefits.

PROPOSED RULE: A dual resident S corporation shareholder may enter into an agreement with the S corporation whereby the dual resident will be subject to tax and withholding as if he or she were a nonresident alien partner in a partnership.

EFFECT OF PROPOSED RULE: An S corporation may have as a shareholder a dual resident of the U.S. and another country, even if the dual resident shareholder claims treaty benefits to reduce his or her income tax liability, without terminating its Subchapter S election.

Linda M. Johnson, PhD, CPA, is an Assistant Professor at Northern Illinois University. David E. Zinneman, CPA, is a tax associate with Deloitte & Touche.