Many individuals who move to the U.S. for work, study or investment, often understand that they will need to be careful to comply with the applicable immigration rules, such as obtaining a visa. And while such persons often have a general idea that they will need to file U.S. tax returns, far less time is spent on tax planning.
This blog post outlines a commonly overlooked filing status that may be of substantial use to foreign investors, workers and students.
U.S. Tax Filing Status by Residency
Under U.S. tax rules, individuals are divided into three general categories, each of which has a different tax filing obligations.
U.S. citizens file U.S. tax returns each year, even if they live and work in another country. Generally, they are required to include all of their income on their U.S. tax returns, regardless of the source of origin of that income.
Non-citizens who are residents of another country are referred to as “non-resident aliens” (NRAs). NRAs generally have no U.S. income tax filing obligations unless they have certain types of U.S.-source income. In addition, an NRA may indirectly bear U.S. tax on certain types of passive U.S. source income (such as dividends and interest) to the extent these payments are subject to U.S. withholding tax. In this case, however, there is generally no U.S. tax filing obligation.
For example, assume Joan is a Chinese citizen who resides and works in China. She has various business interests in China, and also owns a partnership interest in a U.S. real estate project, and holds stock in a small U.S. corporation. Owning the partnership interest will subject her to U.S. taxation, but only with respect to the income allocated to her by the U.S. partnership. Assume that Joan receives dividends from the U.S. stock that are subject to U.S. withholding tax. Again, Joan will bear U.S. tax, but only with respect to the U.S. dividends paid to her. The mere ownership of the partnership interest or the stock would generally not cause Joan’s Chinese income to be taxed in the U.S.
Non-citizens who are residents of the U.S. are called “resident aliens.” Resident aliens generally have to file a U.S. tax return. There are two broad tests for whether a non-citizen is a U.S. resident for tax purposes: the “Green Card” test and the “Substantial Presence Test.”
Under the Green Card test, a foreigner is treated as a U.S. resident for tax purposes if he or she is a lawful permanent resident of the U.S. at any time during 2020. Generally, USCIS will issue such a person an alien registration card, also known as a green card.
Under the Substantial Presence Test, a foreigner is treated as a U.S. resident for tax purposes if he or she is present in the U.S. for any reason for a substantial period. Although the day-count rules for this test are complicated, staying in the U.S. for 183 days or more in a single year will often trigger U.S. resident status.
Effect of Residency on Tax Filing
Often, as noted, resident aliens and their U.S. employers will spend significant amounts of time making sure that the correct visa has been obtained and taking the necessary steps to meet all the compliance obligations of that visa. Less time is spent evaluating the resident alien’s tax filing strategy. A resident alien who files a regular U.S. tax return – IRS Form 1040 – will have to include all of his or her income on it, even foreign-source income. In contrast, some resident aliens may qualify for filing IRS Form 1040-NR, which only requires the inclusion of U.S. source income.
Example. Assume Joan, our Chinese citizen from the previous example, owns a manufacturing business in China. She decides to expand the business by opening up a distribution subsidiary in the U.S. She obtains a business visa and plans on living in the U.S. for three years in order to establish the U.S. subsidiary. Assume she has a U.S. salary of $100,000. Assume that her Chinese company earns $1 million a year and that she has $300,000 of income earned through various trusts and accounts in Singapore and Mauritius.
If Joan files an IRS Form 1040, she may be required to include and pay U.S. tax on her U.S. salary, the earnings of her Chinese company and her personal investments. This could amount to $1.4 million. Assuming a marginal tax rate of about 35%, she will pay approximately $500,000 in U.S. federal income taxes. Moreover, because she is an individual she generally would not be entitled to a foreign tax credit for the taxes paid by her Chinese company.
However, if Joan qualifies to file an IRS Form 1040-NR, she need only report and pay tax on her U.S. source income. Generally, this would be limited to her U.S. salary, but it is possible that some of her personal investments could also be U.S. sourced. Assuming her salary is the only item of U.S. income, her taxable income would fall to $100,000 and her federal tax bill would be $35,000.
Eligibility to File IRS Form 1040-NR
Generally, the 1040-NR can only be filed by a non-resident alien and because of that many resident aliens assume they cannot file this form. However, there are two general ways for resident aliens to qualify.
First, if an individual comes from a country that has a tax treaty with the U.S., then a special test applies. U.S. tax treaties often contain lengthy rules that deal with the problem of dual residents – individual who are treated as residents under the domestic laws of both countries. These rules are used to determine which treaty country is treated as the residence of such a person. Because these rules are set forth in a U.S. tax treaty, they are deemed to override the statutory tests for residency in the Internal Revenue Code (i.e., the Green Card and Substantial Presence tests). For example, assume that Joan in our example above holds an EB-5 visa and spends all of 2021 living and working in the U.S.. Under either the Green Card or Substantial Presence tests, she likely would be treated as a U.S. resident and be required to file an IRS Form 1040. However, the U.S./China tax treaty contains a different set of rules and these override the statutory test.
Generally, if Joan views her U.S. residency as temporary, maintains a home in China, intends to return there, and has her main business connections there, she likely would be treated as a Chinese resident under the treaty. Accordingly, she would be eligible to file a 1040-NR with the beneficial results noted above.
If an individual comes from a country that does not have an income tax treaty with the U.S., but otherwise qualifies as a U.S. resident under the Substantial Presence test, it may still be possible to qualify to file IRS Form 1040-NR if the individual meets certain day-count rules and can establish that his or her tax home is in a foreign country.
Important Caveat: These rules apply only to federal taxes. Income taxes levied by U.S. states are not governed by tax treaties. Accordingly, specialized tax planning is often needed to minimize state income taxes in these situations.
Action Item: If you are relocating to the U.S., you should carefully consider the resulting state and federal income tax rules and contemporaneously document the operative facts that may be useful in establishing which filing regime applies.