Residency Tax Planning for Noncitizens Under IRS Publication 519

by M. Robinson & Company, P.C.
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Executive Summary

Noncitizens who intend to become residents of the United States are often well-advised to receive foreign-source earned income and recognize foreign-source capital gains before establishing residency in the United States. In our experience resident aliens and new citizens of the United States sometimes regret deeply their failure to accelerate foreign-source income or capital gains before establishing their United States residency.

It follows that noncitizens need to know when they have established residency for United States income tax purposes. The rules governing the establishment of residency are surprisingly complex. IRS Publication 519: U.S. Tax Guide for Aliens for 2016 can provide guidance.

The Taxation of Noncitizen Taxpayers’ Foreign-Source Income

Foreign-source income is, generally, income that is derived from economic activity that occurs outside the United States or from transactions in property physically located outside the United States.[1] The tax consequences arising from the receipt of foreign-source income by noncitizen taxpayers are based on the tax status of the taxpayer at the time the income is received. Here are two examples.

  1. Assume that a noncitizen taxpayer sells real estate abroad and enjoys a capital gain. If the taxpayer receives the foreign-source capital gain while s/he is a nonresident of the United States, the income escapes taxation. If, however, the taxpayer receives the foreign-source income after s/he becomes a resident of the United States, the income becomes subject to U.S. taxation.
  2. Similarly assume a noncitizen taxpayer earns money abroad. If the taxpayer receives the foreign-source earned income while s/he is a nonresident of the United States, the income escapes taxation. If, however, the taxpayer receives the income after s/he becomes a resident of the United States, the foreign-source earned income becomes subject to U.S. taxation.[2]

IRS Publication 519: U.S. Tax Guide for Aliens for 2016 describes the basics of tax planning for noncitizen taxpayers (i.e., taxpayers who are not citizens of the United States).  Under Publication 519 a taxpayer’s status as a resident alien or a nonresident alien at the time income is received, determines whether or not foreign-source income is subject to tax. Publication 519 provides:

“Income from sources outside the United States that is not effectively connected with a trade or business in the United States is not taxable if you receive it while you are a nonresident alien. The income is not taxable even if you earned it while you were a resident alien or if you became a resident alien or a U.S. citizen after receiving it and before the end of the year.” [3]

Similarly,

“For the part of the year you are a resident alien, you are taxed on income from all sources. Income from sources outside the United States is taxable if you receive it while you are a resident alien. The income is taxable even if you earned it while you were a nonresident alien or if you became a nonresident alien after receiving it and before the end of the year, [4] 

The IRS position quoted above appears to be based on two sections of the Internal Revenue Code.

  • Section 61. Section 61 requires U.S. citizens and resident aliens to report their world-wide income, without exception (“gross income means all income from whatever source derived”).
  • Section 872. Non-residents, however, need only report their U.S. source income under Section 872(a) (“In the case of a nonresident alien individual …gross income includes only— (1) gross income which is derived from sources within the United States and which is not effectively connected with the conduct of a trade or business within the United States, and (2) gross income which is effectively connected with the conduct of a trade or business within the United States.”)

Thus, noncitizens who intend to become residents of the United States are often well-advised to receive foreign-source earned income and recognize foreign-source capital gains before establishing residency in the United States. But when do noncitizen taxpayers become subject to U.S. income taxation? We answer this question below.

When Do Noncitizen Taxpayers

Become Subject to U.S. Taxation?

The determination of when residency begins can require a surprisingly complex analysis. There are two tests: the Green Card test and the Substantial Presence test. The determination of when residency begins depends, to a certain extent, on whether the taxpayer meets the Green Card test or the Substantial Presence test. Each test is described below.

The Residency Starting Date under the Green Card Test

A Green Card is the status given to noncitizens of the United States who are permitted to reside permanently in the United States.

“You are a lawful permanent resident of the United States at any time if you have been given the privilege, according to the immigration laws, of residing permanently in the United States as an immigrant. You generally have this status if the U.S. Citizenship and Immigration Services (USCIS) (or its predecessor organization) has issued you an alien registration card, also known as a “green card.” You continue to have resident status under this test unless the status is taken away from you or is administratively or judicially determined to have been abandoned.”[5]

Under the Green Card test, the residency starting date is generally the date a taxpayer receives his or her Green Card.

“If you are a U.S. resident for the calendar year, but you were not a U.S. resident at any time during the preceding calendar year, you are a U.S. resident only for the part of the calendar year that begins on the residency starting date. You are a nonresident alien for the part of the year before that date.”[6] 

There is, however, an exception where a noncitizen was a resident at any time during the immediately preceding taxable year. In such case, the noncitizen is treated as a resident as of the beginning of the current year.

“If you were a U.S. resident during any part of the preceding calendar year and you are a U.S. resident for any part of the current year, you will be considered a U.S. resident at the beginning of the current year.”[7]

The Residency Starting Date under the Substantial Presence Test

The Substantial Presence test is much more difficult to apply.

  1. The Substantial Presence Test

The Substantial Presence test requires the application of two related rules: the “31 day test” and the “183 day test”.

“You will be considered a U.S. resident for tax purposes if you meet the substantial presence test for calendar year 2016. To meet this test, you must be physically present in the United States on at least:

     i. 31 days during 2016, and

    ii. 183 days during the 3-year period that includes 2016, 2015, and 2014, counting:

  1. All the days you were present in 2016, and
  2. 1/3 of the days you were present in 2015, and
  3. 1/6 of the days you were present in 2014.” [8]

(Emphasis added.)

In counting days under the Substantial Presence test, described above, partial days count.

“You are treated as present in the United States on any day you are physically present in the country at any time during the day.”[9] 

But not all days are “countable.” For example, some of the days spent by researchers, students and professional athletes are not “countable.”[10] Such taxpayers are included in the category of “exempt individuals.” These taxpayers support their exemption by filing Form 8843.

  1. The Residency Starting Date Under the Substantial Presence Test

The residency starting date under the Substantial Presence test is ambiguous. There are at least four alternatives.

  • General Rule.

If a noncitizen taxpayer meets the residency test by moving to the United States in 2017, s/he becomes subject to taxation as a resident as of the date s/he is first present in the United States.

“If you meet the substantial presence test for a calendar year, your residency starting date is generally the first day you are present in the United States during that calendar year.” [11]

  • Exception.

If noncitizen taxpayer was a resident for any part of 2016, then s/he is treated as a resident of the United States as of January 1, 2017.

“If you were a U.S. resident during any part of the preceding calendar year and you are a U.S. resident for any part of the current year, you will be considered a U.S. resident at the beginning of the current year.”[12]

  • 10 Day Exclusion.

A noncitizen taxpayer may exclude up to ten days of presence from the residency computations if an appropriate statement is timely filed on the taxpayer’s behalf.

“[A] statement [is] required to exclude up to 10 days of presence.” [13]

  • The “Closer-Connection” Exception

Even if the Substantial Presence test is met, it may still be possible to avoid U.S. taxation of foreign-source income received while the taxpayer was physically present in the United States.

“Even if you meet the substantial presence test, you can be treated as a nonresident alien if you: are present in the United States for less than 183 days during the year, maintain a tax home in a foreign country during the year, and have a closer connection during the year to one foreign country in which you have a tax home than to the United States (unless you have a closer connection to two foreign countries, …).”[14]

Taxpayers claiming the “closer-connection” exception are required to file Form 8840.

Other Rules Affecting the Residency Start Date

In addition to the above rules, there are several additional rules whereby a taxpayer can accelerate his/her taxation as a resident. The most important acceleration rules are (1) the first year election;[15] and (2) elections made by a nonresident alien married to a resident alien or U.S. citizen.[16] Also, relevant tax treaties should always be consulted.

Conclusion

Noncitizen taxpayers rely on their tax professionals for guidance on how to lawfully avoid U.S. taxation of foreign-source income. Practitioners should take advantage of the guidance provided by IRS Publication 519.

End of Article

 

[1] See, generally, IRS Publication 519: U.S. Tax Guide for Aliens for 2016, pages 10 through 14. See, also, Section 862, IRC.

[2] Income recognized under Section 61 may, however, be excluded under Section 911 if residency requirements are met and the taxpayer makes a timely election.

[3] IRS Publication 519, U.S. Tax Guide for Aliens (2016), page 32.

[4] Id.

[5] Id. at page 3.

[6] Id. At page 7. “First Year of Residency” See, also, “Residency starting date under green card test” at page 7.

[7] Id. at page 7, “Residency during the preceding year.”

[8] Id. at page 4.

[9] Id. at page 4.

[10] Id. at pages 4 through 6.

[11] Id. at page at page 7, “Residency starting date under substantial presence test.”

[12] Id. at page 7, “Residency during the preceding year.”

[13] Id. at page 7.

[14] Id. at page 6.

[15] Section 7701(b)(1)(A) (iii)

[16] Section 6013(g) and Section 6013(h).

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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