When Led Zeppelin sang about “Going to California,” they were probably blissfully unaware of the potential tax consequences on this side of the pond.
If you have come to the U.S. to live for business reasons, an extended vacation, to avoid high tax rates in your home country, or for a host of other reasons, you need to be aware that you may be liable for U.S. taxes.
Likewise, if you are a U.S. taxpayer who has relocated to another country, you may still have to pay U.S. taxes. The IRS has specific guidelines (tests) to determine whether you owe taxes and how much. This is primarily contingent on how long you lived here during the current tax year.
There are layers of complications to this, such as if the U.S. has a treaty with the country in question, and the terms of the tax treaty between the two countries — if one exists. Additionally, rules exist for green card holders, foreign students and more.
International tax issues are very complex and if errors are made, the penalties can be quite steep. That is why I encourage you to meet with me if you have any doubt as to whether you could be classified as a “U.S. person” in the eyes of the IRS.
Are You a U.S. Person or Not?
The first two steps that you must take in order to figure out whether you have a filing requirement in the U.S. is to:
- Determine whether you are considered a U.S. person or a foreign person for tax purposes, as different rules apply to each of these two groups of people
- Determine whether any of your sources of income must be taxed. This chapter will discuss how the U.S. defines U.S. taxpayers, with an emphasis on how the definition is applied at the individual level.
The definition of a U.S. person, for tax purposes, includes U.S. citizens, residents, partnerships, corporations, estates and trusts. (See 26 U.S. Code § 7701(a)(1); See also the IRS’ page on Classification of Taxpayers for U.S. Tax Purposes).
On the other hand, foreign persons include foreign corporations, partnerships, trust, and estates, as well as nonresident aliens and any other persons who do not fall under the definition of U.S. person. (See Classification of Taxpayers for U.S. Tax Purposes).
It will be important to keep these definitions in mind as you navigate the contents of this book.
In general, any individual who is a U.S. citizen or a resident will be deemed a U.S. taxpayer. When it comes to taxes, the definition of residency does not only include lawful permanent residents. Rather, certain individuals who meet the “substantial presence” test are also considered residents for tax purposes.
Substantial Presence Test
The “substantial presence” test is satisfied when an individual has spent 31 days in the United States for the current year AND 183+ days in the last three years (including the current year). All the days spent in the U.S. during the current tax year, one-third of the days spent in the country in the year before the current year and one-sixth of the days spent in the country two years before the current year will count towards the 183 day requirement.
Any days in which an individual spends in the U.S. temporarily as a either a “foreign government-related” individual under an “A” or “G” visa (not including “A-3” or “G-5” visas), a teacher or trainee holding a J or Q visa, a student with a F," "J," "M," or "Q" visa, or a professional athlete competing in a charitable sporting event will not count towards the 183 day threshold.
See the IRS’ Substantial Presence Test.
Exception for Those Having Liability Under the “Substantial Presence Test”
However, not all individuals who satisfy the residency requirements will have to pay U.S. taxes. If an individual either has closer connections to another country, they may be exempt from paying U.S. taxes despite having met the previously mentioned criteria for the “substantial presence” test.
When determining whether you have a closer connection in another jurisdiction, the IRS will look at various factors pertaining to the individuals’ specific circumstances such as where their home, belongings and family are located and the jurisdiction in which they have registered their car and have been issued an ID, among other factors. (See Closer Connection Exception to the Substantial Presence Test).
U.S. citizens, lawful permanent residents, and any individuals who applied for lawful permanent residency or had an application for residency pending do not qualify for this exemption.
Furthermore, in order to qualify for this exception, the individual must not have spent 183 or more days in the United States and must have had a tax home in another in the foreign jurisdiction for the entire tax year for which they are seeking the exemption.
There is also an exception to the “substantial presence” test that applies specifically to foreign students, in recognition of the fact that most foreign students would be in the United States for more than 183 days in the year.
A foreign student who 1) does not intend to reside permanently in the United States 2) has substantially complied with immigration laws with respect to their status 3) has not taken steps to adjust their nonimmigrant status and 4) has closer connections to a jurisdiction other than the United States may qualify for this exception.
Treaty Country Exception
Additionally, certain green card holders and individuals classified as residents under the substantial presence test may also be exempt from paying U.S. taxes on their income due to a treaty that may be in effect between the U.S. and another country in which they are deemed residents.
While there are various countries with which the U.S. has tax treaties, these treaties will allow individuals who are considered residents of two countries to be reclassified as residents of only one for tax purposes.
The language in the treaties will vary from country to country. However, the reclassification process would typically be done by selecting the jurisdiction in which the individual has their permanent abode or, when there are permanent abodes in both jurisdictions, determining where the individual has their “center of vital interests.”
If no “center of vital interest” or permanent abode is discernible, the next question would be where the individual has a “perpetual abode.” If the inquiry into the taxpayer’s “perpetual abode” yields no answers, then the individual’s nationality will be the determining factor.
For a list of the current tax treaties between the U.S. and various countries, as well as their full text, refer to the IRS page on United States Income Tax Treaties - A to Z.
While these provisions will relieve the individuals from having to pay U.S. taxes, any individual looking to benefit from the treaty provisions will still have to fill out Form 1040NR and Form 8833.
Dual-Status Tax Filer
Dual status tax returns focus on individuals who are in one of two situations: 1) coming from non-resident alien status to becoming a U.S. person for tax purposes, or 2) one leaving the U.S. looking to become a non-resident alien.
If you are a dual-status taxpayer coming into the United States, the primary return you will file will be Form 1040 since you’ll be in the U.S. on the last day of the year. You will also need to file a Form 1040NR to show the part of the year when you had a different residency status. Along with your 1040, you will need to provide a statement allocating your income, expenses, credits, and deductions between the U.S. and foreign places.
If you are a dual-status taxpayer leaving the United States, your primary filing form will be the 1040NR since you will be a non-resident alien on the last day of the year. You must also include a statement splitting your income, expenses, credits, and deductions between your U.S. and non-resident status. You will use the 1040 as the statement to show what you allocate for your time as a U.S. taxpayer.
Allocations as a Dual-Status Taxpayer
How you allocate income, expenses, credits, and deductions depends on your primary filing form, the 1040 or 1040NR. When allocating for periods of U.S. tax residency, you will need to break out your U.S. source income as well as your foreign source income. This will be done by line item on the tax return.
For any non-resident period, you will need to break out effectively connected income from any non-effectively connected income as well as enumerating your U.S. tax withholdings.
Dual-status tax filers cannot claimthe standard deduction. For deductions, you will use Schedule A if your primary form is the 1040 and the 1040NR Schedule A if you are using the 1040NR. For credits, you will use the normal credit schedules or line items if your primary is the 1040, and the 1040NR credits section if you are primarily using the 1040NR. Both the deductions and credit available to those primarily using the 1040NR are severely limited.
Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion (FEIE) is available on the U.S. tax residency portion of a dual-status return. U.S. citizens or residents for tax purposes who work out of the United States may be eligible to receive an exclusion on taxable income earned outside the U.S such as wages, salary, and fees for services rendered.
Only qualifying individuals can claim this exclusion. A taxpayer has to pass two tests: the bona fide resident and physical presence tests. The taxpayer must first be a bona fide resident of the foreign country during the tax year, and then the taxpayer must pass the physical presence test by being present in the foreign country for 330 days.
In addition to the FEIE, a taxpayer can claim the Foreign Housing Exclusion. This is an exclusion or deduction from gross income for your foreign housing amount if your tax home is in a foreign country. You must qualify under either the bona fide residence test or the physical presence test. The limit on housing expenses can be found in the Instructions for Form 2555.
It is important to note that neither exclusion or deduction will reduce your self-employment tax.
Trying to figure out international taxation rules is difficult, even for those who consider themselves fairly “tax literate.” There are a lot of grey areas to navigate when trying to determine U.S. residency and thus, any tax liability.
This area can be tricky, particularly showing the IRS you met the tests. You want to make certain that you are meeting your responsibilities, but on the other hand, why pay extra tax if you do not need to?
Instead of trying to figure this out on your own, give me a call. The professional staff at Brotman Law understands how to navigate international tax laws, because that is what we do. Put our expertise to work for you.