Newcomers to the United States on temporary visas may be unpleasantly surprised at the income tax consequences. A little advance planning with tax and immigration professionals can go a long way towards mitigating income taxes due.
Many countries imposes taxes on income earned in that country (i.e., a territorial tax system). The US often imposes taxes on income earned in the US and outside of the US (i.e., a worldwide tax system). US residents and nonresident aliens are taxed differently. The definition of resident/nonresident is different for US income tax than for US immigration purposes.
The result is that even foreign nationals temporarily present in the US can find themselves paying US income tax on income received abroad, such as proceeds from the sale or rental of a former home after relocation to the US or the sale of stocks, bonds or other assets acquired before the US assignment began.
For US immigration purposes, lawful permanent residents are issued alien registration cards, commonly known as “green cards.” US immigration law more broadly defines an immigrant as any alien in the US, except if legally admitted under specific nonimmigrant visa categories. Thus, even an alien unlawfully present in the US falls within the statutory definition of an immigrant or resident under US immigration law.
US income tax law is even more generous in bestowing resident status. Why? Because the US taxes residents on income earned worldwide and not just on income earned in the US. Resident aliens generally must follow the same tax laws as US citizens and report their worldwide income from all sources, regardless of whether earned in the US or outside the US. This can have expensive income tax consequences, especially for individuals with substantial income earned from sources outside the US in countries that impose little or no tax on such income.
Who is a US resident for income tax purposes?
The IRS generally considers an alien to be a US resident for income tax purposes if either of the following two tests are met for the calendar year:
- The green card test confers tax resident status on an individual who is a lawful permanent resident of the US at any time during the calendar year, and that status is not rescinded or determined to have been abandoned.
- The substantial presence test confers tax resident status on an individual who is physically present in the US on at least:
- 31 days during the current year; and
- 183 days during the three year period that includes the current year and the two prior years, counted as follows:
- All of the days in the US in the current year;
- 1/3 of the days in the US in the year before the current year; and
- 1/6 of the days in the US in the second year before the current year.
In general, any day in which even a fraction of time is spent in the US is counted as an entire day in the US. That said, certain days are not counted, including:
- Days the individual commutes to work in the US from a residence in Canada or Mexico if they regularly commute from Canada or Mexico more than 75 percent of the workdays during the working period in the current year.
- Days the individual is in the US for less than 24 hours in transit between two places outside the US.
- Days the individual is temporarily present in the US as a crew member of a foreign vessel engaged in transportation between the United States and a foreign country or a US possession, unless engaged in any trade or business in the US on those days.
- Days the individual intended to leave, but could not leave the US because of a medical condition or medical problem that arose while in the US.
- Days in the US as an exempt individual.
“Exempt individual” refers to the US immigration status held on the days in the US. Although in fact physically in the US, the days will not be counted if the individual holds:
- A or G visa status as a foreign government-related individual. The individual's spouse and unmarried children (under the age of 21) are also exempt if their status is derived from the individual's visa classification. Days spent as household staff of a foreign government-related individual present in the United States under an A-3 or G-5 visa are counted as days in the US;
- J or Q visa status as an exchange visitor for the purposes of being a teacher or trainee, so long as in substantial compliance with the requirements of the visa;
- F, J, M or Q visa status as a student, so long as in substantial compliance with the requirements of the visa; or
- A professional athlete temporarily present to compete in a charitable sports event.
Impact of income tax treaties between the US and other countries
Treaties between the US and certain other countries sometimes allow US tax residents to be taxed at a reduced rate or be exempt from US income taxes on certain types of income. The US has such treaties with many, but certainly not all, countries. IRS Publication 901 lists the countries that have income tax treaties with the US and the applicable tax rates and exemptions.
The impact of the income tax treaty between Canada and the US, for example, generally is based on the individual's tax resident status. A person who is a US tax resident and has income from sources in Canada will often pay less income tax to Canada on that income. Other special provisions under the US–Canada income tax treaty include provisions that Canadian source interest income received by US tax residents may be exempt from Canadian withholding tax, and Canadian source dividends received by US tax residents are generally subject to no more than a 15 percent Canadian withholding tax.
Also, gains from the sale of personal property by a US tax resident having no permanent establishment in Canada are exempt from Canadian income tax, but gains realized by US tax residents on Canadian real property and on personal property belonging to a permanent establishment in Canada are subject to Canadian income tax.
Treaty provisions vary country by country. The income tax treaty between the US and China includes an exemption from US tax for scholarship income (plus up to US$5,000 of wages per year) received by a Chinese student temporarily present in the US. Although under US tax law, a student visa holder may become a resident alien for US tax purposes if the temporary stay in the US exceeds five calendar years, the US–China income tax treaty allows this exemption from US tax to continue even after the Chinese student becomes a US tax resident.
It is important to note that many of the states in the US have state income tax. Some state income tax laws recognize US federal tax treaties, but some do not, including Alabama, Arkansas, California, Connecticut, Hawaii, Kansas, Kentucky, Maryland, Mississippi, Montana, New Jersey, North Dakota, and Pennsylvania.
Breaking the tie to determine tax residence
Many US tax treaties also contain tie-breaker rules for determining the tax residence of an individual who is otherwise treated as a tax resident of both the US and a treaty partner under each country's internal laws (i.e., a dual-resident taxpayer). Generally, under these rules, an individual with a permanent home available in only one of the two treaty countries will be deemed resident in that country. If the alien has a permanent home available in both countries or neither country, a series of other factors are considered (e.g., center of vital interests, habitual place of abode and nationality). Generally, if no factor breaks the tie, residence is determined by mutual agreement.
Thus, depending on the applicable tax treaty, it is possible that a green card holder who has a home and center of vital interests in a foreign country may be treated as a nonresident alien of the US. The risk of claiming this tax treaty benefit is that it could compromise an individual's future US immigration status (i.e., it may affect a green card holder's ability to continue to qualify for the green card).
Besides tax treaties, even individuals who fall under the substantial presence test may still claim nonresident tax status if they are present in the US for less than 183 days in the current year, maintain a tax home in the foreign country during the year and can show a closer connection to a foreign country.
The “closer connection” test requires showing that the individual has more significant ties to a foreign country than the US. The IRS considers the following factors:
- The country of residence designated on forms and documents;
- The types of official forms and documents you file, such as Form W-9, Request for Taxpayer Identification Number and Certification, W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding, or W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States.
- The location of the individual's:
- permanent home;
- personal belongings (e.g., cars, furniture, clothing and jewelry);
- current social, political, cultural or religious affiliations;
- business activities (other than those that constitute your tax home);
- driver's license;
- voting jurisdiction; and
- charitable organization contributions.
The closer connection test will not apply if the individual has applied or taken steps during the year to change status to a lawful permanent resident, including a pending application for adjustment of status to lawful permanent resident.
In addition, there are other US immigration activities that the IRS will consider as indications of intent to change status to a US resident. These include the filing of an immigrant visa petition or alien employment certification application.
Note that for US gift and estate tax purposes, resident status is based on a different concept—domicile, which should also be considered when making plans before relocation.