Individuals are split into two separate buckets for U.S. federal income tax purposes: (1) United States persons, and (2) nonresident aliens (or non-U.S. persons). Generally speaking, U.S. persons are subject to U.S. federal income tax on their worldwide income, whereas non-U.S. persons are subject to U.S. federal income tax only on their U.S.-source income. Common examples of U.S.-source income include rent from U.S. real estate, dividends from U.S. corporations or income from U.S. businesses. U.S. persons are also subject to various reporting rules that require reporting of non-U.S. accounts and assets (e.g., a Report of Foreign Bank and Financial Accounts or FBAR).
The test for determining whether an individual is a U.S. person for U.S. federal gift and estate tax purposes is different from the test used for U.S. federal income tax purposes. The U.S. federal gift and estate tax test will be covered in an upcoming alert.
Who is a U.S. person under the code?
In the case of individuals, a U.S. person means any one of the following:
- A U.S. citizen
- A U.S. lawful permanent resident (i.e., a “green card holder”)
- An individual who satisfies the substantial presence test (commonly referred to as the “day count test”)
What is the substantial presence test?
The substantial presence test looks at the number of days that an individual has spent in the U.S. over a three-year period—specifically, the calendar year in question and the preceding two years. The substantial presence is determined using a formula, and is satisfied for any calendar year in which the individual spends both:
- At least 31 days in the U.S. during the calendar year in question
- At least 183 days in the U.S. during the calendar year in question and the preceding two years, calculated under a weighted formula that adds together the following:
- All of the days spent in the U.S. during the calendar year in question
- One-third of the days spent in the U.S. during the first year before the year in question
- One-sixth of the days spent in the U.S. during the second year before the year in question
If an individual is physically present in the U.S. at any time during a particular day, that day generally is counted for purposes of the substantial presence test. For example, if an individual arrives in the U.S. one evening and leaves the U.S. the next morning, two days would be counted in full.
Suppose an individual is physically present in the U.S. for 121 days in each of 2019, 2020 and 2021. For purposes of the substantial presence test for tax year 2021, one counts all of the days that the individual was present in 2021 (121) plus one-third of the days that the individual was present in 2020 (40⅓) plus one-sixth of the days that the individual was present in 2019 (20⅙). Those resulting numbers then are added to see if the total is more than 183 days. Because the total number of weighted days is 181.5 in this example (121 plus 40⅓ plus 20⅙), the individual will not be considered a U.S. resident in 2021 (note that there is no requirement to round up to the nearest whole number). As a rule of thumb, if a noncitizen or non-green card holder never stays in the U.S. for more than 121 days in any tax year, that individual will never meet the substantial presence test.
Are there exceptions to the substantial presence test?
There are various exceptions to the substantial presence test. For example, certain categories of individuals—including qualifying students, teachers and certain foreign government-related individuals (such as diplomats and employees of certain international organizations)—are exempt from counting their days of physical presence in the U.S. In other words, when performing the substantial presence test for these individuals, you would count only the days they are physically present in the U.S. as nonexempt persons (e.g., the days before/after an individual acquired an F-1 student visa). Generally, there is a time limit on the ability to claim status as an exempt student or teacher—five years for students, two of the preceding six years for teachers. A student or teacher may be able to qualify for an exception to these time limits in certain situations. An individual generally must file Form 8843 in order to claim exempt student or teacher status.
For individuals who are not within the categories described above, the “closer connection exception” may apply. Under this exemption, individuals may be able to stay up to 182 days in a year without becoming a U.S. resident even if they otherwise satisfy the substantial presence test. In order to qualify for this exception, individuals must show that they had (1) a “tax home” in another country for the entire year (2) a closer connection to that other country and (3) timely file a Form 8840 with the IRS to claim the status. It is important to note that if the Form 8840 is not timely filed, the individual likely will not be able to claim this exception at a later date.
The tax home requirement
Generally, an individual’s “tax home” is the place of the person’s regular or principal place of business. If the individual has no regular or principal place of business, the tax home is the person’s primary place of residence.
Closer connection requirement
Individuals have a closer connection to another country if they can establish that they have more significant contacts with that other country than with the U.S. This is demonstrated by the facts and circumstances. The IRS looks at these primary factors when making the determination:
- The location of a permanent home
- The location of family members
- The location of personal belongings, such as automobiles, furniture, clothing and jewelry
- The location of social networks and social, political, cultural and religious affiliations
- The location of personal banking activities
- The location of other business activities (other than those that constitute the individual’s tax home)
- The jurisdiction in which the individual holds a driver’s license
- Where the person is registered to vote
- The types of official forms and documents filed, such as IRS tax forms that require representations about residence
- The country of residence the individual designates on forms and other documents
- Where personal, financial and legal documents are kept
- The charitable organizations to which the person contributes
The IRS may also consider other relevant facts.
Also, this test is not available to individuals who have taken “affirmative steps” to obtain green card status, including the filing of any initial application.
Could a treaty affect the analysis?
If an individual is a resident of the U.S. and also a resident of another country due to the operation of the tax residency laws of such other country, it may be possible for the individual to make a treaty claim to be treated as a nonresident of the U.S. for income tax purposes. This relief is generally not afforded to U.S. citizens. It also generally applies only for purposes of computing an individual’s U.S. income tax liability. This means, for example, that the individual will continue to have annual reporting obligations with respect to non-U.S. interests in the same manner as a U.S. resident individual, and that the individual’s ownership of non-U.S. entities will be considered in determining whether the entity is subject to certain anti-tax deferral rules, which may have income tax consequences for any other owners of that entity who are U.S. persons.
Individuals who want to take the position that they are not resident in the U.S. because of an applicable treaty must disclose the treaty position (using Form 8833) each year.
What about state income tax?
The rules above only apply when determining an individual’s U.S. federal income tax status. Each state has its own rules that are used to determine whether an individual is resident for state income tax purposes. State income tax rules generally are not governed by the income tax treaties that the federal government has with other countries. Therefore, it is possible to be a nonresident for U.S. federal income tax purposes but still be a resident of a particular state and subject to state income tax on worldwide income.
The above is only an overview for informational purposes. As outlined, there are a number of different rules and exceptions, and each individual’s particular facts and circumstances must be reviewed in order to determine the person’s U.S. tax status. Please feel free to contact our International Trust & Estate Planning team for more information.