The U.S. income tax and estate tax both function under a system with only two possibilities, a taxpayer is either a U.S. person / domiciliary or not a U.S. person, referred to as a non-resident alien (“NRA”). There is no middle ground, it is an all or nothing system. Since U.S. tax law is based on this distinction, the first step in any analysis is determining the correct category. The U.S. laws do not define who is an NRA, rather, they define who is a U.S. person, or for estate taxes a U.S. domiciliary. Therefore, NRAs will be anyone who does not meet the definition of a U.S. person or domiciliary. Due to these rules, before we can decide how a foreigner will be taxed in the U.S., we must first make sure they are in fact a foreigner under the laws.
For income tax purposes, U.S. persons include citizens, residents (also known as green card holders) and other taxpayers who have spent enough time in the U.S. to meet the substantial presence test prescribed by the Internal Revenue Code (“IRC”). It is important to keep in mind that any person who is a citizen or has a green card will continue to be a U.S. person regardless of where they live, how long they live there, where they earn their income, or any other factor. Even if a taxpayer is in violation of their green card, until it is actually revoked they remain a U.S. person. The other category, substantial presence test, is based on a formula looking at time spent in the U.S. during the past three years. The test works as follows:
Current year: Days in the U.S. x 1
1st preceding year: Days in the U.S. x 1/3
2nd preceding year: Days in the U.S. x 1/6
Total: Total Days in U.S.
If the total days calculated is at least 183, and there are at least 31 days in the current year, the taxpayer will be considered a U.S. person. Therefore, the mathematical safe-harbor is 120 days per year as this amount will always cause the test to equal 180, which is just below the threshold. Once again, remember, there is no middle ground. A taxpayer meeting substantial presence immediately has the same taxation and reporting requirements as a lifelong citizen.
While the risk of meeting substantial presence and becoming a U.S. person is very intimidating, there are several exceptions. First, certain days do not count as “days in the U.S.” These include specific situations involving medical conditions or being in transit, and most commonly certain types of visas. For example, if a taxpayer is in the U.S. on a visa from a specific list that includes some visas for students, teachers, and government officials, they do not need to count their days in the U.S. towards the substantial presence test. Also, there are exceptions under the IRC and tax treaties. Under the IRC, a taxpayer that has spent less than 183 days in the current year in the U.S. and has a closer connection to another country can file a form to exempt them from being a U.S. person. The test for a closer connection is based on many factors including if the taxpayer files as a tax resident in the home country, where is their main home, where does their family live, where do they work, where do they vote, and any other factor to show their true home. If this option is not available, possibly because the taxpayer spent more than 183 days in the U.S. in the current year, the taxpayer can still use the treaty tie-breaker if there is a treaty with the home country. The test under the treaty is the same facts and circumstances as the closer connection factors, but there is one major difference. The closer connection test exempts the taxpayer from being a U.S. person, the treaty tie-breaker only exempts the taxpayer from paying U.S. income tax. This means that if using the treaty tie-breaker the taxpayer must still file all foreign information reports including the Foreign Bank Account Report known as the “FBAR.” Therefore, if possible, the closer connection exception is always the better option, especially for foreign investors that may be weary of reporting their worldwide assets and investments to the U.S. government. Lastly, while green card holders may also be able to make use of the treaty tie-breaker test, consultation with an immigration attorney is imperative because filing as a nonresident under a treaty may create a rebuttable presumption that the taxpayer has terminated their green card.
The estate and gift tax applies to U.S. citizens and U.S. domiciliaries. Therefore, as with income tax, a U.S. citizen will be considered a U.S. person for the estate tax under all circumstances. Next, is the determination of who is a U.S. domiciliary. The test is based on the facts and circumstances to assess if the taxpayer is living in the U.S with no intention of leaving. Different that the income tax test, having a green card is a contributing factor but not an automatic qualifier. Other factors to consider include:
- Length of time in the U.S.
- Ties to other country
- Location of business interests
- Location of personal interests
- Reasons for time spent in the U.S.
- Indirect statements of intent (tax returns, contracts, job status, etc.)
- Location of family
Additionally, if there is an estate tax treaty in place between the U.S. and other country this can be a factor. However, the U.S. estate tax treaty network is much less expansive than the number of countries with which the U.S. has income tax treaties. Overall, unless a taxpayer is a citizen or has no ties to the U.S., this is a very important and detailed test to walk through in order to have proper classification for the estate tax.
Based on this analysis, going forward when we discuss the taxation of NRAs, the people we will be referring to are:
- Income taxes – Taxpayers that are not U.S. citizens, do not possess a green card, do not meet the substantial presence test, or meet the substantial presence test but are able to utilize an exception
- Estate taxes – Taxpayers that are not U.S. citizens and are not U.S. domiciliaries