U.S. tax residency: Tax traps for the unwary

The United States continues to be an attractive destination for non-residents to invest their time or money, especially in real estate or business expansion. However, spending significant time in the U.S. could be a tax trap for the unwary.  It’s advisable for the nonresident to receive U.S. tax advice if spending considerable time in the U.S. and prior to obtaining a U.S. green card and/or U.S. citizenship.

The United States taxes the worldwide income of U.S. citizens, regardless of where he/she lives. A non-U.S. citizen is taxed only on his/her U.S.-sourced income, unless the person is deemed to be a tax resident of the United States.

A U.S. tax resident is also taxed on worldwide income. It’s worth noting that there is a difference between legal residency and tax residency under U.S. tax laws. There are many situations in which a person may not be a legal resident of the U.S. according to immigration laws, but is a tax resident according to U.S. tax laws.

A U.S. permanent resident/green card holder is generally deemed to be a U.S. tax resident. There are some exceptions for the green card holder, such as he/she has taken steps to be treated as a resident of another country under an income tax treaty or has formally surrendered a green card but hasn’t received official notification that the green card has been revoked.

Persons who meet the Substantial Presence Test are deemed to be a U.S. tax resident. This is an individual who was physically present in the U.S. for at least:

• 31 days during the current year, and
• 183 testing days pursuant to a three-year weighted average formula, determined as the sum of:
• All the days in the U.S. in the current year, plus
• 1/3^rd of the days in the U.S. in the 1^st prior year, plus
• 1/6^th of the days in the U.S. in the 2^nd prior year.

There are some exceptions to avoid U.S. tax residency status for persons who meet the Substantial Presence Test. Two exceptions are the Closer Connection Exception and the Treaty Residency Tie-Breaker exception.

The Closer Connection Exception can be used to claim U.S. non-residency status for income tax purposes. This applies when an individual:

• Was present in the U.S. for less than 183 days of the year, and
• Can establish a tax home in another country, and
• Can establish that he/she had a closer connection to that other country compared to the U.S., and
• Timely files the IRS Form 8840 Closer Connection Statement with the IRS.

Occasionally, the individual doesn’t qualify for the Closer Connection Exception. For example, the individual was in the U.S. for more than 183 days during the year. In this case, the Treaty Residency Tie-Breaker exception could be used to claim non-residency for income tax purposes. This applies when an individual:

• Was present in the U.S. for more than 183 days of the year, and
• Is eligible to claim benefits under an income tax treaty between the U.S. and another country, and
• Can establish that he/she qualifies as a tax resident of the other country under the tie-breaker rules, and
• Elect the treaty benefit by claiming the position using IRS Form 8833 attached to a timely filed U.S. income tax return.

The United States has income tax treaties with a number of foreign countries. They are listed here. The tie-breaker residency provisions are typically dealt with in Article 4 of the treaty.

There is one potential trap for the unwary with the Treaty Residency Tie-Breaker Exception. The exception only applies to non-residency status for income tax purposes resulting in taxation on U.S. sourced income only. However, the exception doesn’t apply to the foreign disclosure regime. Thus, an individual who relies on the treaty exception is still treated as a U.S. tax resident for foreign disclosure purposes and is required to file the following forms if filing requirements are otherwise met: FBAR, Form 5471, Form 8865, Form 8858, Form 8621, Form 8938, Form 3520, Form 3520-A.

The tax residency rules discussed apply for income tax purposes. It’s important to distinguish these rules with the residency rules for estate and gift tax purposes. The estate and gift residency rules are not discussed here since they are beyond the intent of this article.

An individual would be prudent to seek assistance from a qualified U.S. international tax advisor. The rules are nuanced and complex and it’s easy to quickly find yourself out of bounds with the U.S. tax laws.

If you require additional information on any aspect of these complex rules, please contact the team at Lodder CPA PLLC. We have the U.S. international tax expertise to assist with these complex matters.

The material appearing in this communication is for informational purposes only and should not be construed as legal, accounting, or tax advice or opinion provided by Lodder CPA PLLC. This information is not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Although these materials have been prepared by a professional, the user should not substitute these materials for professional services, and should seek advice from an independent advisor before acting on any information