Armanino Blog

You May Have Some Tax Planning Ahead

by Michael Ozen
June 17, 2012

No, in this case we aren’t referring to little green men, but rather the term that the U.S. tax authorities use to describe an individual who is not a U.S. citizen. Aliens are further categorized into “Resident Aliens” and “Nonresident Aliens.”

It is important to know which category you fall into as the manner in which the U.S. taxes these two groups of individuals is as different as night and day.

Resident Alien or Nonresident Alien?
All aliens are considered nonresident aliens unless they meet one of two tests:

  1. The green card test, or
  2. The physical presence test.

If you have a green card (meaning you are considered a lawful permanent resident of the U.S. on the last day of the year), you will generally be treated as a resident alien from the first day you are in the U.S. This test, as you can imagine, is fairly straight forward. A person generally either has a green card or doesn’t.

The physical presence test is trickier. This test involves counting days that the alien is physically present in the U.S. over a three-year period, includes exceptions for certain classes of people, and a specific exception for aliens who have a “closer connection” to another country during that year.

A person is considered to be a resident alien under the physical presence test if he meets both of the following criteria:

  1. Present in the U.S. for at least 31 days in the current year (say 2012), AND
  2. Present in the U.S. for at least 183 days during the three-year period that includes the current year (e.g., 2012) and the two prior years (2011 and 2010) by adding:
    1. All the days present in the U.S. during 2012, and
    2. 1/3 of the days present in the U.S. during 2011, and
    3. 1/6 of the days present in the U.S. during 2010.

As mentioned above, there are several exceptions that can be used to exclude certain days physically present in the U.S. One of the major exceptions we see is for persons who come to the U.S. on education-related visas. This group includes students, teachers and workers who come to the U.S. for on-the-job training. These persons will generally be present in the U.S. on an “F,” “J,” “M” or “Q” visa.

There are also exceptions available to:

  1. Commuters from Canada and Mexico,
  2. Persons working inside the U.S. for foreign governments (“A” or “G” visas),
  3. Persons who are stuck in the U.S. due to a medical ailment, and
  4. Persons working in international transportation (such as crew members of foreign ships).

The Closer Connection exception mentioned above is available to an alien who:

  1. Is present in the U.S. for less than 183 days during the current year; AND
  2. Maintains a “tax home” in a foreign country during the year; AND
  3. Has a “closer connection” during the year to that foreign country.

The ability to take advantage of the Closer Connection exception depends on the alien’s particular facts and circumstances. Note that there could be immigration/visa issues surrounding the utilization of this exception, so consultation with your tax advisor and immigration attorney is highly recommended.

How are Resident Aliens Taxed?
Whether you are a green card holder or meet the substantial presence test, you will be taxed essentially like a U.S. citizen: taxed on your worldwide income, irrespective of where your income was earned. As you can imagine, this result can be disastrous for aliens who come from low tax or no tax jurisdictions, which is why many of these aliens count the number of days they are physically present in the U.S. like a hawk to avoid accidentally meeting the physical presence test.

How are Nonresident  Aliens Taxed?
While the U.S. can’t tax this group on their worldwide income, it can tax them on income that is “sourced” in the U.S. The U.S. taxes this income in different ways depending on whether the income is active (such as business profits from a U.S. business or wages earned while present in the U.S.) or passive (such as U.S. sourced interest, royalties for patents used in the U.S., or dividends on shares of U.S. corporations).

U.S. source active income earned by nonresident aliens is taxed at graduated rates essentially in the same manner as U.S. citizens are taxed on such income. Passive income from a U.S. source is taxed at a flat 30% tax rate, which can be reduced to a lower percentage through the use of income tax treaties between the U.S. and other countries.

For both of these types of income, the payer is generally required to withhold tax. In the case of passive income, the tax should be the final tax due. If so, no return will be required to be filed by the nonresident alien. In the case of active income, a return will be required to be filed and the tax withheld reflected as a credit.

One note of caution: rental income can be either active or passive. If the IRS determines that the income is passive, then, since this income will typically be taxed at 30% on gross rental receipts, the nonresident alien will receive no benefit for depreciation, interest or other expenses incurred in renting the property. An election is available to treat the income as active.

Finally, the first and last years of an alien’s residence can be complicated because, in many cases, they will be taxed as both a resident alien and a nonresident alien during the same tax year. Note that there are several elections available that allow an alien to choose the first/last day of residency in the year to obtain the best tax result.

So what about California Residency?
California has a concept similar to federal in that it taxes its residents on their worldwide income and its nonresidents only on income that is derived from sources within California. However, the manner in which California determines whether a person is a resident or nonresident is based almost entirely on facts and circumstances, without any of the black or white residency tests that are present at the federal level. Because these systems differ, you may be nonresident for federal purposes but resident for California purposes or vice-versa.

In summary, this area of federal and state taxation can get complicated very quickly. To make matters worse, there is a substantial amount of misinformation making the rounds at cocktail parties. And then, of course, we have the IRS who is focusing a significant amount of effort in this area.

If you are an alien, resident or nonresident, we encourage you to consult with your accountant.

If you would like more information in this area, we highly recommend the following publications:

June 17, 2012

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