Dateline: Merida, Mexico
I just got off the phone with Jonathan.
Jonathan used to be a US green card holder. However, he eventually realized that his little card came with some intense tax obligations that were not worth the benefits he thought he would get out of the deal.
He recently surrendered his permanent resident status in the United States and was convinced that that was the end of the nightmare. He was sure that his US tax obligations were over with now that he had given up his green card.
He was terribly wrong.
And he was not happy when he discovered that a country he was not born in and was no longer tied to as a resident still demanded that he pay them their “fair share,” even though he was now living on the other side of the world.
It turns out, Jonathan missed a few steps on his way out the door. Unfortunately, Uncle Sam was 100% legally justified in asking Jonathan to hand over his cash and whip up a colossal pile of tax documents.
True to character, the United States manages to make it difficult for anyone to cut ties with them – not just citizens but residents too. In fact, the US has even found ways to tax folks who are nonresidents.
This unpleasant reminder of just how wide a reach “the land of the free” has on anyone who would dare to – even once – live or make money within its borders, inspired me to tackle this topic once and for all in the hopes that fewer folks like Jonathan make the same mistake and unknowingly end up in Uncle Sam’s tax trap.
U.S. and Citizenship Based Taxation
For non-US citizens, the first distinction to be made when it comes to avoiding taxation in the US is the distinction between immigration law and tax law.
While immigration law divides people into numerous groups – citizens, resident immigrants, nonimmigrants, and undocumented (illegal) immigrants – tax law only divides them into two: resident and nonresident.
Whether you are tax resident or not has less to do with your immigration status and much more to do with the length of time you spend in the United States.
Understanding how the IRS applies the labels of tax resident or nonresident will allow you to develop an informed plan about how much time you spend in the United States in order to avoid situations that will obligate you to report your income and possibly even manage to legally not pay taxes to Uncle Sam.
What Qualifies You As a US Tax Resident?
While it is generally known that all US citizens and green card holders must file US tax returns, most people are unfamiliar with the laws that subject many nonimmigrants (i.e., those who move to the US on non-resident visas) to US taxation on their worldwide income.
If they are not careful, a nonresident visa holder can become a US tax resident.
So, what will officially qualify you as a tax resident in the United States? There are four ways to determine whether or not you qualify:
- The Green Card Test
- An “Improperly” Surrendered Green Card
- The Substantial Presence Test
Since I’ve extensively covered the many options for reducing your tax burden as a US citizen in other articles on this site, we’ll only examine the last three options, which apply to resident aliens.
Resident aliens are non-US citizens who either have a green card or have spent 183 days or more in the United States in the past three years.
The Green Card Test
If you have applied for and been issued an alien registration card (commonly known as a green card) you are considered a lawful permanent resident of the United States. This automatically deems you a tax resident of the US from the date your new immigration status went into effect going forward.
Unless you are eligible for an exception, you will be taxed on the same grounds as US citizens, with all the same laws, regulations, and reporting obligations. Even if you live outside the United States, as long as you are a green card holder, you must report your worldwide income and pay any necessary tax to the land of the free.
An “Improperly” Surrendered Green Card
As Jonathan’s story reminded me, simply surrendering your green card may not be enough to relieve you of your tax obligations.
Jonathan’s mistake? He forgot to inform the Department of Homeland Security that he had given up his green card.
The IRS will still classify you as a tax resident of the United States until you notify the Department of Homeland security that you have relinquished your permanent residence and you deliver the documentation they request.
Furthermore, if you leave the US for any period of time as a green card holder, you must obtain a certificate of compliance stating that you have paid your US taxes before leaving. In some cases, you may be required to file a tax return and pay any taxes due at the point of departure before leaving the country. If you do plan to leave, review Form 1040-C to learn what you must report.
The Substantial Presence Test
Each year, non-US citizens visit the United States as nonimmigrants for numerous reasons. Some come as tourists, others come as college students, teachers, professors, athletes, exchange visitors, temporary workers, business people, diplomats, trainees, religious representatives, medical patients and more.
While they are not permanent residents, many of these folks could become tax residents of the United States if they spend a certain amount of time in the country each year. The test to determine whether or not they have reached that threshold is called the Substantial Presence Test.
Under the rules of the Substantial Presence Test, even illegal immigrants will be treated as tax residents in the United States and will be required to report and pay any taxes due.
The IRS will consider that you have established a “substantial presence” in the United States if you:
- Were or will be in the US for at least 31 days during the current year; and
- Will spend at least 183 “days” in the US within a three-year period.
Technically, you could spend more than 183 days in the US over a three-year period and still avoid becoming a tax resident. This is because the 183-day limit does not give equal value to the days from each year. The formula used to calculate how many days you spent in the US is as follows:
- Days you were present in the current year = 1
- Days you were present in the previous year = 1/3
- Days you were present two years previous = 1/6
For example, while you may have spent 90 days in the US in year two, only 30 of those days would count toward the 183-day limit. Conversely, if you spent 183 days in the US during the current year, then you will automatically qualify as a tax resident, regardless of how many days you spent in the US for the two years previous.
While you could work with various combinations of days spent in the US each year to stay within the limit, the general rule is that if you are physically present in the US for 120 days or less each calendar year, you will avoid qualifying as a US tax resident indefinitely.
There are a few exclusions to the 183-day rule. For example, the days’ regular commuters cross the border to work in the US from either Canada or Mexico do not factor into the formula. However, cross-border shopping trips will count as a full day toward the 183-day limit.
Another beneficial exclusion is that the days you stop in the United States while traveling between two other countries do not count. In addition, if you were ever unable to leave the country due to a medical condition you acquired while in the US, the days spent receiving medical treatment will not count against you either. (Although you will have to file Form 8843 to claim the exception.)
Reporting Requirements & Taxation – Tax Residents
If you qualify as a tax resident in the United States, you will be subject to the same rules as US citizens in regards to filing and paying taxes. This means that you must report your worldwide income, including all investment income, capital gains, regular employment income, income from non-US rental properties, and even income from foreign pensions.
For lawful permanent residents, you become a tax resident on the first day that you are present in the United States. Many permanent residents who obtain their residency at some point later on in the year will qualify for dual status their first year. (We’ll discuss the details of dual status in just a minute.)
Finally, while becoming a tax resident does mean that you will have to report your entire worldwide income, it does not necessarily mean that the IRS will tax you for everything that you report. Still, the reporting requirement is ‘taxing’ enough to motivate most people to avoid the tax resident status.
Nonresident Aliens for Tax Purposes
The good news is that the residence test contains numerous exemptions that relieve a large percentage of legal aliens in the US from having to report or pay income tax. The IRS considers these folks nonresidents for tax purposes – or, tax nonresidents.
Like the exclusions to the 183-day rule discussed above, the US offers exemptions for many qualifying individuals that essentially allows them to stay in the US for a period longer than 183 days. There are three main types of exemptions:
- Exempt Individuals
- Tax Treaties
- The Closer Connection Exemption
Nonimmigrants who qualify as “exempt individuals” can avoid the tax resident status in the United States. These individuals will need to file Form 8843 in order to claim the exemption, but that is enough to get them off the hook when it comes to reporting and paying taxes on their worldwide income. Exempt individuals include:
- Foreign government officers holding an A or G visa (A-3 and G-5 visas are not exempt)
- Teachers and trainees holding J or Q visas
- Students holding an F, J, M, or Q visa
- Professional athletes competing in a charitable sports event in the United States
- Employees of an international organization
- Immediate family members of any of the individuals listed above
The days an exempt individual spends in the United States will not count toward the 183-day threshold of the Substantial Presence Test, which would make them liable to report their worldwide income. This does not, however, exempt them from paying tax on their US-sourced income.
Each exemption comes with its own timeline. For instance, teachers and trainees on a J or Q visa can claim the exempt individual status no more than two calendar years every six calendar years. Similarly, students are granted five exempt calendar years before they are subject to the Substantial Presence Test.
However, unlike the Substantial Presence Test, any day an exempt individual spends in the United States during a calendar year counts as a full calendar year. If you arrive in December, for example, then that entire year will count toward one of your exempt calendar years. Plan accordingly.
The second way to avoid being labeled as a US tax resident by the IRS is through a tax treaty. To prevent double taxation, the US has tax treaties with over 60 countries. The credit obtained through such treaties is separate from, and in addition to, the foreign tax credits you can claim by filing Form 1116.
If you meet the following conditions, you will be considered a tax resident of both countries and can utilize a treaty election to avoid US tax residency:
- You are a citizen of one of the 60 plus countries with which the US has a tax treaty;
- You have worked in the US on a temporary work visa; and
- You have been physically present in the US for more than 183 days.
By filing Form 1040NR with a Form 8833 treaty election, you can be treated as a tax resident of your origin country and avoid being classified as a US tax resident.
This, of course, can only be used if you can prove that your origin country is your permanent home. While the tax treaty serves as a tiebreaker if you are equally a resident of both countries, it will be difficult to claim the right to the tax treaties if your “vital interests” and “habitual abode” are centered in the US.
Lamentably, using a tax treaty to be taxed as a US nonresident does not mean that you are free of your reporting obligations. The IRS will still expect you to report financial accounts and interests in foreign corporations, trusts, and partnerships.