U.S. Tax Residency: Some Black-and-White Rules, Some Gray

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COLUMNS I Tax Practice & Procedure
U.S. Tax Residency
Some Black-and-White Rules, Some Gray
By Ian Weinstock
When advising taxpayers or preparing returns, bright- line rules are generally the easiest to explain and to handle. In contrast, tax outcomes that depend on facts and circumstances are inherently more difficult to evaluate. It is therefore a relief that many federal tax residency rules applicable to individuals are black-and-white, particularly considering how critical an issue residency is, both in terms of what is subject to tax and what returns are required. Unfortunately, there is a large gray area as well.
waters, but not including U.S. possessions or territories or U.S. airspace), however fleeting, will count as a day for purposes of substantial presence. Treasury Regulations section 301.7701(b) 3 details certain exceptions to substantial presence; for example, days present in the United States if an individual has exempt status (e.g., on a student visa or diplomatic visa, or as a professional athlete) are not considered when deter- mining substantial presence, nor are days present in the United States if an individual is unable to leave due to a medical con- dition that arose when the individual was in the United States. (Form 8843 is generally attached to an income tax return to exclude days present in determining substantial presence.) Moreover, days present in the United States do not include any days on which the only presence in the United States is due to being in transit between two non-U.S. locations, such as catching a connecting flight at a U.S. airport. There is also a special exception for individuals from Mexico or Canada who commute for employment or self-employment in the United States regularly (i.e., on at least 75% of working days).
For federal income tax purposes, individuals who are U.S. persons are subject to tax on their worldwide income and file a Form 1040, whereas individuals who are not U.S. persons are only subject to tax on their U.S.-source income and file Form 1040NR. U.S. citizens are automatically U.S. persons under Internal Revenue Code (IRC) section 7701(a)(30)(A), but noncitizens are only U.S. persons if they are U.S. residents (i.e., resident aliens).
Black-and-White Rules—Income Tax Residency
Under IRC section 7701(b), a resident alien is either 1) a lawful permanent resident (i.e., a green card holder) or 2) an individual who is “substantially present” in the United States. (Under certain circumstances, an individual can also elect to be treated as a U.S. resident.) Substantial presence is based on day count; if an individual is present in the United States at least 31 days in the current year and the sum of 1) the days that individual is present in the United States during the current tax year, 2) one-third of the days that individual is present in the United States during the first preceding tax year, and 3) one-sixth of the days that individual is present in the United States during the second preceding tax year equals or exceeds 183, then that individual is substantially present in the United States. Special rules apply in the year residency begins; for lawful permanent residence, residency—and therefore taxation as a U.S. person—is deemed to commence on the first day of actual presence in the United States after receipt of the green card; for substantial presence, residency is deemed to com- mence on the first day of actual presence in the United States. For the year in which residency ends, however, the individual is generally treated as a U.S. resident for the entire tax year.
Notwithstanding the above exceptions, a nonresident alien who is present in the United States at least 183 days is still subject to tax on his net gains on the sale of capital assets located in the U.S. [see IRC section 871(a)(2)], whereas a non- resident alien is normally not taxable on any capital gains other than gains on U.S. real property or gains that are effectively connected with a U.S. trade or business.
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Any presence in the United States (including territorial
Closer connection. An individual who is otherwise substan- tially present in the United States may still avoid classification as a U.S. resident if she 1) is not present in the United States for 183 days in the current tax year, 2) maintains a tax home in a single foreign country, and 3) has a closer connection to that foreign country [Treasury Regulations section 301.7701(b)- 2]. For this purpose, a foreign country includes U.S. territories and possessions, and under very specific conditions an indi- vidual may have a closer connection to two foreign countries. A tax home is where an individual maintains her regular place of business, or, if more than one, her principal place of busi-
Beyond the bright-line rules noted above, there are several exceptions that depend upon the facts and circumstances.
Gray Rules—Income Tax Residency