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Defining Residency for Tax vs. Immigration Purposes

A fundamental first step in individual income tax planning is determining the person’s residency status. Here’s what to consider.

October 29, 2007
Sponsored by BNA Software

by Nancy Faussett, CPA

A fundamental first step in individual income tax planning is determining the person’s residency status. However, the rules differ for federal income tax purposes versus citizenship and immigration purposes. An individual’s status is important because it determines how the income tax rules should be applied and which form, if any, needs to be filed. Resident aliens are not taxed the same as nonresident aliens. Furthermore, aliens who are in the U.S. illegally are sometimes treated as resident aliens for tax purposes.

Resident versus Nonresident Aliens

The following definitions are important:

  • Alien: Anyone who is not a U.S. citizen
  • Resident alien: An alien who meets one of two tax law residency tests
  • Nonresident alien: An alien who does not meet a tax law residency test

Before aliens can apply for U.S. citizenship, they must first become legal permanent residents with a green card. For immigration purposes, anyone without a green card is always deemed a nonresident. However, possessing a green card is not necessary to be considered a resident for federal income tax purposes.

The IRS taxes U.S. citizens and residents on their worldwide income. U.S. citizens and resident aliens are generally taxed in the same manner although there are a few exceptions. However, nonresidents are taxed only on U.S.-source income and are allowed only limited deductions and credits. A nonresident alien is generally taxed at a flat 30 percent rate on U.S.-source investment income, whereas income that is effectively connected to a U.S. business is taxable at graduated rates.

Tax Law Residency Tests

To be considered a resident for federal income tax purposes, an individual must meet either of two tests:

  • Green card test, or
  • Substantial presence test

The substantial presence test is applied to individuals who either do not have a visa or have a nonimmigrant visa. It consists of a mathematical calculation: The individual must be in the U.S. for a minimum of 31 days in the current tax year and at least 183 days in a three-year period. The calculation is complicated by the fact that only 1/3 of the days in the first prior year are counted and only 1/6 of the days in the second prior year are counted.

When determining the number of days in the U.S. for the substantial presence test, certain days are not included even if the individual is in the U.S.:

  • Partial days
  • Days spent commuting between either Canada or Mexico
  • Partial days spent in transit between two places outside of the U.S.
  • Days you are in the U.S as a crew member of a foreign vessel
  • Days during which the individual cannot leave the U.S. due to a medical condition that arose after being in the U.S., and the intent of the individual was to leave the U.S.
  • Days that the individual is in the U.S. on an exempt visa

Foreign-Born Spouse

A foreign-born spouse must meet one of the same residency tests as any other alien in the U.S. If the spouse qualifies under either of the residency tests, the couple is treated the same as any other couple. They can either file separately or as married filing jointly. All worldwide income must be reported on their tax return.

However, even if a spouse is a nonresident alien, the married couple may elect to file a joint income tax return. When this is done, both spouses are treated as U.S. residents for income tax purposes and are taxed on their worldwide income. While a joint return must be filed for the year in which the election is made, in subsequent years, the couple can choose to file either joint or separate U.S resident returns.

If the election to treat a nonresident alien spouse as a resident alien is not made, the U.S. citizen (or resident alien) is treated as unmarried for the head of household status. However, all of the head-of-household tests must be met (and the nonresident spouse is not a qualifying person). When the tests are not met, the U.S. citizen (or resident alien) must then file as married filing separately.

Dual-Status Taxpayers

Unless an individual elected to be treated as a resident alien, an individual may hold a dual status for a year. Generally, this occurs when an individual either arrives or departs the U.S. and changes one’s status between nonresident and resident alien.

Depending on an individual’s status as of the last day of the year, file either the Form 1040 or 1040NR as appropriate. Enter “Dual-Status Return” across the top of the return and calculate the individual’s income separately as a resident and as a nonresident.

Dual-status taxpayers cannot claim the standard deduction nor can they use the Head of Household Tax table column. If an individual did not elect to be taxed as a resident alien, a joint return cannot be filed. Also, the earned income credit, the credit for the elderly or disabled or the education credit cannot be claimed.

Form 1040NR

You must file an IRS Form 1040NR, U.S. Nonresident Alien Income Tax Return, in the following four scenarios:

  1. You are engaged in a trade or business (or are an employee) in the U.S., even if there is no U.S. income,
  2. You have U.S.-source interest, dividends, rental income, pension income or Social Security benefits and not enough tax was withheld,
  3. Your represent a decedent who would have had to file a 1040NR, or
  4. You represent an estate or trust that must file a 1040NR.

If the following exceptions apply, however, you do not have to file a Form 1040NR:

  • Your only trade or business in the U.S. involved the performance of personal services, and
  • Your wages were less than the personal exemption amount ($3,300 in 2006).

There are three categories of U.S.-source income for a nonresident alien:

  1. Income connected to a U.S. trade or business (taxed at a graduated rate),
  2. Income not connected to a U.S. trade or business (generally taxed at a 30% rate) and
  3. Income exempt from U.S. tax.

Conclusion

Clearly the rules for determining when an individual is a U.S. resident are different for income tax reporting than for immigration or citizenship purposes. The two tax law residency tests are the green card test and the substantial presence test.

An illegal alien is subject to the same income tax rules as a legal alien. The substantial presence test must be applied to determine whether the individual should be taxed as a resident or nonresident alien.

A foreign-born spouse (who is a nonresident alien) of either a U.S. citizen or resident alien holds no special status except for being able to elect to be treated on the tax return as a resident alien. Because the couple can either file separately or as married filing jointly, owning tax planning software eases the decision-making process, ensuring that their tax liability will be as low as possible.

Don’t forget state tax law. Every state has its own definition of residency. A nonresident alien for federal tax purposes may be a resident for state purposes (and vice versa).

And finally, always remember before you do tax planning, determine the individual’s residency status.

For more information, visit BNA Software.