Unraveling the Mysteries of U.S. Taxes for Resident and Non-Resident Aliens
Article Highlights:
Tax Status of Non-Resident Aliens
Green Card Test
Substantial Presence Test
First-Year Residency
U.S. Sourced Income
Effectively Connected Income (ECI)
Fixed, Determinable, Annual, or Periodic (FDAP) Income
Income Subject to the 30% or Treaty Withholding
Issues Employing Non-Residents in the U.S.
Issues Employing Non-Residents Working from Their Home Country
Totalization Agreements
Withholding Requirements
Commonly Used Forms
Navigating the U.S. tax system can be a complex task, especially for non-resident aliens. This article aims to provide a comprehensive overview of the taxation rules applicable to non-resident aliens, including the substantial presence test, first-year residency, U.S. sourced income, effectively connected income (ECI), Fixed, Determinable, Annual, or Periodic (FDAP) income, income subject to the 30% or treaty withholding, issues related to employing non-residents, totalization agreements, and withholding requirements. Additionally, we will explain visa definitions and the taxation of individuals temporarily in the U.S.
Tax Status of Non-Resident Aliens - The U.S. tax system categorizes individuals into resident aliens and non-resident aliens. Resident aliens are taxed similarly to U.S. citizens on their worldwide income, while non-resident aliens are taxed only on their U.S. sourced income and income effectively connected with a U.S. trade or business.
Green Card Test – Taxpayers are considered residents, for tax purposes, if they are a Lawful Permanent Resident of the United States at any time during the calendar year. This is known as the "green card" test. They generally have this status if the U.S. Citizenship and Immigration Service (USCIS) has issued them Form I-551, also known as a "green card,” or their foreign passport bears an I-551 stamp while awaiting issuance of the actual green card. That status continues unless voluntarily renounced and abandoned or terminated by the USCIS or a U.S. federal court. Their residency starting date is the first day on which they are present in the United States as a Lawful Permanent Resident, or they choose to be taxed as a resident alien for the entire calendar year.
Substantial Presence Test - The substantial presence test is a numerical formula used to determine whether an individual qualifies as a resident alien for tax purposes. To meet this test, an individual must be physically present in the U.S. for at least:
31 days during the current year, and
183 days during the 3-year period that includes the current year and the two years immediately before that, counting:
o All the days present in the current year,
o 1/3 of the days present in the first year before the current year, and
o 1/6 of the days present in the second year before the current year.
Example Scenario: if Eduardo spent 112 days in the U.S. in 2024, 119 days in 2023, and 136 days in 2022, he would calculate his days of presence as follows:
2024: 112 days
2023: 119 days * 1/3 = 39.67 days
2022: 136 days * 1/6 = 22.67 days
Total = 112 + 39.67 + 22.67 = 174.34 days
Since Eduardo does not meet the 183-day requirement, he would be considered a non-resident alien for tax purposes for 2024.
First-Year Residency - Non-resident aliens can elect to be treated as resident aliens for their first year of residency under the "First-Year Choice." This allows them to meet the substantial presence test one year earlier than usual. To qualify, the individual must:
Be present in the U.S. for at least 31 consecutive days in the year of choice,
Be present in the U.S. for at least 75% of the days from the start of the 31-day period to the end of the year, and
Meet the substantial presence test in the following year.
Example Scenario: Maria is a citizen of Brazil. She came to the United States for the first time on October 15, 2023, and stayed continuously until November 20, 2023 (37 days). She then returned to Brazil for a short visit and came back to the United States on December 5, 2023, staying for the rest of the year.
Steps to Determine First-Year Residency:
31-Day Requirement: Maria was present in the United States for 37 consecutive days from October 15, 2023, to November 20, 2023. This satisfies the requirement of being present for at least 31 days in a row.
75% Requirement: From October 15, 2023, to December 31, 2023, there are 78 days. Maria needs to be present in the U.S. for at least 75% of these 78 days. 75% of 78 days = 58.5 days (round up to 59 days).
Maria was present in the U.S. for 37 days (October 15 to November 20) + 27 days (December 5 to December 31) = 64 days. Since 64 days is more than 59 days, Maria meets the 75% requirement.
Maria meets both the 31-day and 75% requirements. Therefore, she can choose to be treated as a U.S. resident for part of 2023. Her residency starting date would be October 15, 2023, the first day of her 31-day period. She will be treated as a U.S. resident for the rest of the year 2023.
By making this choice, Maria will be considered a resident alien for tax purposes from October 15, 2023, through December 31, 2023, and will be taxed on her worldwide income for that period.
U.S. Sourced Income - Non-resident aliens are taxed on their U.S. sourced income, which includes:
Earned income (wages, salaries, etc.),
Investment income (interest, dividends, etc.),
Rental income from U.S. properties,
Royalties from U.S. sources,
Gains from the sale of U.S. real property.
Effectively Connected Income (ECI) - ECI refers to income earned by a non-resident alien from conducting a trade or business within the U.S. This income is subject to U.S. income tax and must be reported on a U.S. income tax return. ECI can include:
Income from the sale of goods or services,
Rental income,
Income from investments connected to a U.S. trade or business.
Fixed, Determinable, Annual, or Periodic (FDAP) Income - FDAP income refers to U.S. source non-business income paid to a foreign person or corporation that is not ECI. This can include:
Salaries, wages, premiums, and compensation for services performed in the U.S.,
Other fixed or determinable annual or periodic gains, profits, and income.
FDAP income is subject to a 30% (or lower treaty) tax rate. Non-resident aliens receiving only FDAP income upon which the 30% (or lower treaty) rate has been withheld are not required to file a U.S. income tax return.
Income Subject to the 30% or Treaty Withholding - Non-resident aliens are subject to a 30% withholding tax on their U.S. sourced FDAP income unless a tax treaty between the U.S. and their country of residence provides for a lower rate. To claim a reduced rate or exemption under a tax treaty, non-resident aliens must file Form 8233 with their U.S. employer or withholding agent.
Issues Employing Non-Residents in the U.S. - Employing non-resident aliens in the U.S. involves specific documentation and withholding requirements. Employers must ensure that non-resident aliens complete the necessary forms, such as:
Form I-9 for employment eligibility verification,
Form W-4 for withholding allowances,
Form 8233 for claiming tax treaty exemptions.
Non-resident aliens cannot claim the standard deduction, except for students and business apprentices from India who meet certain conditions. Employers must follow special procedures outlined in IRS Notice 1392 and Publication 15-T for withholding calculations.
Issues Employing Non-Residents Working from Their Home Country - For non-resident aliens working for a U.S. employer but providing their services within their foreign country, the taxation and withholding rules are as follows:
No U.S. Income Tax Liability - Non-resident aliens who perform their services for a U.S. business from their native countries are not subject to U.S. income tax liabilities. This means that the income they earn from the U.S. employer for services performed outside the U.S. is not taxable by the U.S.
No Withholding Requirements - Since the income is not subject to U.S. income tax, there are no withholding requirements for the U.S. employer. This means the employer does not need to withhold U.S. federal income tax, Social Security, or Medicare taxes from the payments made to the non-resident alien employee.
No Information Reporting Requirements - The U.S. employer is not required to file information reporting forms such as Form 1099 for the payments made to the non-resident alien employee for services performed outside the U.S.
Deductibility of Payments - The U.S. employer can deduct the amounts paid to the non-resident alien employee as business expenses, just as they would for payments made to any other employee or contractor.
In summary, non-resident aliens working outside the U.S. for a U.S. employer are not subject to U.S. income tax, withholding, or information reporting requirements. The U.S. employer treats them as independent contractors and can deduct the payments made to these workers as business expenses, thus not subject to payroll taxes or any information reporting requirements, which is huge benefit to U.S. employers.
Totalization Agreements - Totalization agreements are international agreements between the U.S. and other countries to avoid dual Social Security taxation. These agreements ensure that foreign employees working in the U.S. do not pay Social Security taxes to both the U.S. and their home country on the same wages. To claim an exemption under a totalization agreement, foreign workers must provide their U.S. employer with a certificate of coverage from their resident country.
Withholding Requirements - U.S. employers may need to withhold federal income tax, Social Security, and Medicare taxes from the wages of non-resident alien employees working in the U.S., depending on the withholding requirements based on the employee's visa status and tax treaty benefits. Employers required to withhold payroll taxes must:
Ensure non-resident aliens complete Form W-4 with special adjustments,
Follow the special withholding procedures outlined in Publication 15-T,
Report wages on Forms 941 or 944 and W-2.
Visa Definitions and Taxation of Individuals Temporarily in the U.S. - The taxation of non-resident aliens also depends on their visa status. Common visa categories include:
F-1 and J-1 Visas - Students and exchange visitors on F-1 and J-1 visas are generally exempt from Social Security and Medicare taxes for a specified period. They are also eligible for certain tax treaty benefits.
H-1B Visa - Non-resident aliens on H-1B visas are subject to the same tax rules as resident aliens if they meet the substantial presence test. They are also subject to Social Security and Medicare taxes.
H-2A Visa – Agricultural workers in the U.S. from approved countries on a temporary basis (not more than 3 years) work for employers who anticipate a shortage of workers. They are exempt from Social Security and Medicare taxes but may be subject to income tax on the income earned, depending on residency status. Employers are not required to withhold income tax.
B-1/B-2 Visas - Visitors on B-1 (business) and B-2 (tourist) visas are generally considered non-resident aliens and are taxed only on their U.S. sourced income.
Commonly Used Forms - Forms W-8BEN and W-8ECI serve distinct purposes for foreign individuals and entities dealing with U.S. income. Here's a breakdown of each form's purpose:
Form W-8BEN - is primarily for foreign individuals to establish their foreign status and claim benefits under tax treaties, and is used for the following purposes:
Establish Foreign Status - This form is used by foreign individuals to certify that they are not U.S. residents for tax purposes.
Claim Beneficial Ownership - It allows the individual to claim that they are the beneficial owner of the income for which the form is being furnished. This can include income from investments, partnerships, or other sources.
Claim Tax Treaty Benefits - If applicable, the individual can use this form to claim a reduced rate of, or exemption from, withholding tax under an income tax treaty between their country of residence and the United States.
Exemption from Form 1099 Reporting and Backup Withholding - The form can also be used to claim exemption from Form 1099 reporting and backup withholding for income that is not subject to Chapter 3 withholding and is not a withholdable payment.
Form W-8ECI - is for foreign persons (individuals or entities) to claim that their income is effectively connected with a U.S. trade or business, making it subject to U.S. taxation.
Establish Foreign Status - This form is used by foreign persons (individuals or entities) to certify that they are not U.S. residents for tax purposes.
Claim Beneficial Ownership - It allows the foreign person to claim that they are the beneficial owner of the income for which the form is being furnished.
Claim Effectively Connected Income (ECI) - The form is used to claim that the income is effectively connected with the conduct of a trade or business in the United States. This means the income is subject to U.S. taxation as if the foreign person were a U.S. resident.
Exception to Withholding for Dealers in Securities - The form can also be used by dealers in securities to claim an exception to withholding under specific regulations.
Both forms are essential for ensuring proper tax treatment and withholding for foreign individuals and entities receiving U.S. source income.
Understanding the taxation rules for resident and non-resident aliens is crucial for both the individuals and their employers. Non-resident aliens must navigate the substantial presence test, first-year residency, U.S. sourced income, ECI, FDAP income, and income subject to the 30% or treaty withholding. Employers must be aware of the specific documentation and withholding requirements for non-resident alien employees, including totalization agreements and visa definitions. By following these guidelines, non-resident aliens and their employers can ensure compliance with U.S. tax laws and avoid potential issues.
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