KPMG US

U.S. Taxation of
Foreign Citizens

 

 

Contents | Introduction | Chapter 1 | Chapter 2 | Chapter 3 | Chapter 4 | Chapter 5 | Chapter 6 | Chapter 7 | Chapter 8 | Chapter 9 | Chapter 10 | Appendixes


Chapter 4 -- Taxation of Dual-Status Aliens

Full-Year Residency Election | First-Year Residency Election | Moving Expenses | Deductions and Personal Exemptions | Tax Rates and Filing Status

 


A foreign citizen is a dual-status alien if in one taxable year he or she is both a resident alien and a nonresident alien. The most common dual-status taxable years are the year of arrival in the United States and the year of departure from the United States. In the year of arrival, an individual is a nonresident alien for the part of the taxable year before arrival. For the part of the year after arrival, the individual can be taxed as either a nonresident alien or a resident alien depending on the circumstances. Similarly, in the year of departure, a resident alien generally will continue to be treated as a resident alien until final departure from the United States. Generally, if the lawful permanent resident test is met, U.S. residency begins on the first day the alien is present in the United States as a lawful permanent resident with a valid greencard and ceases on the day his or her lawful permanent resident status is officially terminated. If the substantial presence test is met, qualification as a U.S resident begins on the first day during the taxable year in which the individual is physically present in the United States and ceases on the last day of physical presence in the United States (provided that the individual has a closer connection to another country than to the United States during that part of the year after departure, maintains a tax home in the other country for the remainder of the year, and is not a U.S. resident at any time during the next calendar year). Under certain circumstances, up to 10 days of U.S. presence may be disregarded in determining residency starting and ending dates. (For a further discussion of the residency starting and ending dates, see Chapter 1.)

The income of a dual-status alien is segregated into two categories, each of which is taxed separately. A foreign citizen is taxed at graduated rates on his or her worldwide income during the part of the year in which he or she is treated as a resident alien. Additionally, he or she is taxed only on U.S. source income during the part of the year in which he or she is a nonresident alien. U.S. source gross income that is not effectively connected with a U.S. trade or business (for example, certain U.S. source dividends and interest) is taxed at a flat 30-percent rate or at a lower treaty rate. Income that is effectively connected with a U.S. trade or business (for example, compensation for services performed in the United States) is combined with income from the residency period and taxed at graduated rates.

Income is generally taxable to individuals when received rather than when earned or accrued. Thus, foreign source income (for example, compensation for services performed abroad) is not subject to U.S. tax if earned and received before a foreign citizen becomes a U.S. resident. However, this foreign source income would be subject to U.S. tax if received after an individual becomes a resident alien, even though earned when the individual was a nonresident alien. Similarly, foreign source income is generally exempt from U.S. tax if earned and received after a foreign citizen has departed from the United States and becomes a nonresident alien. This income would be taxable in the United States if received while the individual was still a resident alien.

U.S. source income that a departing foreign citizen receives after becoming a nonresident alien is generally taxed at a 30-percent rate or lower treaty rate. However, certain business income, including compensation for services performed in the United States, will be taxed at the regular graduated tax rates regardless of when received.

An individual is treated as receiving income when he or she actually or constructively receives it. For example, if a foreign citizen is entitled to receive a check for income while a resident alien, he or she has constructively received it. The income would be subject to U.S. tax even if the actual receipt and cashing of the check is deferred until the individual has departed the United States.

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Full-Year Residency Election

Two elections are available to married individuals that allow them to file a joint return and qualify for the preferential “married filing jointly” tax rates.  (As mentioned in Chapter 2, a joint tax return can only be filed if both spouses were either citizens or residents of the U.S. for the entire tax year.)

First, a nonresident alien who is married to an individual who is either a citizen or resident alien of the United States at year end may elect to be treated as a resident for the entire tax year. Both spouses must make the election, which applies to the year made and all subsequent years until terminated. The election, however, will not cause foreign citizens to be treated as U.S. residents for any tax year if neither spouse is a citizen or resident of the United States at any time during the taxable year.

The election is made by attaching a statement, signed by both spouses, to the joint return for the first year in which the election applies. While the election is normally made with the return, it can be made with an amended return. The election remains in effect until a tax year in which neither spouse is a citizen or resident at any time during the year, or until terminated in any of the following ways:

  • Revocation by either spouse;
  • Death of either spouse;
  • Legal separation; or
  • Inadequate record keeping (as determined by the IRS).

Once terminated for any of these reasons, neither spouse may make the election again.

Since the effect of the election is to make both spouses full-year residents of the U.S., both spouses will be considered full-year residents of the U.S. in any year in which either spouse is a resident for any part of the year (including the year of departure to another country).

Second, an election to be taxed as a resident alien for the entire taxable year may be made by an individual who is a nonresident alien at the beginning of the year and a resident alien at the end of the year, and who is married to an individual who is either a citizen or resident of the United States at year end. Thus, this election can be made by foreign married individuals arriving in the United States during the taxable year and who are resident aliens at year end. The election is made by attaching a statement signed by both spouses to the joint return for the taxable year to which the election applies. The election applies only to the current year. Moreover, neither spouse is eligible to make another such election in any later year.

The principal reason for making either of the full-year residency elections is to be eligible to file a joint U.S. tax return. A joint return cannot be filed if either the husband or the wife, at any time during the taxable year, is a nonresident alien. Making such an election removes the nonresident alien status for filing purposes.

If a full-year residency election is made, a joint return may be filed to use the lower joint tax rates, but the worldwide income of both spouses for the entire taxable year will be subject to U.S. tax. The foreign tax credit can offset the U.S. tax on foreign source income, subject to the foreign tax credit limitation rules. Additionally, the standard deduction is permitted.

The benefits and detriments of making either of the full-year residency elections must be carefully evaluated. Making such an election is usually beneficial if the tax benefit from using joint tax rates and itemizing deductions for the full year is greater than the additional U.S. tax, net of the foreign tax credit, on income earned during the non-residency period that otherwise would not be subject to U.S. taxation. The date of arrival in the United States will bear heavily on the election decision because compensation earned after arrival will be subject to U.S. tax regardless of whether the individual is a resident or nonresident alien. Therefore, a foreign citizen who arrives early in the year may not be subjecting a large amount of additional income to U.S. taxation by making the election. 

If a foreign couple is eligible to make either full-year residency election, it may be more beneficial to make the first election described above, since that election applies for subsequent years unless terminated or suspended. As a result, the foreign married individuals would be considered full-year U.S. residents in the year of departure from the United States and may be able to file a joint U.S. return for that year.

It is important to note that if neither spouse is a resident at year end, the married couple is ineligible to make either of the two elections to be taxed as full-year resident. However, use of the first-year residency election described below may enable one or both spouses to be treated as a resident at year end, thus making them eligible to make either of the full-year residency elections described above.

First-Year Residency Election

A qualifying foreign citizen may elect to be treated as a resident alien for a calendar year in which the individual is not otherwise treated as a U.S. resident because he or she does not meet either the lawful permanent resident test or the substantial presence test.

A qualifying alien individual is one who:

  • Was not a resident alien during the preceding year;
  • Meets the requirements of the substantial presence test for residency in the following calendar year;
  • Is present in the United States for at least 31 consecutive days during the election year;
  • Is present in the United States during the period beginning with the first day of such 31-day period and ending with the last day of the election year (for example, December 31) for a number of days equal to or exceeding 75 percent of the number of days in such period. In applying this 75-percent test, an individual may treat up to five days of absence from the United States as days of presence in the United States.

A foreign citizen who makes the first-year election will be treated as a U.S. resident only for that portion of the year that begins on the first day of the earliest-presence period for which the individual can satisfy both the 31-day and the 75-percent tests. For purposes of these tests, an individual will not be treated as present in the United States on any days in which the foreign citizen is an exempt individual for purposes of the substantial presence test (for example, diplomats, certain students and teachers). The first-year election allows the taxpayer to claim the spousal exemption and greater itemized deductions. Additionally, foreign tax credits and foreign losses incurred during the residency period are allowed. However, foreign income earned during residency is subject to U.S. tax.

A qualifying alien must make the election on his or her tax return for the election year. However, the election may not be made before the individual has actually met the substantial presence test for the following year. Once made, the election cannot be revoked without the consent of the IRS.

A qualifying alien is also allowed to make the residency election for his or her dependent children. This may allow the taxpayer to benefit from the dependency exemptions for nonresident dependent children who would not otherwise qualify. This first-year residency election may be made for dependent children on the parents’ tax return for the election year. It is not necessary to file a separate tax return for each dependent child in order to make a valid election.

Example

A foreign citizen vacations in the United States from January 1 through January 31, 2007. She returns to the United States on October 15, 2007, and begins a three-year assignment working for a U.S. company. For the remainder of 2007, she is absent from the United States for 10 days (from December 20 through December 29). She satisfies the substantial presence test as a resident alien for 2008. She was not a resident alien in 2006. The individual may make a first-year election to be taxed as a resident alien starting on October 15, 2007. The January presence is not included since the 75-percent test is not satisfied for the period beginning January 1.

 

A foreign citizen may make the full-year residency election in conjunction with the first-year residency election. As a result, a married foreign citizen and his or her spouse may file a joint return for the year of arrival in the United States even if they are not treated as resident aliens under the lawful permanent resident or substantial presence tests. Furthermore, the electing foreign citizen may make the residency election for his or her dependent children on the same tax return.

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Moving Expenses

Reimbursed moving expenses of an employee are excluded from gross income. The definition of what constitutes “moving expenses” incurred in connection with moving to a new location for employment-related reasons is limited to the costs of moving household goods and personal effects to the new residence, and travel and lodging costs during the move. The definition of “moving expenses” does not include:

  • Meal expenses;
  • Expenses incurred while searching for a new home after obtaining employment;
  • The costs of selling the old residence (or settling a lease) or purchasing (or acquiring a lease on) a new home; or
  • Temporary lodging at the new location after obtaining employment.

Also, moving expense reimbursements are only excludible if the following two conditions apply:

  • The taxpayer’s new job location is at least 50 miles farther from the taxpayer’s old residence than the old residence was from the former place of employment.
  • The taxpayer is a full-time employee at the new location for at least 39 weeks during the 12-month period following the move. If the taxpayer is self-employed, he or she must work full time at the new location for at least 39 weeks during the first 12 months and a total of at least 78 weeks during the first 24 months right after the move.

Unreimbursed moving expenses are a deduction in computing adjusted gross income rather than an itemized deduction. Reimbursed moving expenses are not deductible. Moving expense reimbursements are excluded from income (unless the taxpayer previously deducted the expenses).

A nonresident alien generally only may deduct moving expenses incurred on a move to the United States.

Deductions and Personal Exemptions

A dual-status alien may claim itemized deductions in computing taxable income related to the period during which he or she is taxed as a resident alien. According to the IRS, he or she may not use the standard deduction that other taxpayers may generally elect in lieu of itemizing deductions (see Chapter 2).   

A dual-status alien is entitled to personal exemptions for himself or herself, his or her spouse, and dependents in computing taxable income for the residency part of the taxable year. The deduction for these exemptions, however, is generally limited to taxable income before exemptions for the part of the year that the foreign citizen is a resident alien.

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Tax Rates and Filing Status

An unmarried dual-status alien must use the tax rates for single taxpayers in computing his or her tax at graduated rates. He or she may not file as head of household.

A married dual-status alien must generally use the tax rates applicable to married taxpayers filing separately. However, he or she may use the joint rates if the individual and his or her spouse elect to be taxed as full-year residents, as discussed above. 

 

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