To say that U.S. tax laws are complicated would almost be an understatement. Additionally, because the United States is one of the few countries in the world that subjects its residents and citizens to taxation on their worldwide income, it is understandable that many individuals—residents and nonresidents alike—are unaware of their U.S. tax filing requirements. This article aims to provide an overview of certain U.S. federal income tax filing requirements for resident and nonresident individuals. (Note that this article focuses only on U.S. federal income taxes; a discussion of U.S. state and local tax filing requirements, U.S. Medicare and Social Security taxes, and other non-income tax filing obligations are beyond the scope of this article.)
In order to determine the taxing rights of the United States on an individual taxpayer, the two most important factors to consider are the taxpayer’s residence and the source of his or her income. In determining residence, if the taxpayer is a U.S. citizen, then regardless of where the taxpayer is physically located, he or she will be considered a tax resident for U.S. income tax purposes and generally subject to U.S. tax on his or her worldwide income (See Cook v. Tait, 265 U.S. 47 (1924)). On the other hand, if the individual is an alien, which is defined for U.S. tax purposes as any individual who is not a U.S. citizen, then a further determination must be made on whether the individual is a resident or a nonresident alien. This is an important distinction because while resident aliens are generally subject to worldwide taxation similarly to U.S. citizens, nonresident aliens are potentially only taxed by the United States on income that is either sourced in the United States or effectively connected with the conduct of a U.S. trade or business; such income is known as effectively connected income (ECI) (I.R.C. §§ 871(a), 871(b) (see also § 2(d))).
Taxation of resident aliens. A foreigner who resides in the United States is generally considered a nonresident alien unless the individual is a lawful permanent resident of the United States at any time during the tax year (often referred to as the Green Card Test) or the individual meets the substantial presence test under § 7701(b)(3), which generally provides that an alien individual shall be treated as a resident of the United States for tax purposes if such individual was present in the United States for at least 31 days during the current calendar year and the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar years (when multiplied by the applicable multiplier under § 7701(b)(3)(ii)) equals or exceeds 183 days.
While the substantial presence test may appear complicated at first, with the help of a little bit of math, a general rule of thumb is that as long as a foreigner stays in the United States for less than 122 days each year, he or she will not be treated as a resident for U.S. federal income tax purposes.
Foreigners who meet the tax residency test either under the Green Card Test or the substantial presence test will be treated as a U.S. resident for tax purposes and must file IRS Form 1040, U.S. Individual Income Tax Return, for each calendar year, the same as U.S. citizens, and will be subject to U.S. taxation on the taxpayer’s worldwide income. Alternatively, if an individual is treated as a nonresident alien for U.S. tax purposes, then he or she will generally be subject to U.S. taxation only on U.S.-sourced non-ECI or ECI income and would only file a Form 1040-NR, U.S. Nonresident Alien Income Tax Return, if he or she meets certain requirements as prescribed by the IRS. (See IRS Publication 519, which provides that, in general, nonresident aliens must file a Form 1040-NR if the individual engaged in a trade or business in the United States during the year, or if the individual has U.S.-sourced income on which tax liability was not satisfied by the withholding of tax at the source; note that, in certain situations, it is possible for an individual to qualify as both a resident and nonresident in the same year, and such individual would be treated as a dual-status alien.)
Exception to the substantial presence test. Exempt individuals. It would not be U.S. tax law without exceptions to the rules, and the U.S. tax code provides for several exceptions to the substantial presence test. One of the most important exceptions is that any time spent in the United States as an exempt individual (e.g., employees of foreign governments, teachers and students, and certain professional athletes temporarily in the United States to compete in a sports event) does not count for purposes of determining presence in the United States (I.R.C. § 7701(b)(3)(D)(i)).
Even though the United States has the world’s largest population of international students, it is important to highlight that the U.S. tax law exception for treating foreign teachers and students as exempt individuals is limited, and international students who have been studying in the United States for a prolonged period may find themselves inadvertently becoming U.S. residents for tax purposes. For tax purposes, a “student” is defined under § 7701(b)(5)(D) as any individual who is temporarily in the United States on an F, J, M, or Q visa who substantially complies with the requirements of that visa. However, an international student who has been in the United States for more than five calendar years will no longer be treated as an exempt individual unless he or she files a Form 8840, Closer Connection Exception Statement for Aliens, along with his or her Form 1040-NR, and sets forth the facts and circumstances that establish that he or she does not intend to reside permanently in the United States (I.R.C. § 7701(b)(3)(E)(ii)). For teachers, the limitation is generally two years (see § 7701(b)(3)(E)(i)).
Exception for certain medical conditions. The regulations provide another exception for individuals unable to leave the United States due to a medical condition that arises while such individual is present in the United States (I.R.C. § 7701(b)(3)(D)(ii)). Under the medical conditions exception, the days during which the individual is unable to leave the United States due to the medical condition do not count toward the substantial presence test.
It is worth noting that unique to calendar year 2020, due to the global COVID-19 pandemic and corresponding travel disruptions, the IRS has provided relief to certain nonresident individuals who, but for travel and related disruptions resulting from the pandemic, would not have been in the United States long enough to meet the substantial presence test (I.R.S. Rev. Proc. 2020-20). Eligible individuals may file a Form 8843, Statement for Exempt Individuals and Individuals with a Medical Condition, and claim a COVID-19 medical condition travel exception to exclude up to 60 consecutive calendar days they select, starting no earlier than February 1, 2020, but no later than April 1, 2020, during which they were physically present in the United States for purposes of applying the substantial presence test (see Instructions for Form 8843).
Taxation of nonresident aliens. As discussed previously, if a taxpayer is classified as a nonresident alien, then he or she will generally only be subject to U.S. tax on income that is sourced from within the United States or income that is effectively connected with a U.S. trade or business. One of the fundamental principles of international taxation is that the country in which income is earned (i.e., the source country) reserves the primary right to tax the income. Thus, in instances where the taxpayer is not a resident of the source country, the source country should nevertheless reserve the right to tax income that is locally sourced unless there exists a tax treaty between the residence country and source country that dictates otherwise.
In general, subject to certain exceptions and exclusions, § 1441 and § 1442 (if paid to corporations) impose a flat 30 percent withholding tax on U.S.-sourced fixed, determinable, annual, or periodic (FDAP) income paid to foreign individuals (e.g., passive income such as dividends, interests, rents, and royalties) unless the beneficial owner of the FDAP income provides a W-8 series form (or, in some instances, an alternative documentation that is acceptable or associated with lower rates of withholding) that establishes that the payee is entitled to a lower treaty rate or that the income is ECI, which will be taxed at applicable individual tax rates. (The source of income is critical because the taxpayer’s ability to credit foreign taxes is directly affected by the amount of the taxpayer’s foreign source income.) Note that under § 1461, it is the payor, as the withholding agent, who is liable for the withholding tax; thus, it is generally prudent for the payor to withhold at the source and request the appropriate documentation (e.g., the applicable W-8 series form) from its payees to ensure proper withholding, and to file a Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, informational return as well as a Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, return each year and furnish a copy to payees.
As discussed in the previous section, U.S. citizens, by virtue of their citizenship and the various benefits that come with having U.S. citizenship, are subject to U.S. tax on their worldwide income, regardless of whether the income is from a related U.S. source. In other words, every penny made by a U.S. taxpayer overseas may potentially be subject to U.S. tax even if the taxpayer has not been in the United States at all during the calendar year and the income is derived from foreign sources with no connection to the United States, and the taxpayer would continue to have a U.S. tax filing obligation so long as his or her income exceeds a certain threshold. (See Instructions for Form 1040. For single taxpayers the threshold amount is $12,400 for 2020 or $24,800 if married and filing jointly. For 2021 the threshold amount is $12,550 for single taxpayers or $25,100 if married and filing jointly.)
Foreign earned income exclusion. In order to reduce the U.S. tax burden on U.S. citizens and U.S. resident aliens living and working abroad, the Internal Revenue Code provides a few avenues of relief. A U.S. citizen or U.S. resident alien may qualify for the foreign earned income exclusion (FEIE) and the foreign housing exclusion (FHE), which provide that a qualifying individual who lives and works abroad may file a Form 2555, Foreign Earned Income, and elect to exclude from gross income a certain amount of foreign earned income attributable to his or her residence in a foreign country during the tax year as well as certain housing expenses (I.R.C. § 911(a)(1) and (b)(2)). For purposes of FEIE and FHE, the term “qualified individual” refers to an individual whose tax home is in a foreign country and who is a U.S. citizen or resident who is a bona fide resident of a foreign country for an entire taxable year or at least 330 days during a period of 12 consecutive months (I.R.C. § 911(d)(1)). For tax year 2020, the maximum amount of foreign earned income that may be excluded is $107,600 for an individual; in the case of married taxpayers, each spouse may compute the limitation separately and thus may potentially exclude up to $215,200 (I.R.S. Rev. Proc. 2019-44). For 2021, the maximum exclusion for an individual is $108,700 (I.R.S. Rev. Proc. 2020-45; see Treas. Reg. § 1.911-5 for special rules for married couples who are both qualified individuals).
The amount of the FHE is generally dependent on the country of residence, and the taxpayer should refer to the Instructions for Form 2555 when calculating the allowance for his or her individual situation. It is important to note that the FEIE applies only to foreign earned income such as wages, salaries, professional fees, and other amounts received as compensation for personal services rendered and does not include any income that is passive in nature (e.g., pensions, interest, dividends, capital gains) or income that is U.S.-sourced, which will be subject to U.S. tax (I.R.C. § 911(b)(1)(B)).
As an illustrative example, individual A is a U.S. citizen and a bona fide resident of foreign country X for all of 2020 and received $120,000 in salary for work performed in country X. Assuming A is single, after the FEIE reduction, A has U.S. taxable income of $12,400, which will be taxable at the applicable individual tax rate of 24 percent, resulting in U.S. tax liability of $2,976. Note that the amount of taxable income in excess of the FEIE will be taxed at the applicable tax rate prior to the application of the FEIE (i.e., $120,000 instead of $12,400).
Foreign tax credit or deduction. To minimize double taxation, a U.S. taxpayer may elect to credit foreign taxes paid as a foreign tax credit (FTC) or deduct such taxes in determining taxable income, subject to certain limitations (I.R.C. § 901 and Treas. Reg. § 1.901-1; see § 904 and Treas. Reg. § 1.904-1 for limitations). In order to claim the FTC, a U.S. taxpayer must generally file a Form 1116, Foreign Tax Credit, along with his or her individual income tax returns and elect to claim the FTC on an annual basis. Under certain limited situations, the taxpayer may directly claim the FTC on his or her tax return without filing Form 1116 (I.R.C. § 904(j)).
The rules governing FTCs or foreign tax deductions are complex and beyond the scope of this article. However, in general, a U.S. taxpayer may claim an FTC or a foreign tax deduction with respect to any creditable income tax, including war profits and excess profits taxes, paid or accrued to a foreign country during the tax year on foreign sourced income. This also includes taxes paid or accrued “in lieu of” income taxes imposed by the foreign country (I.R.C. § 903). It is worth pointing out that not all taxes are creditable for FTC purposes. Under Treas. Reg. § 1.901-2(a)(3), creditable tax generally must have a “predominant character” as that of a compulsory income tax, according to U.S. tax principles. In other words, a penalty, fine, custom duty, interest payments, or other payments to a foreign government in exchange for a specific economic benefit that is not available on substantially the same terms to all persons (e.g., royalties for exploration rights) do not count as a tax.
A U.S. taxpayer may claim either an FTC or a foreign tax deduction but not both. Generally, for most U.S. taxpayers, it is more advantageous to elect to claim an FTC because it is a dollar-for-dollar reduction against an individual’s U.S. tax liability, whereas a deduction simply reduces the individual’s income subject to tax. (Note that because not all foreign taxes paid are eligible for an FTC, a foreign tax deduction may yield a better tax result in certain situations.)
Additionally, an individual cannot claim an FTC on income that has already been excluded under the FEIE because to do so otherwise would allow a credit for tax paid on income not subject to U.S. tax. To illustrate, consider the example above, assume that country X has an individual tax rate of 15 percent, so A’s total tax liability in country X is $18,000. However, because A has taken an FEIE reduction of $107,600, A can claim only 10.33 percent of the $18,000 foreign taxes paid as FTC, or $1,859, resulting in total U.S. tax liability of $1,117. (These figures are derived as follows: ($120,000 – $107,600) / ($120,000) = 0.1033, then $18,000 * 0.1033 = $1,859.)
Foreign assets held by U.S. citizens and residents. Generally, all U.S. persons are required to file a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), in addition to their annual individual income tax return if they had a financial interest in or signature authority over at least one non-U.S. financial account and the aggregate value of such account exceeds $10,000 at any time during the calendar year (31 C.F.R. § 1010.306(c) and 1010.350). The term “U.S. persons” includes both U.S. citizens and residents as well as various legal entities organized under the laws of the United States (e.g., corporations, partnerships, limited liability companies, etc.). The definition of a financial account generally includes, but is not limited to, securities, brokerage, savings, demand, checking, deposit, time deposit, or other accounts maintained with a financial institution, as well as commodity or options accounts or certain insurance or annuity policies with a cash value. For 2021, the penalty for a non-willful failure to file an FBAR is $13,640 per missed form or missed account per year.
Additionally, under the U.S. Foreign Account Tax Compliance Act (FATCA), any individual who holds an interest in a specified foreign financial asset during the tax year must also attach a Form 8938, Statement of Specified Foreign Financial Assets, to his or her annual individual income tax return if the total value of all such assets (determined using the fair market value of the asset in USD on the last day of the tax year) exceeds an applicable threshold amount (I.R.C. § 6038D; § 1.6038D-2 (threshold amount); §1.6038D-5 (determination of asset value)). Individuals living abroad must file a Form 8938 if the total value of specified foreign assets is more than $200,000 on the last day of the tax year or more than $300,000 at any time during the year. Note that the filing of the FBAR does not relieve the individual of the requirement to file Form 8938 to report specified foreign financial assets, and an individual may be required to file both Form 8938 and the FBAR to report the same information on certain foreign accounts.
As this article illustrates, the status of an individual taxpayer is critical in determining the individual’s potential U.S. federal tax consequences and filing requirements. In addition, the U.S. system of extraterritorial taxation that subjects residents of other countries to U.S. taxation based on citizenship means that individuals may be subject to U.S. taxation and filing requirements even if their only tie to the United States is their citizenship. It is therefore imperative that individuals understand their residency status for U.S. federal income tax purposes or else face the possibility of an unfavorable surprise.
