Residency Under U.S. Tax Law

Taxation of non-U.S. citizens is determined based on the residency status of the individual or entity.

Different from U.S. immigration laws, the tax laws divide taxpayer into two categories:

  1. Resident aliens are taxed in the same manner as U.S. citizens on their worldwide income, and
  2. Nonresident aliens are taxed according to special rules contained in certain parts of the Internal Revenue Code. For instance, some nonresident aliens are subject to federal income tax only on income which is derived from sources within the United States and/or income that is effectively connected with a U.S. trade or business.

Tax residency allows an individual to leave their former country of residence or nationality and become tax non-residents upon departure. Providing the potential for an individual to become tax nonresidents and only remain taxable in their former country on income from that country.

Under the residency rules of the tax code, an alien will become a resident alien in one of three ways:

  1. By being admitted to the United States as, or changing status to, a Lawful Permanent Resident under the immigration laws (the Green Card Test);
  2. By passing the Substantial Presence Test (which is a numerical formula which measures days of presence in the United States); or
  3. By making what is called the “First-Year Choice” (a numerical formula under which an alien may pass the Substantial Presence Test one year earlier than under the normal rules).

Under these rules, even an undocumented (illegal) alien under the immigration laws who passes the Substantial Presence Test will be treated for tax purposes as a resident alien.

Tax residency is important in the federal laws of tax payment obligations regarding the Internal Revenue Service and reporting obligations. State tax residency is a different issue and more information can be found here.(to be added).

Example of a taxpayer capitalizing on U.S. Tax Residency manipulation:

A taxpayer is a resident alien and will become a nonresident alien, and then again a resident alien. The taxpayer’s unused net operating losses that were generated while he was taxed as a U.S. resident, and that would have been allocated and apportioned to the gross income of the U.S. business had he been taxed on such income as a nonresident alien for such years, may be used to the extent provided in to offset gross income effectively connected with the conduct of the U.S. business while he is a nonresident alien.

A taxpayer may carry over any unused net operating losses from the U.S. business allocated and apportioned to income effectively connected with the conduct of the U.S. business while he is taxed as a nonresident alien, and may apply such losses against gross income from the U.S. business after he reacquires U.S. resident status. A taxpayer may carry over any unused net operating losses from the U.S. business generated while he was taxed as a U.S. resident, if still available, against his gross income after he reacquires U.S. resident status.

Contact Moskowitz, LLP for more information.

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