Taxation on Foreign Individuals in the US

The US government levies taxes on US citizen or resident's worldwide income and aliens' US source income. An individual who has income from different country sources may be taxed twice, three times or even more with some exceptions of tax treaty overrides. Therefore, for such individuals, it is very important to distinguish his status and income sources and make effective tax planning to comply with US laws and to avoid multiple taxation where possible. A Foreign citizen who stays in the US temporarily may be classified as a resident alien if certain conditions are met.

Resident vs. Non-resident Alien

Foreign citizens present in the US are classified as resident or non-resident aliens for the US federal tax purposes. There are two tests to determine the filing status:

  1. Green-card test Any US permanent residents (aliens with green card) are resident alien for tax purposes regardless of their presence in the tax year.

  2. Substantive presence tests. Aliens who do not have green cards but stay in the US for over 183 days during a tax year on a temporary visa may still be classified as resident alien for US federal or state tax purposes. "Substantial presence" test are also met if total days present in US in current year (over 31 days) plus 1/3 and 1/6 of days present in the preceding two years exceed 183 days.

The substantial presence test is exempted for students, trainees, visiting scholars with "F", "Q" or "J" visas or the personnel of foreign governments and international organizations.

Dual Status

In the year that an alien change status between non-resident and resident alien, usually the first tax year or the last tax year of the resident alien status (such as the year in which a green card is given or revoked), a tax payer may file as "dual status". It means to file as resident alien for part of the year when he qualifies, and as non-resident alien for the other part of year. Since a resident alien is taxed for income of all sources, while a non-resident alien is taxed only on US source income, there may be tax savings by filing as dual status.

Flowchart 2 shows the detailed procedure to assess whether one is classified as a resident or non-resident alien in the US.

IV. Tax on US income of Non-Resident Aliens

"Business" Income

The US federal tax laws have different treatments on "business" and "non-business" income of a non-resident alien. "Business" or "ECTB" income (Effectively Connected to US Trade or Business) refers to such income as wages, commission, or profits from a trade or business in which the taxpayer actively involve.

A non-resident alien with US source business income must file a Form 1040NR. His or her US source "business" income is taxed on a net basis (with itemized deduction only) based on a graduated rate system. The calculation of taxable income and tax is similar to the rules for a US citizen (in Form 1040). The tax rates are the same for Form 1040 and 1040NR. However, in computing taxable income, 1040NR does not allow exemptions for spouse and dependents, nor does it allow standard deduction.

"Non-Business" Income

"Non-business" or "FDPI" (Fixed or Determinable Periodic Income) means investment income such as interest and dividends from publicly traded stocks, securities, commodity futures, options etc.

Non-business income is usually taxed at a flat rate of 30% on a gross basis (without deduction), and non-resident alien with only US investment income usually does not have to file a US tax return as long as the 30% tax is withheld from the source (by the banks or brokerage firms).

In general the rate is 28% (for individuals, estates or trusts) and 34% for corporate partners on non-passive income distribution to foreign owners of US partnerships.

Capital Gains on Real Estates and Other Assets

Nonresident alien individuals generally are not subject to U.S. tax on capital gains realized from assets sold which are not effectively connected with a U.S. trade or business, and are not U.S. real property interest. (BNA 907 A-31)

Gains realized by nonresidents on the sale of U.S. real property will be subject to a 10% withholding tax on the gross proceeds. Alternatively, a taxpayer may withhold 30% of the capital gains realized upon sale of the property. The 10% or 30% withholding are required to be made at the source.

Exemptions

Non-resident aliens filing 1040NR usually can only have one exemption of himself /herself. He cannot claim the exemption of his spouse or children. There are certain exceptions based on US tax treaties with Canada, Mexico, India, Japan and South Korea. One may be able to claim his/her spouse and children if he is a citizen of the above countries.

Deductions

Non-resident aliens are not eligible to standard deductions, unless their home country has a treaty with the US that provides it. They can claim itemized deduction in a way similar to residents. Foreign tax paid can be deducted in the same way as state or local tax paid on the federal tax return. Alternatively, taxpayer can elect to take a foreign tax credit rather than the deduction.

Income Tax Treaties

To avoid double taxation, many countries enter bi-lateral tax treaties that provide reduced withholding tax rates, favorable income exclusion and information exchange between treaty nations. The US currently has income tax treaties with:

Australia, Austria, Barbados, Belgium, Bermuda, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Luxembourg, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russian Federation, Slovak Republic.

It's important to check on the reduced withholding tax rates and other benefits, there may be great tax saving if a non-resident alien’s home country has a tax treaty with the US.

Tax Withholding Requirements

A 30% tax is required to be withheld and remitted to the US Government on all payments of interest, dividends or royalties which are derived within the United States and paid to a resident of a foreign country that does not have a tax treaty with the US in effect.

The tax withheld must be deposited with an authorized financial institution or a federal reserve bank using a federal tax deposit coupon, Form 8109. The taxes withheld should generally be deposited with the bank within three banking days from the date of payment. If the deposit is not made on time, the IRS may assess penalties on the late deposit.

Any U.S. company is required to file an annual withholding tax return on U.S. source income paid to foreign persons (Form 1042), and complete Form 1042S, "Foreign Persons U.S. Source Income subject to Withholding." These returns must be filed on a calendar year bases and filed by March 15th of each year.

Alternative Minimum Tax

The tax laws give preferential treatment to certain kinds of income and allow special deductions and credits for some kinds of expenses. The alternative minimum tax attempts to ensure that all individuals who benefit from these tax advantages will pay at least a minimum amount of tax. The alternative minimum tax has a different tax computation that adds back most deductions and compares the total with a specified exemption amount. It creates a tax liability for an individual who would otherwise pay little or no tax. For details on the calculation of AMT, refer to Form 6251, Alternative Minimum Tax - Individuals.

State Taxation

The treaties between the United States and other countries have no bearing on the ability of various States. For example, the State of California has an entirely different approach to the taxation of inbound nonresident aliens. There is no comparable 183-day test of residency for California. In essence, California will tax an individual on compensation received for services performed in California. Therefore, it is important to check on the state law and plan ahead before becoming a US resident of certain state with state tax.

Tax saving - Deductible Travel Expenses

A non-resident alien may be able to deduct travel expenses if he or she is temporarily performing personal services in the US. For instance, a multinational employee come to the US for rotation experience may be able to deduct expenses of transportation, lodging and 50% of meals when he/she is temporarily working in the US for an assignment of less than one year. The deduction, however, will be limited to his/her taxable US source income.