When advising taxpayers or preparing returns, bright-line rules are generally the easiest to explain and to handle. In contrast, tax outcomes that depend on facts and circumstances are inherently more difficult to evaluate. It is therefore a relief that many federal tax residency rules applicable to individuals are black-and-white, particularly considering how critical an issue residency is, both in terms of what is subject to tax and what returns are required. Unfortunately, there is a large gray area as well.
Black-and-White Rules—Income Tax Residency
For federal income tax purposes, individuals who are U.S. persons are subject to tax on their worldwide income and file a Form 1040, whereas individuals who are not U.S. persons are only subject to tax on their U.S.-source income and file Form 1040NR. U.S. citizens are automatically U.S. persons under Internal Revenue Code (IRC) section 7701(a)(30)(A), but noncitizens are only U.S. persons if they are U.S. residents (i.e., resident aliens).
Under IRC section 7701(b), a resident alien is either 1) a lawful permanent resident (i.e., a green card holder) or 2) an individual who is “substantially present” in the United States. (Under certain circumstances, an individual can also elect to be treated as a U.S. resident.) Substantial presence is based on day count; if an individual is present in the United States at least 31 days in the current year and the sum of 1) the days that individual is present in the United States during the current tax year, 2) one-third of the days that individual is present in the United States during the first preceding tax year, and 3) one-sixth of the days that individual is present in the United States during the second preceding tax year equals or exceeds 183, then that individual is substantially present in the United States. Special rules apply in the year residency begins; for lawful permanent residence, residency—and therefore taxation as a U.S. person—is deemed to commence on the first day of actual presence in the United States after receipt of the green card; for substantial presence, residency is deemed to commence on the first day of actual presence in the United States. For the year in which residency ends, however, the individual is generally treated as a U.S. resident for the entire tax year.
Any presence in the United States (including territorial waters, but not including U.S. possessions or territories or U.S. airspace), however fleeting, will count as a day for purposes of substantial presence. Treasury Regulations section 301.7701(b) 3 details certain exceptions to substantial presence; for example, days present in the United States if an individual has exempt status (e.g., on a student visa or diplomatic visa, or as a professional athlete) are not considered when determining substantial presence, nor are days present in the United States if an individual is unable to leave due to a medical condition that arose when the individual was in the United States. (Form 8843 is generally attached to an income tax return to exclude days present in determining substantial presence.) Moreover, days present in the United States do not include any days on which the only presence in the United States is due to being in transit between two non-U.S. locations, such as catching a connecting flight at a U.S. airport. There is also a special exception for individuals from Mexico or Canada who commute for employment or self-employment in the United States regularly (i.e., on at least 75% of working days).
Notwithstanding the above exceptions, a nonresident alien who is present in the United States at least 183 days is still subject to tax on his net gains on the sale of capital assets located in the U.S. [see IRC section 871(a)(2)], whereas a non-resident alien is normally not taxable on any capital gains other than gains on U.S. real property or gains that are effectively connected with a U.S. trade or business.
Gray Rules—Income Tax Residency
Beyond the bright-line rules noted above, there are several exceptions that depend upon the facts and circumstances.
An individual who is otherwise substantially present in the United States may still avoid classification as a U.S. resident if she 1) is not present in the United States for 183 days in the current tax year, 2) maintains a tax home in a single foreign country, and 3) has a closer connection to that foreign country [Treasury Regulations section 301.7701(b)2]. For this purpose, a foreign country includes U.S. territories and possessions, and under very specific conditions an individual may have a closer connection to two foreign countries. A tax home is where an individual maintains her regular place of business, or, if more than one, her principal place of business; if the individual does not maintain a regular place of business, a tax home is the individual’s regular place of abode. The individual must maintain the tax home for the entire year, and the tax home must be in the same country to which the individual is claiming a closer connection.
A closer connection means having more significant contacts with the foreign country, with the following among the criteria relevant to that determination:
- The location of the individual’s permanent home
- The location of the individual’s family
- The location of personal belongings, such as automobiles, furniture, clothing, and jewelry owned by the individual and his family
- The location of social, political, cultural or religious organizations with which the individual has a current relationship
- The location where the individual conducts routine personal banking activities
- The location where the individual conducts business activities (other than those that constitute the individual’s tax home)
- The location of the jurisdiction in which the individual holds a driver’s license
- The location of the jurisdiction in which the individual votes
- The country of residence designated by the individual on forms and documents
- The types of official forms and documents filed by the individual, such as Form 1078 (Certificate of Alien Claiming Residence in the United States), Form W-8 (Certificate of Foreign Status), or Form W-9 (Payer’s Request for Taxpayer Identification Number).
For these purposes, a permanent home can be owned or rented and can be a house, an apartment, or a furnished room, but must be continuously available rather than available only for stays of short duration.
Form 8840 is attached to an income tax return to claim a closer connection. The closer connection exception is only available for purposes of substantial presence—a green card holder (or even one in the process of applying for a green card) cannot claim a closer connection to a foreign county.
An individual who is a U.S. resident based on either having a green card or being substantially present may be able to avoid being taxed as a U.S. resident if the individual is also treated as a resident of a foreign country under the laws of that country and under the tiebreaker rules of the income tax treaty between the United States and that foreign country [Treasury Regulations section 301.7701(b)-7]. There may be variations in the tiebreaker rules from treaty to treaty, but the rules under the U.S. model treaty are reasonably representative of those under actual in-force treaties, and those rules provide that, if an individual is treated as a resident of each country under that country’s domestic laws, for purposes of the treaty—
- he shall be deemed to be a resident only of the country in which he has a permanent home available to him;
- if he has a permanent home available to him in both countries, he shall be deemed to be a resident only of the country with which his personal and economic relations are closer (center of vital interests);
- if the country in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either country, he shall be deemed to be a resident only of the country in which he has an habitual abode;
- if he has an habitual abode in both countries or in neither of them, he shall be deemed to be a resident only of the country of which he is a national;
- if he is a national of both countries or of neither of them, the competent authorities of the countries shall endeavor to settle the question by mutual agreement.
“Center of vital interests” is not a defined term in the U.S. model treaty, but the commentary to the Organization for Economic Cooperation and Development model treaty indicated that it is the country to which the individual’s personal and economic relations are closer, making it quite similar to the closer connection test.
A treaty tiebreaker election is made by filing Form 8833 along with that year’s income tax return. (If treaty residency status is deemed to change in the middle of a tax year, the individual is a dual status taxpayer, and the income tax reporting can become quite complicated.) Note that, under IRC sections 877(e)(1) and 7701(b)(6), if a green card holder makes a treaty tiebreaker election, it is the equivalent for tax purposes of relinquishing the green card, which could expose the individual to expatriation tax consequences and require the filing of Form 8854, depending upon how long the individual has held the green card.
One critically important difference between the closer connection election and the treaty tiebreaker election is that, under the former, the individual making the election is deemed not to be a U.S. resident for any income tax purpose, whereas under the latter, the individual making the election is deemed not to be a U.S. resident only for purposes of computing the individual’s tax liability. For other purposes, including filing foreign informational reporting forms such as the Foreign Bank Account Report (FBAR), the individual is still deemed to be a U.S. resident.
Residency start date and termination date.
As noted above, the general rule is that in the last year of residency, an individual is resident the entire tax year. The individual’s residency termination date—and therefore the date on which the individual ceases to be taxed as a U.S. person—can, however, be a date earlier than December 31 (specifically, the final date of actual presence in the United States for purposes of substantial presence, or the date on which the individual ceases to be a legal resident) if the individual 1) has a tax home in a foreign country for the balance of the tax year and 2) has a closer connection to that country for the balance of the tax year [Treasury Regulations section 301.7701(b)-4].
Moreover, under the substantial presence test for purposes of determining the first day present in the United States or the residency termination date, up to 10 days of actual presence can be excluded if the individual had a tax home in and a closer connection to another country during that time.
Gray Area—Estate and Gift Tax Residency
For federal estate and gift tax purposes, individuals who are U.S. persons are subject to tax on their worldwide assets, whereas individuals who are not U.S. persons are only subject to tax on their U.S. situs assets. U.S. citizens are automatically U.S. persons, but noncitizens are only U.S. persons if they are U.S. residents.
Residency for estate and gift tax purposes is, however, determined completely differently from residency for income tax purposes. Residence for estate and gift (and generation-skipping transfer) tax purposes is not based on any bright-line rules, but rather on the amorphous concept of domicile [Treasury Regulations section 20.0-1, 25.2501-1(b)]. An individual acquires domicile by residing in a place with no present intention of leaving. Intent is, of course, entirely subjective, but the IRS will look to external indicia of intent, including many of the same factors as the closer connection test, as well as factors such as immigration status or day count; no one factor is dispositive.
Choosing a Tack
It can be a challenge to give a clear answer to an individual who asks, “Am I a U.S. resident?” For income tax purposes, the baseline answer is usually based on black-and-white rules, but whether exceptions apply is largely a gray area; for estate and gift tax purposes, the entire answer is gray. Often, the best advice is to acknowledge that there may be some uncertainty, and therefore some risk, but to steer taxpayers to change their facts and circumstances to fit the tax treatment they seek.