Tax Treatment and Planning Strategies for Nonresident Individuals

By Danny Hollingsworth, DBA, CPA

 

EXECUTIVE
SUMMARY

 

Illustration by Leontura/iStock

  • Alien individuals that have U.S.-source income can be taxed as residents of the United States if they meet certain requirements. Otherwise, they will be taxed under the generally less favorable rules for nonresident aliens.
  • Nonresident aliens who are engaged in a trade or business in the United States or have income that is subject to U.S. taxation must file a U.S. return. Nonresident aliens pay tax on U.S.-source income that is effectively connected to a U.S. trade or business at graduated rates and pay tax on fixed or determinable annual or periodic income and certain other income at a flat rate (generally, 30%).
  • Rules regarding filing statuses, deductions, and exemptions for nonresident aliens are more restrictive than for other taxpayers. Nonresident aliens file Form 1040NR, U.S. Nonresident Alien Income Tax Return. Most nonresident aliens are not eligible to receive a Social Security number and must file using an individual taxpayer identification number obtained from the IRS instead.

President Barack Obama's executive action on immigration announced on Nov. 20, 2014, 1 would allow some unauthorized aliens to temporarily work and remain in the United States. Although opposed in Congress and, at this writing, still blocked from implementation in a lawsuit brought by more than two dozen states or their officials, 2 the executive action creates some uncertainty in federal and state laws, including those concerning taxation of nonresidents. While the executive action would grant some unauthorized aliens the right to legally work in the United States, it does not appear to make these workers resident aliens under the green-card test and thus subject to tax laws for citizens, U.S. nationals, and resident aliens. Yet, the workers covered by the executive action would likely meet the resident alien substantial-presence test, thereby possibly making them subject to the tax laws for resident aliens. Many workers covered by the executive action may not meet the substantial-presence test, and such workers generally are nonresident aliens under the Code.

 
If the executive action is implemented, since the covered workers will not have not had legal status in the United States previously, it is reasonable to conclude that many will not have complied with U.S. tax filing requirements. Approximately 5 million unauthorized aliens could receive protection from deportation, most of whom could then work legally in the United States. 3 Many more individuals than before would likely face the nonresident alien tax compliance rules and file Form 1040NR, U.S. Nonresident Alien Income Tax Return. This could represent a substantial increase in taxpayers filing a nonresident alien tax return over the number under current policies. The IRS in 2012 projected only a 1.4% increase, to 683,600, in Forms 1040NR (or 1040NR-EZ) to be filed in 2018, over those in 2011. 4 This forecast could need to be revised upward significantly. By the same token, many tax practitioners and preparers unfamiliar with the rules pertaining to nonresident aliens may need to become more adept in this area. This article therefore provides an outline of the basic tax-compliance rules, as well as tax planning strategies, for nonresident aliens.

Resident Versus Nonresident Aliens

Individuals who are not U.S. citizens or U.S. nationals are considered aliens, either resident or nonresident. If an individual is not a resident alien by meeting the green-card test, substantial-presence test, or first-year-choice option described below, he or she will be classified as a nonresident alien and may be required to file a U.S. tax return and pay any required tax under rules prescribed for nonresident aliens.

A resident alien is an immigrant who has been granted the right to reside permanently in the United States and may work without restrictions in the United States, meeting the green-card test. 5 The substantial-presence test requires the individual to be present in the United States at least 31 days during the current calendar year and 183 days during a three-year period that includes the current year and the two immediately preceding years. 6 Days are counted as all days present in the current year, one-third of days from the first preceding year, and one-sixth of days from the second preceding year.

In addition, a first-year-choice option may be available for aliens not meeting the green-card or substantial-presence test. 7 This election is available if an individual is physically present in the United States for at least 31 consecutive days during the current year and for a period of "continuous presence" beginning with the first day of that 31-day period. Continuous presence is defined as including 75% of the days in the current year, beginning with the first day of the 31-day-presence period. For purposes of the continuous-presence period (but not the 31 consecutive days), an individual will be deemed present in the United States up to five days in which he or she is absent from the United States. In addition, the individual must not have been a resident under the green-card rules or substantial-presence test in the immediately preceding year, and the individual must be a resident under the substantial-presence test in the next subsequent year.

Nonresident Aliens Who Must File Tax Returns

Regs. Sec. 1.6012-1(b)(1) provides that nonresident aliens engaged in a trade or business in the United States at any time during the tax year or who have income subject to U.S. federal taxation must file a return on Form 1040NR or 1040NR-EZ. It is irrelevant if the gross income for the tax year is less than the minimum amount specified for citizens, U.S. nationals, and resident aliens to have to file a return. In other words, a nonresident alien individual who is engaged, or considered engaged, in a trade or business in the United States during the tax year must file a Form 1040NR or 1040NR-EZ. Income of a nonresident as a student, teacher, or trainee with an F, J, M, or Q visa is considered to be effectively connected to a U.S. trade or business, and the nonresident is considered to be engaged in a trade or business for filing purposes. 8 In addition, Regs. Sec. 1.6012-1(b)(1) provides that even if the income of a nonresident alien that is engaged in a trade or business in the United States is exempt from taxation under a specific Code section or tax convention, he or she must file a U.S. tax return. The nonresident alien should attach a statement to his or her tax return indicating the amount of income excluded and an appropriate explanation of the exclusion.

If a nonresident alien individual has U.S.-source income but is not engaged in a trade or business in the United States during the tax year (or treated as such) and his or her tax liability is fully satisfied by the withholding of tax at the source, the taxpayer is not required to file a tax return for the tax year. 9 Also, if the nonresident's only U.S.-source income is wages for personal services that are effectively connected to a U.S. trade or business and the amount is less than the personal exemption for citizens, U.S. nationals, or resident aliens, a tax return is not required to be filed. 10 However, if a nonresident alien wants to obtain a refund of overwithheld taxes, to satisfy additional withholding at source, or to claim income exempt or partly exempt by treaty, he or she must file a tax return even if, because of low taxable income, a return is not required.

Example 1: B, a single alien individual, received $3,500 in income that is considered to have been from a trade or business in the United States. His personal exemption was $3,950 for the 2014 tax year. Despite having income less than his personal exemption, he must file Form 1040NR (or 1040NR-EZ) because he was engaged in a U.S. trade or business. If B had received only wages for personal services effectively connected to a U.S. trade or business, he would not have to file a U.S. tax return for that tax year.

In addition, Regs. Sec. 1.6012-1(b)(3) requires anyone within the United States who is a representative or agent of a nonresident alien individual to file a U.S. tax return on that individual's behalf.

Strategy: Since a small amount of income connected to a U.S. trade or business will require filing a U.S. tax return, certain taxpayers might seek to accelerate or defer U.S.-connected income to recognize in one tax year income that would otherwise be spread over two or more years. The drawback of this strategy is missing the use of multiple personal exemptions. Each situation should be analyzed to determine the best strategy.

Example 2: Z, a nonresident alien student from India, receives $3,000 each year for three years, and this income is connected to a U.S. trade or business. His personal exemption more than offsets the $3,000, but he still must file a return each year because the income is connected to a U.S. trade or business. Alternatively, suppose Z was able to defer the $3,000 for the first two years into the third year. He now does not file a return in years 1 and 2, but in year 3 his $9,000 of income is offset only by the year 3 personal exemption and standard deduction available to nonresident alien students from India.

Generally, the standard deduction is not available to nonresident aliens, except for students and business apprentices from India under the U.S.-India tax treaty, as described more fully later.

Filing Status of Nonresidents

The single filing status is available to nonresident aliens, just as for citizens, U.S. nationals, and resident aliens. The use of the married-filing-jointly status is limited, however. Regs. Sec. 1.6013-1(b) provides that a nonresident alien may not file a joint return if either the husband or wife is a nonresident alien at any time during the tax year. However, Secs. 6013(g) and (h) provide elections for nonresident alien individuals to be treated as a U.S. resident with regard to income tax, including wage withholding, and to file a joint return. Sec. 6013(g) applies to tax years when an individual is a nonresident alien married to a citizen or resident of the United States at the close of the year, and Sec. 6013(h) applies to the tax year a nonresident alien becomes a resident. Without these elections, married nonresidents are ineligible to file jointly and must use married-filing-separately status. Also, nonresident aliens cannot use head-of-household filing status. 11

However, qualifying widow or widower status may be allowed if the nonresident alien's spouse died during the first or second prior tax year (and the nonresident alien did not remarry by the end of the current tax year), the nonresident has a dependent child living with him or her, and the nonresident is a U.S. national or a resident of Canada, Mexico, or South Korea. To use this status, the taxpayer must also have been a resident alien or U.S. citizen the year his or her spouse died, and the taxpayer must have been able to file a joint return with his or her spouse in the year of death, even if the taxpayer did not do so.

Strategy: Making the Sec. 6013(g) or (h) election causes the taxpayer to be taxed under the rules for U.S. citizens, U.S. nationals, and resident aliens, thereby making worldwide income taxable. Taxpayers with income outside the United States should consider the effect of having foreign-source income taxed in the United States.

Filing Requirements of Nonresidents

Nonresident aliens who are required to file a tax return must complete and file Form 1040NR or Form 1040NR-EZ, along with supporting schedules and forms, to the appropriate IRS service center by the required due date, which is the 15thday of the fourth month following the end of the tax year (generally, April 15) if the taxpayer is an employee with wages subject to withholding or a self-employed individual maintaining a place of business within the United States with nonemployee compensation subject to withholding. 12 The due date for all other nonresident taxpayers is the 15th day of the sixth month (generally, June 15). For either due date, the law allows a six-month extension by filing Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, on or before the original due date of the return. The IRS may deny the nonresident's deductions and credits if he or she does not file the return within 16 months after the due date of the return. 13

In addition to filing an annual Form 1040NR, any nonresident alien leaving the United States who is not specifically exempted (as described below) must file a Form 1040-C, U.S. Departing Alien Income Tax Return, or a Form 2063, U.S. Departing Alien Income Tax Statement. 14 Meeting this filing requirement is necessary for the nonresident alien to obtain a required certificate of compliance (also known as a sailing permit or departure permit) from the IRS. The certificate of compliance certifies that the nonresident has paid any income tax due as of the date he or she leaves the United States. An annual U.S. tax return (Form 1040NR) is still required after filing the Form 1040-C or Form 2063, but any tax paid with Form 1040-C or Form 2063 can be used as a credit on Form 1040NR.

Example 3: B, a nonresident alien individual, is required to file Form 1040NR by April 15. He plans to leave the United States on the preceding Dec. 1 but will return by the April 15 due date. Unless B is an exempt individual, he must file Form 1040-C (or Form 2063) and pay any tax on taxable income received during the tax year through the departure date before the departure can be approved (i.e., sailing permit issued). Any tax paid with Form 1040-C (or Form 2063) is treated as a prepayment when the Form 1040NR is filed on April 15.

According to Regs. Sec. 1.6851-2(a)(2) and IRS Publication 519, U.S. Tax Guide for Aliens, certain nonresident aliens are not required to obtain a departure permit, including:

  • Representatives of foreign governments with diplomatic passports and their household members.
  • Employees (and their households) of international organizations or foreign governments whose pay for official services is exempt from U.S. taxes and who have no other U.S.-source income.
  • Certain exchange visitors, trainees, or students (including their spouses and children) who have an F-1, F-2, H-3, H-4, J-1, J-2, or Q visa. Also, certain students (including spouses and children) with an M-1 or M-2 visa.
  • The following categories of individuals, provided they do not have income in the current year through the departure date and in the preceding year:
    • Military trainees admitted for instruction under sponsorship of the Department of Defense;
    • Individuals on visits for business of 90 days or less or pleasure who have a B-1 or B-2 visa, respectively;
    • Individuals in transit through the United States or any of its possessions on a C-1 visa;
    • Individuals crossing the border using a border crossing identification card, if they also fall into one of the two preceding categories; and
    • Residents of Mexico or Canada who commute frequently to the United States to work and whose wages are subject to U.S. income tax withholding.

Strategy: Taxpayers who are subject to the departure permit rules should plan trips outside the United States early in the year, before U.S. taxable income is earned, thereby minimizing the amount of tax paid in advance.

Nonresident Identification Numbers

Regs. Sec. 301.6109-1 requires all taxpayers to include an identification number on their tax return filed with the IRS. For citizens and most U.S. nationals and resident aliens (including their dependents), a Social Security number is the identification number. Social Security numbers can be obtained by filing Form SS-5, Application for a Social Security Card, with the local Social Security Administration office. Most nonresident aliens are not eligible for Social Security numbers and thus must use an individual taxpayer identification number (ITIN) issued by the IRS. 15 The nonresident alien obtains an ITIN by filing by mail Form W-7, Application for IRS Individual Taxpayer Identification Number, with the IRS or in person at any IRS assistance center. In addition, an ITIN may be applied for at IRS offices at the U.S. consulate in Frankfurt, Germany, and the U.S. embassies in London and Paris. 16 The ITIN is used only for tax form filing (unlike the Social Security number, which also pertains to Social Security benefits). Obtaining an ITIN does not affect the individual's immigration status.

Taxpayers Who Are Both Resident Aliens and Nonresident Aliens in the Same Tax Year

It is common for an individual taxpayer to be classified as both a resident alien and a nonresident alien during the year in which a nonresident alien becomes a resident alien. Also, it is possible for resident aliens to lose their green-card status, making them a nonresident alien in the same year. Regs. Sec. 1.6012-1(b)(2)(ii) provides that the tax return filing requirements for these taxpayers is determined by their status at the end of the tax year. Thus, if the taxpayer was a resident alien on the last day of the tax year, then he or she files Form 1040, U.S. Individual Income Tax Return (or 1040A or 1040-EZ), by the due date. These taxpayers must attach a separate schedule to their tax return showing the tax computation for the portion of the year that the taxpayer was a nonresident alien.

For any tax year in which a taxpayer holds dual status, different rules apply to the resident and nonresident parts of the year. For the portion of the year that the taxpayer was a resident alien, the taxpayer is subject to the tax rules applicable to citizens, resident aliens, and U.S. nationals (i.e., taxed on income from all sources). Any income received during the resident-alien portion of the year is taxable, even if it was earned during the nonresident-alien portion of the year. The dual-status taxpayer is generally subject to the nonresident alien tax rules discussed in this article for the portion of the year that he or she is a nonresident alien.

Certain restrictions apply to dual-status taxpayers:

  • They cannot claim the standard deduction (however, they can itemize deductions);
  • The total exemptions taken for the taxpayer's spouse and dependent children cannot exceed the taxpayer's income for the resident-alien portion of the year;
  • Dual-status taxpayers cannot file joint returns (except using the Sec. 6013(g) election) or as head of household;
  • Married dual-status taxpayers who do not file jointly using the Sec. 6013(g) election must compute their tax using married-filing-separately status, except in certain circumstances; and
  • They cannot claim the education credits, earned income credit, or credit for the elderly or disabled, unless they make the Sec. 6013(g) election.

Strategy: The timing of when to become a resident alien could affect the tax paid for a given year. It may be advantageous for a taxpayer with large amounts of non-U.S.-related income to intentionally fail the substantial-presence test for a year and wait until a subsequent year to become a resident alien for tax purposes.

Nonresident Gross Income That Must Be Reported

Sec. 61(a) defines gross income as "all income from whatever source derived." The determination of gross income for an individual taxpayer is affected by whether the taxpayer is a citizen, resident alien, or nonresident alien and the source of such income. For example, certain income of a nonresident alien may be excluded because it is from a foreign source. Thus, gross income for nonresident aliens is typically more narrowly defined than for citizens or residents of the United States. The Code requires all citizens and resident aliens to include all income from within and outside the United States. Thus, gross income for them includes the receipt of all forms of money, goods, property, or services that are not specifically exempt from tax.

Unlike citizens, U.S. nationals, and resident aliens, who are taxed on worldwide income, nonresident aliens are generally subject to U.S. income tax only on U.S.-source income. U.S.-source income for purposes of nonresident taxation falls into two categories: income that is effectively connected with a U.S. trade or business (regardless of whether the income is from sources within or without the United States) and income from sources within the United States that is not effectively connected to a U.S. trade or business. 17 The exhibit provides a summary of how to determine the source of various types of income.

Gross Income Effectively Connected to U.S. Trade or Business

The definition of "effectively connected" is broad. If a nonresident alien is engaged in a U.S. trade or business, all income, gain, or loss for the tax year from sources within the United States (including certain investment income, as described below) is treated as effectively connected income. This applies whether or not there is any connection between the income and the trade or business the nonresident alien is carrying on in the United States during the tax year.

A nonresident alien who is performing personal services in the United States is considered to be engaging in a trade or business in the United States. Thus, a nonresident alien's personal service income is generally considered to be effectively connected income. Under Sec. 864(c)(6), this is true even if the income is received after the year in which the nonresident alien performed the services and the nonresident alien was not engaged in a trade or business in that subsequent year. Consequently, pension or retirement payments attributable to personal services performed in the United States are treated as effectively connected income in the year received, even if the recipient is not engaged in a U.S. trade or business in that year.

Investment income generally is not treated as effectively connected income, but certain types of investment income under certain circumstances will be treated as effectively connected income. Per Sec. 864(c)(2) and Regs. Secs. 1.864-4(c)(2) and (3), investment income that can be treated as effectively connected income includes:

  • Fixed or determinable annual or periodic (FDAP) income (i.e., interest, dividends, rents, royalties, premiums, annuities, etc.);
  • Gains from the sale or exchange of timber, coal, or domestic iron ore with a retained economic interest; patents, copyrights, and similar property on which the nonresident alien receives contingent payments; patents transferred before Oct. 5, 1966; and original issue discount (OID) obligations; and
  • Capital gains (and losses).

These types of investment income will be included if two factors strongly indicate the income is effectively connected to a U.S. trade or business. First, an asset-use factor determines whether a taxpayer's assets were used or held for use to generate income, gain, or loss from a U.S. trade or business. Second, a business-activities factor determines whether the conduct of a U.S. trade or business was a material factor in generating taxpayer income, gain, or loss.

In some situations, nonresident aliens can elect under Regs. Sec. 1.871-10 to have income that is not otherwise effectively connected to a U.S. trade or business that is generated by real property (e.g., mines, wells, timber, coal, or iron ore) located in the United States to be treated as effectively connected to a U.S. trade or business. The income for which this treatment is elected is taxed along with other effectively connected income, even if the individual is not engaged in a trade or business within the United States during the tax year. The election is effective for the year of election and is irrevocable without IRS consent.

Strategy: If a nonresident alien has otherwise unused itemized deductions, electing to treat real property income as effectively connected income may enable the nonresident alien to minimize the amount of his or her income subject to tax.

Under Sec. 864(c)(6) and Regs. Sec. 1.864-4(b), income may be effectively connected to a U.S. trade or business in a year even if the income for that year is not directly related to conduct of the business in that year.

Example 4: B, an alien individual, received income for the 2014 tax year that was connected to a U.S. trade or business. However, not all of this income was received in the 2014 tax year. Instead, it was received on an installment basis, resulting in some amounts being received in the 2015 tax year, when B no longer worked for the employer. B has income effectively connected to a U.S. trade or business in 2015, even though he is no longer actively engaged in a U.S. trade or business. As a result, B must file a tax return in 2015 because the income was earned while he was working for a U.S. trade of business.

In addition to U.S.-source income, certain foreign-source income of a nonresident alien is taxed as effectively connected to a U.S. trade or business. Under Sec. 864(c)(4) and Regs. Sec. 1.864-6, foreign-source income that is attributable to an office or other fixed place of business in the United States is treated as effectively connected to a U.S. trade or business. Income is attributable to an office or other fixed place of business only if the office or other fixed place of business is a material factor in the realization of the income and the income is realized in the ordinary course of business carried on at the location. Foreign-source income that may be treated as effectively connected to a U.S. trade or business under this provision includes rents, royalties, and gains or losses related to intangible personal property; dividends, interest, and gains or losses on the sale or exchange of stocks or securities; and income from the sale of goods or merchandise. 18

Income That Is Not Effectively Connected

Sec. 871(a) taxes certain income and gains from U.S. sources that are not effectively connected to a U.S. business at a flat rate of 30%. The most significant category of income subject to the 30% tax is gross U.S.-source FDAP income. Regs. Sec. 1.1441-2(b)(1) indicates that income is fixed if the amount is known in advance, and it is determinable if there is a process or basis for computing the amount. Income does not have to be paid annually or at regular intervals to be periodic. It only needs to be paid from time to time. The length of time can diminish or increase and the income payment will still be considered determinable and periodic.

Regs. Sec. 1.871-7 states that FDAP income includes the following items received from sources within the United States: interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and royalties. A substitute dividend or interest payment received under a securities lending transaction or a sale-repurchase transaction is treated the same as the amounts received on the transferred security.

Other types of income that are subject to the 30% tax include:

  • OID from payments on or sales of debt instruments with OID;
  • Gross gambling winnings in the United States if they are not effectively connected with a U.S. business (with certain exceptions);
  • 85% of any Social Security benefit, unless exempted by a treaty;
  • Gains from sales of timber, coal, or domestic iron ore with retained economic interest;
  • Gains related to the sale or exchange of intangible assets, such as patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, or similar property to the extent such gains are from payments that are contingent on the productivity, use, or disposition of the property or interest sold or exchanged;
  • Net capital gains (other than those in the two preceding categories) that are not effectively connected to a U.S. trade or business that are earned by a nonresident alien who is present in the United States for 183 days or more during the tax year; and
  • Income from real property that a nonresident alien does not elect, as discussed above, to treat as effectively connected income

Capital loss carryovers and the small business stock exception under Sec. 1202 are not taken into account in determining a taxpayer's net gain. 19

Example 5: B, a nonresident alien individual, was present in the United States for 190 days during the tax year in which he received an annual salary from a U.S. trade or business, dividend income from a U.S. business, and a net capital gain from investment in property not effectively connected to a U.S. business. B will file Form 1040NR and include the salary as income earned from a U.S. trade or business taxed according to his tax bracket. The dividend income and net capital gain will be taxed at a 30% flat rate.

Strategy: In years that the taxpayer has large capital gains, avoiding application of the 183-day residency rule could save tax on capital gains.

Deductions Allowed

Nonresident aliens generally may only deduct ordinary and necessary expenses paid or incurred in the operation of a U.S. trade or business to the extent that they relate to income effectively connected with that trade or business, other than certain itemized deductions that do not have to be directly related to effectively connected income. 20 The itemized deductions nonresident aliens can take are limited to state and local income taxes, contributions to U.S. charities, casualty and theft losses, and miscellaneous itemized deductions. While the itemized deductions do not have to be directly related to effectively connected income from a trade or business, nonresident aliens can only take itemized deductions if they have income effectively connected to a U.S. trade or business.

Nonresident aliens generally cannot elect to take a standard deduction; however, there is a treaty exception for students and business apprentices from India. 21

Example 6: B, who is a nonresident alien individual and is not a student or business apprentice from India, has income that was not connected to a U.S. trade or business. In addition, he has charitable contributions that were given to a U.S. nonprofit organization. B cannot take the standard deduction because he is not a student or business apprentice from India. Also, B cannot itemize his deductions because he did not receive income connected to a U.S. trade or business, so he cannot deduct the charitable contributions.

Calculating Nonresident Tax Liability

In addition to differences in the definitions of income and deductions for nonresident aliens versus citizens, U.S. nationals, and resident aliens, calculating the tax liability is different for nonresident aliens. Generally, as described below, the rates applied to categories of income are different and, as noted earlier, nonresident aliens determine their filing status differently.

There are also limitations on personal and dependency exemptions. No spousal or dependent exemption is allowed unless the taxpayer is a U.S. national or resident of Canada, Mexico, South Korea, or India (must be a student or business apprentice). 22 Under all these exceptions, the dependents must meet the same requirements for qualifying as dependents as do dependents of U.S. citizens, nationals, and resident aliens. Also, a spouse cannot have gross income for U.S. tax purposes and cannot be claimed as a dependent on another U.S. return.

For residents of South Korea, the spouse and all children claimed as dependents also must have lived with the taxpayer at some time during the tax year. In calculating the exemption for South Korean residents, the additional deductions for spouse and children are prorated based on the ratio of the alien's U.S. income effectively connected with a U.S. trade or business to the alien's worldwide income from all sources, and the additional deductions for spouse and children are limited to the extent of the alien's taxable income.

Example 7: B is an alien individual whose wife, Z, is also an alien individual. B and Z have two children who live with them. Neither B, Z, nor either of their children is a U.S. national or resident of Canada, Mexico, South Korea, or India. Z does not claim herself on her tax return, nor does she have taxable income for U.S. tax purposes (i.e., she has income, but it does not require a U.S. tax return). B will have to file as married filing separately. Z will not file a tax return because her income does not meet the requirements to be taxed in the United States. B cannot claim exemptions for his wife or any of their children on his tax return.

Nonresident aliens who have income from U.S. sources must divide their income among (1) income effectively connected to a U.S. trade or business, (2) FDAP or other income, and (3) tax-exempt income and allocate their deductions among the different types of income. Generally, nonresident aliens can claim deductions only to the extent they are associated with effectively connected income. However, certain casualty losses of property located in the United States, charitable contributions, and personal exemptions (subject to the limitations discussed above) are deductible whether or not they are related to effectively connected income.

Once income is divided into the proper categories, deductions are allocated to these categories, and taxable income is determined, the taxpayer's tax liability is computed using the appropriate tax rates. Page 1 of Form 1040NR lists the sources of effectively connected income, and page 2 lists the exemptions and itemized deductions related to the effectively connected income. The net effectively connected income, or taxable income, is the base for computing the tax from either the tax table, if the taxable income is less than $100,000, or tax computation worksheet, for taxable incomes over $100,000. The tax rates that apply to this income are the same graduated rates that apply to U.S. citizens and residents, ranging from 10% to 39.6%. If the taxpayer has children with unearned income in excess of the kiddie tax threshold ($2,100 for 2015), the taxpayer must use Form 8615, Tax for Certain Children Who Have Unearned Income .

FDAP income and capital gains subject to tax and not effectively connected to a U.S. trade or business are taxed at a flat rate (generally 30%, but may be lower under a tax treaty). They are reported on Form 1040NR, Schedule NEC, "Tax on Income Not Effectively Connected With a U.S. Trade or Business," and the total tax carried to the "Other Taxes" section of Form 1040NR.

Example 8: X is a single nonresident alien who has been in the United States for the entire 2014 tax year. After allocation of allowable expenses, X had $80,000 salary from an employer located in Baltimore; $1,050 interest income; and $750 net long-term gain on the sale of a painting. X's $80,000 salary is taxed as effectively connected income, and the $1,050 interest is FDAP and thus taxed at a flat 30% rate. The $750 long-term capital gain is not FDAP but is also taxed at a 30% rate.

Tax Treaties

If a nonresident alien comes from a country that has signed an income tax treaty with the United States, the taxpayer may be eligible for certain benefits. The benefits vary from treaty to treaty, but typical examples are listed below. Some treaties require the nonresident alien to be a resident of the treaty country in order to benefit under the treaty; others require the nonresident alien to be a citizen or national of that country.

  • Often, a treaty will allow nonresidents who are in the United States for less than a specified number of days during the tax year to exempt from U.S. tax any compensation they receive for personal services performed in the United States. Some treaties cap the maximum compensation subject to this exemption.
  • Teachers and professors who visit the United States to teach at a university or other accredited educational institution may be exempt from U.S. income tax for the first two or three years they are in the United States.
  • Certain employees of foreign governments are exempt from U.S. taxation, although the treaties differ on who qualifies for this benefit.
  • Some treaties exempt students, apprentices, and trainees from income tax on remittances they receive from overseas for their maintenance or study.
  • Many treaties exempt sales or exchanges of personal property by nonresident aliens from capital gains tax.
Penalties and Sanctions

The Code provides various penalties applicable to all taxpayers, including nonresident aliens, for failure to file returns or pay taxes as required on a timely basis. These penalties include those for (1) failure to provide taxpayer identification, (2) late filing, (3) late payment, (4) accuracy-related underpayments, (5) civil fraud, and (6) criminal fraud.

The penalty for failure to provide a taxpayer identification number pertains to taxpayers who do not provide a Social Security number or an ITIN for the taxpayer, spouse, or dependents. The penalty is $50 for each failure to comply. 23 The late-filing penalty is assessed if a valid tax return is not filed by the original due date (e.g., April 15) or extended due date (e.g., Oct. 15). The penalty is 5% per month, or part of a month, up to a maximum of 25% of the unpaid tax at the original due date. 24 These percentages increase to 15% and 75%, respectively, if the failure was due to fraud. 25 A late-payment penalty may be assessed if at least 90% of the tax due at the original due date is not paid at the due date without regard to an extension, even if an extension of time to file the tax return is granted. The late-payment penalty is 0.5% of unpaid taxes for each month, or part of a month, after the original due date that the tax is not paid. 26 If both the failure-to-file penalty and the failure-to-pay penalty apply to a month, the failure-to-file penalty percentage is reduced by the failure-to-pay percentage (i.e., the failure-to-file percentage is 4.5%)

The Sec. 6662 accuracy-related penalty is 20% of the amount of tax underpayment for the year. The penalty pertains to (1) negligence or disregard of rules or regulations; (2) substantial underpayment of tax; (3) substantial valuation misstatement; (4) substantial overstatement of pension liabilities; (5) substantial estate or gift tax valuation understatement; (6) a transaction lacking economic substance; and (7) an undisclosed foreign financial asset understatement. 27

Conclusion

Immigration reform is on the horizon in the United States, but many unauthorized aliens will still have to comply with the tax law for nonresident aliens unless Congress changes these rules as part of an overall tax reform package. The tax laws and procedures for nonresident aliens are different in many ways from those applicable to citizens, U.S. nationals, and resident aliens. Unless taxpayers and tax preparers are familiar with the tax laws for nonresident aliens, compliance can be difficult and penalties can be severe. This article provides a fundamental discussion of applicable nonresident alien tax laws, along with strategies that can help them maximize after-tax income.

Contributor

Danny Hollingsworth is the Joseph Decosimo Professor of Accounting and head of the Accounting Department in the College of Business at the University of Tennessee at Chattanooga in Chattanooga, Tenn. For more information on this article, contract Prof. Hollingsworth at dan-hollingsworth@utc.edu.

Footnotes

1 See The President's Immigration Accountability Executive Action of November 20, 2014, Congressional Research Service Rep't No. R43852 (Feb. 24, 2015).

2 Texas, No. 1:14-cv-00254 (S.D. Tex. 2/16/15) (order granting preliminary injunction), motion to stay denied, No. 15-40238 (5th Cir. 5/26/15).

3 Shear and Pear, "Obama's Immigration Plan Could Shield Five Million," The New York Times (Nov. 19, 2014).

4 Collins, "Projections of Federal Tax Return Filings: Calendar Years 2011–2018," 31 Statistics of Income Bulletin 182, Figure A (Winter 2012).

5 Sec. 7701(b)(1)(A); Regs. Sec. 301.7701(b)-1(b)(1).

6 Sec. 7701(b)(3); Regs. Sec. 301.7701(b)-1(c).

7 Sec. 7701(b)(4); Regs. Sec. 301.7701(b)-4(c)(3).

8 Sec. 871(c).

9 Regs. Sec. 1.6012-1(b)(2).

10 Notice 2005-77.

11 Sec. 2(b)(3)(A).

12 Regs. Sec. 1.6072-1(c).

13 Regs. Sec. 1.874-1(b).

14 Regs. Sec. 1.6851-2.

15 Some nonresident aliens are authorized to work in the United States and are eligible to receive a Social Security number, including those holding an employment authorization document from U.S. Citizenship and Immigration Services (see IRS Publication 1915, Understanding Your IRS Individual Taxpayer Identification Number (2014)).

16 IRS Publication 1915.

17 Sec. 872(a) and Regs. Sec. 1.872-1(a)(1).

18 Regs. Sec. 1.864-6(b)(2).

19 Regs. Sec. 1.871-7(c)(3).

20 IRS Publication 519.

21 United States-India Income Tax Treaty, Article 21; Rev. Proc. 93-20.

22 Sec. 152(b)(3); United States-South Korea Income Tax Treaty, Article 4; United States-India Income Tax Treaty, Article 21.

23 Regs. Sec. 301.6723-1(a).

24 Sec. 6651(a)(1).

25 Sec. 6651(f).

26 Sec. 6651(a)(2).

27 See Regs. Sec. 1.6662-2.

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