International Students and the American Opportunity Tax Credit

Editor: Mark G. Cook, CPA, MBA

Credits Against Tax

On February 17, 2009, President Barack Obama signed the American Recovery and Reinvestment Act of 2009, P.L. 111-5, which created the American opportunity tax credit (AOTC). Effective for tax years 2009–2012, the AOTC provides for a maximum tax credit of $2,500 (100% of the first $2,000 of qualified expenses and 25% of the next $2,000) (Sec. 25A(i)). Unlike its predecessor, the Hope scholarship credit, the AOTC is partially refundable up to $1,000 (40% of $2,500) (Sec. 25A(i)(6)).

Nonresident Aliens

Nonresident aliens have always been ineligible for education tax credits (unless married filing jointly with a U.S. citizen or resident and electing to be treated as a U.S. resident) (Sec. 25A(g)(7)). However, since the enactment of the AOTC, this rule has taken on greater importance. The tax compliance of international students is now a more critical issue because of the partially refundable nature of the AOTC. If an international student improperly files a Form 1040, U.S. Individual Income Tax Return, as a resident alien (instead of Form 1040NR, U.S. Nonresident Alien Income Tax Return), the government stands to lose a much greater amount than it did for the Hope credit.

Who is considered a nonresident alien? Sec. 7701(b)(1)(B) defines a nonresident alien as someone who is not a citizen or resident of the United States. An alien qualifies as a resident by meeting either the lawful permanent residence (green card) test or the substantial presence test (Sec. 7701(b)(1)(A)). To satisfy the substantial presence test, an alien must be present in the United States at least 31 days in the current year and 183 days during the current and preceding two calendar tax years. For purposes of the 183-day rule, aliens count days of presence using the formula provided in Sec. 7701(b)(3)(A)(ii), as shown in Exhibit 1.

International Students

Are international students treated as resident aliens? The answer depends on the type of visa the student holds and the length of time the student has been in the United States. International students generally enter the United States on an F visa. Because a student studying in the United States on an F visa is treated as an exempt individual for purposes of counting days of presence (Sec. 7701(b)(5)(D)), the overwhelming majority of international students are treated as nonresident aliens while they are studying in the United States. Thus, even though some students live on campus in the United States for an entire year, no days of presence count for purposes of the substantial presence test. As a result, if required to file a U.S. individual income tax return, they must use Form 1040NR (or 1040NR-EZ) as nonresident aliens. The exempt individual “taint” lasts for five years (Sec. 7701(b)(5)(E)(ii)). Once individuals reach their sixth year in the United States, they start counting their days of presence.

Resident vs. Nonresident Alien

While residents are taxed on their worldwide income (Regs. Sec. 1.1-1(b)), nonresident aliens are taxed on only their U.S.-source income (Sec. 871). Although this rule may appear beneficial to nonresidents, international students are generally worse off because of their ineligibility for certain tax credits and deductions. Exhibit 2 illustrates the difference between the taxation of residents and of nonresidents for an international student who works on campus.

Conclusion

For 2011 and 2012 (or longer if the AOTC is renewed), the government will risk losing revenue if it does not improve its efforts to insure compliance by international students. At a time when the country is running unsustainable budget deficits, the government needs to take appropriate action to close this potential tax gap. To avoid lost revenue from incorrect returns, the federal government should require colleges and universities to identify international students as residents or nonresidents for tax purposes. The designation could simply be an additional box on the Form 1098-T, Tuition Statement. Unless a student provides evidence to the contrary, universities could assume that all international students are nonresidents. If the nonresident box is checked, the IRS could match the 1098-T to the tax return to make sure the student has properly filed a Form 1040NR. Although this proposal would increase the burden on institutions of higher education, it would improve compliance among international students without requiring substantial audit efforts by the IRS.

EditorNotes

Mark Cook is a partner at SingerLewak LLP in Irvine, CA.

The editor would like to offer a special thanks to Christian J. Burgos, J.D., LL.M., for his assistance with this column.

For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.