US Tax Residency: Understanding the Rules, Exceptions, and Tax Implications

Introduction:

Understanding the concept of tax residency is crucial for individuals living or earning income in the United States. The determination of tax residency has significant implications on an individual’s tax obligations, filing requirements, and potential tax benefits. In this article, we will explore the rules and implications of US Federal tax residency (States have their own tax residency rules).

Rules for US Tax Residency:

US citizens are always US tax resident. The US tax system then uses two primary tests to determine an individual’s tax residency status for non-citizens: the Green Card Test and the Substantial Presence Test.

1. Green Card Test: If an individual holds a valid US permanent resident card, also known as a green card, they are considered a US tax resident regardless of the amount of time spent in the US during the tax year.
2. Substantial Presence Test: This test is used to determine tax residency for individuals who do not hold a green card. It considers the number of days an individual has been physically present in the US over a three-year period, taking into account the current tax year and the two preceding years. To meet the substantial presence test, an individual must be physically present in the US for:
   1. At least 31 days during the current tax year, and
   2. A weighted average of 183 days or more over the three-year period, calculated as follows:
      1. All days present in the current year count as they are,
      2.  
      3. One-third of the days present in the preceding year count,
      4. One-sixth of the days present in the second preceding year count.

Exceptions:

Closer connection
An exception to the SPT applies to individuals with a foreign country as a “tax home” to which they have established a “closer connection”. As a result, an individual who spends less than 183 actual days in the US during the current tax year can establish non-residency even if under the three-year look-back rule he or she has 183 counted days for the three-year total.  Generally, an individual’s tax home is their regular place of business or post of duty. An individual must normally be considered tax resident in the place that they are claiming is their tax home. To determine whether an individual has established a closer connection to a country other than the US, the IRS guidance states that the following facts and circumstances should be considered:

• Where is the individual’s permanent home located?
• Where is the individual’s family located?
• Where are the individual’s personal belongings (cars, furniture, clothing, etc) located?
• What are the individual’s current social, political, cultural and religious affiliations?
• Where does the individual conduct their business activities?
• Where is the individual’s driver’s license held?
• Where does the individual vote?

It should be noted that this exception does not apply in cases where the individual has 183. The taxpayer also needs to maintain their non-US tax home for the entire year.

Treaty Residence
If an individual meets tax residence in both the US and another jurisdiction under the domestic rules of both countries they are considered a ‘dual resident’. For countries where there is a Double Tax Treaty the treaty can be considered to determine where the individual is ultimately resident and which country has the primary taxing rights. The treaty residence position will override residency determinations under the domestic laws of the given jurisdiction. The residence article of the Treaty, sometimes referred to as the “tie breaker” article, determines an individual’s residence status and is most commonly (but not always, e.g., US/China tax treaty) based on the following tests. If one test is met then they do not move to the next test:

1. The individual is resident in the country in which they have a permanent place of abode available to them.
2. If the individual has a permanent place of abode available to them in both countries, they are resident in the country to which their social and economic ties are strongest (their “centre of vital interests”).
3. If the individual’s “centre of vital interests” cannot be determined, they are resident in the country in which they have a habitual abode.
4. If the individual has a habitual abode in both countries, they are resident in the country of which they are a national

Implications of US Tax Residency:

1. Worldwide Income: US tax residents are subject to tax on their worldwide income. This includes income earned both within and outside the US. All sources of income, such as wages, self-employment income, investment income, and rental income, must be reported on the US tax return.
2. Filing Requirements: US tax residents are generally required to file an annual tax return, reporting their worldwide income. This can apply even if the individual’s income is below the filing threshold or if they have no tax liability.
3. Tax Benefits and Deductions: US tax residents may be eligible for various tax benefits and deductions, such as the standard deduction, itemized deductions, and tax credits. These can help reduce the overall tax liability and optimize tax planning strategies.
4. Reporting Foreign Assets: US tax residents have additional reporting requirements for foreign financial accounts and assets. This includes reporting foreign bank accounts on the Report of Foreign Bank and Financial Accounts (FBAR) and disclosing foreign investments on the Foreign Account Tax Compliance Act (FATCA) Form 8938. Where an individual owns a non-US entity the entity is usually brought into the US tax remit and additional planning needs to be considered.
5. Estate and Gift Taxes: US tax residents can be subject to US estate and gift tax on their worldwide assets, including gifts made during their lifetime and assets transferred upon death. Proper estate planning is essential to minimize potential tax liabilities. For those temporarily in the US the rules are complicated and additional caution should be exercised.

Conclusion:

Understanding the rules and implications of US tax residency is crucial for individuals living or earning income in the United States. Whether through the Green Card Test or the Substantial Presence Test, tax residency status determines an individual’s tax obligations, filing requirements, and potential tax benefits. Planning before becoming US resident is essential to ensure an individual’s tax position can be optimized.