Tax trap for second-time U.S. residents.

• Author: Ochsenschlager, Thomas P.

Practitioners need to be aware of a special tax trap for foreign individuals who become U.S. tax residents for a second time. These taxpayers include foreign nationals who came to the U.S. to work under an H, L, E or other nonimmigrant work permit. When the economy softened, most of these special visitors left. While here, they typically filed a return as a U.S. tax resident. Many were in the U.S. for at least three years; some were granted permanent residency visas (i.e., "green cards").

The U.S. economy seems to be improving, prompting some of these individuals to return to the U.S. However, if they come back, they might have a tax surprise. Just as Sec. 877 imposes a tax on expatriates (unless tax avoidance was not a principal purpose of expatriation), Sec. 7701 (b) (10) provides that an alien treated as a U.S. resident for at least three consecutive calendar years (the initial residency period) who ceases to be a U.S. resident, but becomes one again before three years after the end of the initial residency period, is subject to tax under Sec. 877(b), for the period after the initial residency period closed, until the day before the second residency began.

Regs. Sec. 301.7701(b)-5(a)(2) provides that the three-year count includes the year of arrival and departure. If an individual is in the U.S. at least 183 days in the year he or she arrives in the U.S., or in the U.S. at least 183 days in the year he or she departs the U.S., each of those periods is treated as a resident year. For example, if an individual came to the U.S. in June 2001 and left the U.S. in July of 2003, he or she would be in the U.S. for three years.

Sec. 7701(b)(10)(B), like Sec. 877, provides that the tax does not apply ifthe individual would pay a higher U.S. tax as a nonresident alien. An individual subject to the Sec. 877 tax cannot claim treaty benefits to lower the U.S. tax. Under Notice 97-19, an individual subject to the Sec. 7701(b)(10) tax is entitled to treaty benefits in the intervening period. This tax applies without regard to the departing individual's net worth or previous earnings (i.e., the regular Sec. 877 tax takes these items into consideration).

Sec 877 alters the application of various source and recognition rules. Thus, for individuals subject to Sec. 7701(b)(10), the Sec. 877(d) special sourcing rules are:

1. Sales of property: Sales of property (other than stocks and bonds) located in the U.S. are U.S. sourced. This ruledisregards the...