Tax treatment and planning strategies for nonresident individuals.

• Author: Hollingsworth, Danny

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)(l) 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 fifing purposes. (8) In addition, Regs. Sec. 1.6012-1(b)(l) 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 fifing 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...