Guide to U.S. income taxation of foreign nationals.

• Author: Raasch, Barbara J.

Despite the economic and financial turmoil of the past 21 months, the U.S. economy still lies at the center of the economic universe. The fact that the U.S. maintains such a high economic profile is based on several factors. First, it is one of the most stable governments in the world and has a very well-established legal system in place to protect investors' rights. Second, it has the most liquid debt and equity markets in the world, in part because of the diversity of the U.S. economy and the strength of the U.S. dollar. For these reasons, especially during the tumultuous times after September 11th, almost everyone looks to the U.S. for leadership and economic stability.

Because of the U.S's high economic profile, most wealthy foreign nationals find themselves subject to U.S. taxation at some point, which can take many forms.

Tax planning for foreign nationals includes an entrance strategy, a U.S. tax presence and an exit strategy.

Foreign Nationals with a U.S. Taxable Presence

The two main types of foreign nationals that fall within the regime of U.S. income taxation are:

* The foreign investor who spends little or no time in the U.S.: His U.S. investments generally consist of U.S. stocks and bonds, and perhaps U.S. real estate or real estate investment trusts.

* The foreign businessperson who spends a good deal of time in the U S.: His investment portfolio may be weighted toward U.S. assets. Generally, for substantial stays, he also possesses a U.S. nonimmigrant visa.

Before any tax planning can begin, an adviser must determine whether a foreign citizen is a resident alien (RA) or a nonresident alien (NRA) for U.S. tax purposes. The difference is important; an RA is taxed by the U.S. on worldwide income, an NRA only on U.S.-source investment income and income "effectively connected" with a U.S. trade or business.

U.S. Tax Residency for Income Tax Purposes

The term "resident" for U.S. income tax purposes is not the same as for estate tax purposes. The rules on U.S. residency for income tax purposes are largely contained in Sec. 7701(b) and the regulations.

For U.S. income tax purposes, generally, a foreign national is treated as a U.S. resident for any calendar year if he (1) is a lawful permanent U.S. resident at any time during the calendar year or (2) meets the substantial-presence test. Under certain circumstances, an alien can elect to be treated as a resident.

Lawful permanent resident. To become a lawful permanent U.S. resident, a person must be "lawfully accorded the privilege of residing permanently in the U.S. as an immigrant in accordance with the immigration laws" Therefore, a green-card holder qualifies. A lawful permanent resident continues to be a resident for U.S. tax purposes until this status has been rescinded or administratively or judicially determined to have been abandoned.

Substantial-presence test. Generally, under Sec. 7701(b)(3), a foreign national meets the substantial-presence test and qualifies as a U.S. resident if he is present in the U.S. for at least 31 days during the tax year and meets the 183day test. The foreign national satisfies the 183-day test if the sum of days present in the U.S. during the current year, plus one third of the days present in the first preceding year, plus one sixth of the days present in the second preceding year, equals at least 183.

However, even if he qualifies under the substantial-presence test, Sec. 7701 (b) (3) (B) could prevent an alien from being treated as a U.S. resident if he (1) is actually present in the U.S. for fewer than 183 days during the current year; (2) has a tax home in a foreign country during the year; and (3) has a closer connection to that country than the U.S. for the entire year. Note: an individual does not satisfy the closer-connection test if he has an application pending for a change of immigration status or has taken other steps to apply for a green card.

When counting days in the U.S., an individual would be present for a particular day if he is physically present in the U.S. (not including Puerto Rico and other U.S. territories) at any time during such day. Many exceptions exist in determining whether a day in the U.S. actually counts as a day for the 183-day test. This determination can be quite complex; when the alien wants to establish residency under the substantial-presence test, he should keep very detailed records.

If a foreign national meets certain criteria, he could elect to be treated as a U.S. resident for a portion of the year that immediately precedes the year in which he first meets the substantial-presence test. This allows an individual to elect to have U.S. residence begin when he moves to the U.S., even though he does not meet the substantial-presence test until the next year. This situation may not occur frequently, but it requires extra due diligence when offering the appropriate tax planning advice.

Tax treaty considerations for dual residents. Under most income tax treaties, when an individual is a resident under the laws of both the U.S. and a treaty country, the treaty determines the individual's residence through a series of...