How U.S. Taxes Work for Foreign Nationals, Residents & Citizens

How US Taxes Work for Foreign Nationals, Residents & Citizens

How U.S. Taxes Work for Foreigners 

As if making it through the United States immigration system is not complicated enough, once a foreigner becomes a U.S. person for tax purposes, that is where the real complications begin. That is because, unlike almost every other country across the globe, the United States follows a worldwide income tax model based on citizenship or rather U.S. a person’s ‘tax status’ and not merely their residence. For example, most countries only tax their residents on worldwide income when the resident is considered to be a permanent resident of that country — which usually means that they have resided in that country for at least six months in the year. The United States taxes individuals based solely on their U.S. Person tax status. Thus, a U.S. citizen who resides overseas is still taxed as a U.S. citizen who lives in the United States. Let’s take an example of how a person goes from being a foreigner to a U.S. citizen and what the tax implications may be.

How is a Non-Resident Alien Taxed?

Marcus is a foreign national, a non-U.S. Person who has no relationship to the United States at all. He first travels to the United States on an F-1 visa, which he remains on for three years before transferring to an H-1B visa through his employer.  Marcus was on an F1 visa and he had never visited the United States prior — so the only three years of status he had before becoming an H-1B visa holder was as an F1 visa holder.

Student Visa, Pre-5 Years

During the time that Marcus was an F1 visa holder, he was not taxed as a U.S. person because there is an exemption for certain taxpayers who are on an F-1 visa and the exemption lasts for five years. Therefore, even though Marcus had significant assets overseas as well as income-generating investments he did not have any U.S.-sourced income and therefore he had no U.S. taxes that were due. If he did, he would have filed a form 1040-NR and reported his US-sourced income.

A U.S. Work Visa Changes Everything

Marcus became an H-1B visa holder four years ago in February. Thus, in that year, Marcus met the substantial presence test and since he lived, resided, and worked in the United States he would not meet the closer connection exception. Also, Marcus would not qualify for any of the other exceptions as well on Form 8843. Therefore, starting in the first year that Marcus met the substantial presence test — and in every subsequent year that he met the substantial presence test (when no exception applied) — he reports his taxes as if he was a U.S. citizen or a lawful permanent resident.

In other words, Marcus is taxed on his worldwide income, as well as being required to report his foreign accounts, assets, investments, and income on different international information reporting forms such as the FBAR and Form 8938 — these forms are not required in the year that mark is is not a U.S. person.

The Following Year Marcus Lives Abroad

The year after Marcus was on H-1B, he returned overseas to work for two years. Even though Marcus was still on an H-1B status since he did not live in the United States for at least 31 days in any one of these years, he does not meet this substantial presence test. Since Marcus does not meet the substantial presence test, he is not taxed on his worldwide income but is only taxed on his US-sourced income. Marcus only had a small amount of US-sourced income but he filed a Form 1040NR to report it anyway.

Marcus Marries a U.S. Citizen, Gets a Green Card

Marcus married a U.S. citizen (USC) while he lived abroad and they decided to move back to the United States. As a spouse of a USC,  Marcus is entitled to a conditional green card. As a result, his tax situation changed significantly period since Marcus is a lawful permanent resident (LPR). And, as an LPR he is taxed similarly to a US citizen. That means similar to when he was taxed using this substantial presence test, Marcus is taxed on his worldwide income and required to report all of his foreign accounts, assets, and investments on those pesky international information return forms.

Treaty Election While Living Abroad

After living a few years in the United States, Marcus’s LPR conditions were removed and he had a regular green card. Marcus and his wife decided that they were going to live outside of the United States for the next few years and picked a treaty country to reside in. Marcus obtained the necessary reentry permit so that he could re-enter the United States with a green card even though he lived outside of the United States for more than six months for those few years.

Even though Marcus was living outside of the United States, as a green card holder he is still taxed on his worldwide income. But, since Marcus lived in a treaty country and had significant contacts with that country under the tax treaty, Marcus was able to make a treaty election using Form 8833 to be treated as a foreign person for tax purposes. This means that Marcus did not file a Form 1040, but rather filed the Form 1040NR since he is treated as a non-resident for U.S. tax purposes. Still, to be on the safe side Marcus filed his annual FBAR because the IRS takes the position that a treaty election does not negate the requirement to have to file an FBAR — although a recent court decision in California puts the IRS‘s position in some doubt.

Relocation to the United States as a Permanent Home

Marcus and his wife decided to relocate to the United States and make it their permanent home. At this time, Marcus applies for and becomes a naturalized USC. Now that Marcus is naturalized, he is considered a U.S. citizen which is a great benefit for travel purposes but may pose some complications later for him from a tax perspective. That is because even if Marcus and his wife decide to relocate back to a treaty country they typically cannot claim treaty benefits to be treated as a foreign person., because now they are citizens of the United States and not just residents. Likewise, it can become more complicated for Marcus if he does decide to give up his citizenship at some point due to his net worth, annual earnings, and the complications surrounding an exit tax for a covered expatriate.

A Few Things to Consider

Here are a few things to consider when determining which U.S. status to pursue.

Visa vs Green Card

For taxpayers who are not sure if they are seeking to permanently reside in the United States, they may want to pause between obtaining their green card and may want to consider remaining on a visa if at all possible due to potential exit tax issues down the line.

Treaty vs Non-Treaty

For taxpayers who are obtaining a green card but will be working outside of the United States and possibly in a jurisdiction that taxes significantly less than the United States, they may want to consider whether the green card is worth it. That is because if they are in a non-treaty country then they cannot make a treaty election to be treated as a foreign person for tax purposes. Depending on how much income they generate this may have a significant tax implication.

Green Card vs USC

A common question we receive here is whether it is worth it to obtain US citizenship or whether they should relinquish the green card. There are pros and cons to each approach and taxpayers have to be cautious in reviewing the two main components — which is the immigration aspect of being able to travel freely to and from the United States vs. being stuck in the tax matrix. The tax matrix can become a bigger issue in a situation in which the majority of the money is earned overseas and the income does not qualify for the foreign earned income exclusion and slash or there are not sufficient tax credits to offset the US tax implication.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.