- Taxes-Getting it Right for Foreign Nationals Working in the U.S.
- December 30, 2010 | Authors: John F. Koryto; Raj A. Malviya
- Law Firms: Miller Johnson - Kalamazoo Office ; Miller Johnson - Grand Rapids Office
Foreign nationals working in the U.S. (who fail to follow U.S. tax laws) can present challenges and risk for employers. The Internal Revenue Service (IRS) has identified employer withholding errors on income to foreign nationals as an area of focus. This article reviews the most common U.S. income tax issues foreign nationals and their employers face to assist with compliance efforts.
FOREIGN NATIONAL’S TAX STATUS: RESIDENT OR NON-RESIDENT
The term “foreign national” includes anyone who is not a U.S. Citizen or lawful permanent resident and includes both non-resident aliens (individuals temporarily in the U.S. for employment or education) and resident aliens (“green card” holders or U.S. permanent residents under immigration law). However, a foreign national’s immigration status does not dictate U.S. income tax consequences. A foreign national will be treated as a resident for U.S. income tax purposes if: (1) the individual is admitted as a lawful permanent resident; or (2) the individual is present in the U.S. for at least 31 days during the calendar year at issue and more than 183 days during the current and prior two calendar years (counting 1/3 of the days in the preceding year and 1/6 of the days in the second preceding year); or (3) the individual files an election to be treated as a resident. There are also several limitations and exceptions to this rule that are beyond the scope of this article, and should be reviewed with a tax professional.
A foreign national who satisfies any of the above tests will be considered a resident alien (resident) for U.S. income tax purposes, and subject to tax on world-wide income. Conversely, a foreign national who does not satisfy any of the above tests will be considered a non-resident alien ( non-resident) for U.S. income tax purposes, and only subject to tax on U.S. source income. Recognizing this distinction is a critical step to complying with U.S. tax laws and avoiding costly fines.
IDENTIFYING THE CORRECT INCOME TAX RETURN
Many foreign nationals submit incorrect federal tax returns (or fail to submit a return altogether) because of a lack of awareness of the different rules that apply. This is one reason the IRS has become more focused on tax compliance by foreign nationals and their U.S. employers. The IRS is increasingly scrutinizing individual tax returns and employer withholding reports for errors or the failure to pay all taxes due.
Depending on a foreign national’s U.S. income tax status, the following federal returns should be filed:
- Non-resident: Form 1040NR or 1040NR-EZ
- Resident: Form 1040 or 1040EZ
- Dual-status taxpayer (a resident and non-resident in the same tax year): Form 1040 with a Form 1040NR statement if a resident by the end of the year or Form 1040NR with a Form 1040 statement if you are not a resident at the end of the year.
A non-resident cannot file a joint return if married to another non-resident. Instead, the non-resident must file using married filing separately rates, which are generally higher. However, a non-resident married to a U.S. citizen or resident by the end of the calendar year can elect to file as a resident jointly with a spouse. If this election is made, both the non-resident and resident spouse are treated as residents for U.S. income tax purposes for the year the return is filed. Recall that residents are taxed on world-wide income. Therefore, careful attention should be given to this election and other applicable factors since it may ultimately result in unintended tax consequences.
REPORTING ALL INCOME
Unless a tax treaty benefit applies, a resident is taxed on world-wide income. This means that all income earned in the resident’s home country (common examples include rental income or interest income) must be reported in the U.S. Conversely, a non-resident is not taxed on world-wide income; rather, taxes are paid on U.S. source income. But any income earned by the non-resident from a U.S. employer or from U.S. property (rental income or sale of U.S. property in U.S.) must be reported in the U.S.
The U.S. has income tax conventions (treaties) with over 65 countries. One of the main purposes for a tax treaty is to prevent double taxation of foreign nationals subject to income tax in the U.S. as well as another country. Determining whether a tax treaty exists with the foreign national’s home country should be done well in advance of annual tax filing deadlines to analyze whether the foreign national qualifies for any treaty benefits or tax relief.
A non-resident is generally not eligible to claim the standard deduction. However, some exceptions to this rule exist, including students and business apprentices from India, who may be eligible to claim the standard deduction under the U.S./India Income Tax Treaty.
EMPLOYER WITHHOLDING FOR NON-RESIDENTS
A non-resident only pays tax on U.S. source income. Unless a certain exception or applicable tax treaty provision applies, a non-resident will be subject to a 30 percent U.S. withholding tax on most types of U.S. source income referred to as Non Resident Alien (NRA) withholding. The tax withholding obligation is on the U.S. employer. NRA withholding may also be required even if the payment is not made in the ordinary course of business, such as a private arrangement outside an employer. Payers must timely deposit withheld amounts using the deposit schedule outlined under IRS Publication 515. Payers who fail to withhold and timely deposit the taxes are liable for the underwithheld taxes, plus penalties and interest.
A resident who maintains income-producing assets overseas; transfers assets to a foreign entity; establishes or receives benefits from a foreign trust; claims treaty benefits, or is the recipient of certain gifts from abroad may be required to submit certain disclosure forms to the IRS. With the recent IRS crackdown on U.S. taxpayers failing to report funds held in offshore accounts, Form TD F 90-22.1, also known as the FBAR, is a disclosure form that has been particularly publicized to promote compliance. This form requires U.S. citizens and residents to report a financial interest in, or signatory authority over one or more financial account(s) in a foreign country if the aggregate value of these accounts exceeds $10,000 at any time during the calendar year.
A non-resident may also be required to submit certain disclosure forms to the IRS for the purpose of reporting facts that support a claim of nonresidency status based on the closer connection exception to a foreign country (an exception to the residency test not discussed in this article), reporting days that don’t count for the residency test outlined above, and reporting annual required personal and financial information if the non-resident expatriated from the U.S.