I. The Residence of Individuals
Individual residents of the United States, regardless of nationality, must pay U.S. tax on their worldwide income. U.S. taxation of nonresident aliens, by contrast, is largely limited to income from sources in the United States. Therefore, residence is the first and most important touchstone of U.S. taxation for foreign nationals.
Residence is a measure of the extent and permanence of an individual’s presence in a given place. The notion of residence, which has bearing in many legal contexts, took on a life of its own early on in the realm of taxation. Even within taxation, the notion of residence is now made up of several separate strands.
There is no blanket definition of a “resident” in the Code that applies to all individuals and entities for all purposes. Rather, the terms “resident” and “nonresident” attach to various persons for various purposes. The result is that there are several standards of residence germane to U.S. international taxation.
The most important, and pervasive, is the residence of foreign nationals. Foreign nationals can be subject to one of two forms of taxation depending on whether they are “resident aliens” or “nonresident aliens.” A foreign national is a resident alien if he lives in the United States. And a foreign national is a nonresident alien if he lives outside of the United States. The United States taxes its resident aliens on their worldwide income but only taxes its nonresident aliens on the income that they earn within the United States (i.e., source-based taxation).
Of lesser, but significant effect is the residence of U.S. citizens. Even though they are taxed on their worldwide income, U.S. citizens who reside outside the United States enjoy favorable taxation of part of their income earned outside the United States.
II. Resident Aliens (Section 7701(b))
A largely arithmetic statutory definition of “resident alien” was added to the Code in 1984. It can be found in section 7701(b). The definition of resident alien in section 7701(b) applies only to foreign nationals and therefore, does not govern residence for U.S. citizens.
Section 7701(b) applies to foreign nationals for all purposes of the Internal Revenue Code, with the exception of estate and gift taxes. Therefore, foreign nationals are subject to a single standard of residence for U.S. income taxes, social security, and unemployment taxes.
Under section 7701(b), U.S. residence is explicitly tied to two largely objective elements. They are (1) the immigration status of foreign nationals and (2) the amount of time they spend in the United States. Section 7701(b) is by no means a bright-line provision. At its core is an indeterminacy in which the residence of foreign nationals depends on the facts and circumstances.
a. Immigration Status: Lawful Permanent Residence
First, a foreign national who is a “lawful permanent resident of the United States” during a calendar year is a resident of the United States in that year. § 7701(b)(1)(A)(i). A lawful permanent resident, also known as a “green card” holder, is an individual entitled to remain permanently in the United States.
Immigration status and tax status are inextricably tied. Therefore, no one admitted to the United States as a permanent resident can avoid tax residence, no matter how little time he spends in the United States.
b. “Substantial Presence” in the United States
The second major test of residence, entirely independent of immigration status, is physical presence in the United States. A foreign national who is present in the United States for 183 or more days during a calendar year is a United States resident in that year. § 7701(b)(3).
The core idea of the 183-day rule is quite simple: 183 days is more (by a few hours) than half of a year. A foreign national who is in the United States for that period of time during a year establishes a more important – or at least lengthier – connection with the United States than with any other country in that year.
The 183-day rule is known as the “substantial presence” test. Viewed at closer range, the substantial presence test has two forms, one of which can be thought of as the “strong” form of the test and the other of which can be thought of as the “weak” form of the test.
i. Actual Physical Presence
Under the strong form of the test, U.S. residence results from the actual physical presence of an individual in the United States for 183 days or more during a calendar year. Actual presence establishes United States residence for the calendar year, and this determination survives any showing of a contrary intention or of a stronger or more permanent connection to another country. §§ 7701(b)(1)(A)(ii), 7701(b)(3).
This form of the substantial presence test is a veritable straightjacket provision under which residence in the United States automatically results from physical presence of 183 days. A taxpayer’s intentions regarding U.S. presence are meaningless. For example, a foreign national serving a prison term in the United States and wishing every minute that he were somewhere else, is nonetheless a U.S. resident under this test.
ii. Substantial Presence by Carryover of Days
If residence in the United States turned on nothing more than physical presence for 183 days in any given year, it would be relatively easy to circumvent this test. For example, by spending 180 days in the United States for several years in a row, a foreign person could maintain a substantial permanent connection with the United States without ever becoming a U.S. resident.
Similarly, a stay of 182 days at the end of one year followed by an equal stay at the beginning of the next would add up very nearly to one full year in the United States without establishing U.S. residence. With this much flexibility, the careful timing of gains and losses could significantly reduce the tax cost of U.S. residence.
A second strand of the substantial presence test serves as a limitation to prevent it from being abused. How so? By taking into consideration not only time spent in the United States during the current calendar year, but also days spent in the United States during the two preceding calendar years. The latter – i.e., days spent in the two preceding calendar years – is added to days in the most recent calendar year for purposes of measuring substantial presence. The effect is to include periods of protracted but less intense connection with the United States as periods of U.S. residence.
However, one very important point must be made. Days from the preceding two years are accorded less weight in arriving at the total than the days of the actual calendar year. Specifically, the tally of days spent in the United States – to be counted toward the 183 – is determined as follows:
- Days from the current year are counted at their full value;
- Days from the first preceding calendar year are counted as 1/3 of a day; and
- Days from the second preceding calendar year are counted as 1/6 of a day.
Consider the following example. Pierre is a foreign national who has never been to the United States before. For purposes of illustrating this rule, however odd this may sound, assume that every month has thirty days. Pierre arrives in the United States on September 1, 2000 and leaves on November 30, 2000, staying a total of ninety days. He returns to the United States on March 1, 2001 and leaves on July 30, 2001, staying a total of one hundred and fifty days. He returns to the United States on May 1, 2002 and leaves on August 30, 2002, staying a total of one hundred and twenty days.
Below are the number of days that Pierre spent in the United States each year:
After applying the substantial presence test, how many days is Pierre treated as having spent in the United States in 2001 and in 2002? Let’s begin with 2001. Pierre is treated as having spent 180 days in the United States in year 2001. The calculation is as follows: 150 days actually spent in 2001 (+) 1/3 of the 90 days spent in 2000 = 150 days (+) 30 days = 180 days. Because he does not cross the 183-day threshold, he does not pass the substantial presence test. And because he does not pass the substantial presence test, he is not a resident alien in 2001. Therefore, the U.S. cannot tax Pierre on his worldwide income.
Unfortunately, 2002 is not going to be as nice a year for Pierre. In 2002, Pierre is treated as having spent 185 days in the United States. See the chart below:
|YEAR||ACTUAL NUMBER OF DAYS||WEIGHT ACCORDED TO DAYS (EXPRESSED AS FRACTION)||“SUBSTANTIAL PRESENCE” DAYS|
The calculation is as follows: 120 days actually spent in 2002 (+) 1/3 of the 150 days spent in 2001 (+) 1/6 of the 90 days spent in 2000 = 120 (+) 50 (+) 15 = 185 days. Therefore, Pierre is a resident alien in year 2002 because he crossed the 183-day threshold requirement of the substantial presence test. And because he is a resident alien, he is subject to U.S. taxation on his worldwide income.
Another way of looking at this test is that every day spent in the United States potentially contributes 1 ½ days (i.e., 1 + 1/3 + 1/6) to the count of days used in measuring substantial presence over the succeeding years.
It follows that the greatest constant-level number of days that can be spent in the United States year in and year out without triggering United States residence is 121. Repeated annual stays of 121 days eventually become measured as 181 ½ under this extended substantial presence test – still below 183.
A word of caution is in order. United States residence cannot result entirely from days carried forward from earlier years. A minimum physical presence of at least 31 days in the United States is required before substantial presence is ever triggered.
This extended formulation of substantial presence means that foreign nationals can still be classified as U.S. residents even if they’ve spent less than 183 days in the United States in a given year. However, this possibility is rendered less likely by a qualification of the substantial presence test when it is met only by a carryover of days.
For individuals who satisfy the substantial presence test by a carryover of days during a calendar year, but who are actually present fewer than 183 days in the United States, application of the 183-day test is not absolute. Under an “exception” provided in section 7701(b)(3)(B), an individual who is actually present in the United States for fewer than 183 days during a calendar year – despite an extended count of days exceeding 183 – is not treated as a U.S. resident for that year if the following conditions are satisfied. First, the individual must have a “tax home” in a foreign country. And second, the individual must have a “closer connection” to that foreign country than to the United States.
The overlay of such notions as “tax home” and “closer connection” necessarily reduces the certainty of this aspect of the substantial presence test. The count of days remains a numerical threshold. But when substantial presence is met by a carryover of days (as opposed to actual physical presence of 183 days or more), the count of days creates in effect a presumption of United States residence, which can be rebutted by evidence that the person’s residence is in another country.
Determining the country to which an individual has a “closer connection” is not an exact science. Instead, it requires specific focus on the particular individual, along with a balancing of such factors as the individual’s principal place of residence and where he maintains the strongest social, economic, and family ties.
iii. Protected Groups of Individuals Who Are Excluded From The Substantial Presence Test
Certain groups of individuals are excluded from the substantial presence test. These are foreign nationals whose presence in the United States, even if lengthy, is generally not permanent.
Mechanically, these exceptions operate by excluding days spent in the United States under an exempted status from the days counted as presence in the United States. Among the protected group are full-time diplomats and consular officials, teachers, and students. Also excluded from the count are days spent in the United States by an individual unable to leave due to a medical condition that arose while he or she was there.
Before shouting for joy, it is important to recognize that there is a pitfall in these exceptions. And that pitfall is that a foreign national who holds an exempt status during part of a year is not necessarily insulated from U.S. residence for the balance of the year. Indeed, such an individual may still become a U.S. resident in that year merely by spending enough days in the United States without the exempt status.
Consider the following example. Hans is a full-time student who graduates from the University of Michigan on June 1. Graduation is the event that brings his exempt status to an end. However, Hans remains in the United States for pleasure until the end of the year (another 213 days). In doing so, he has crossed the threshold requirement of the substantial presence test. Therefore, he will be treated as a resident alien and subject to U.S. taxation on his worldwide income.