Can Foreign Investors be in the U.S. without Being Here for Income Tax Purposes? by Joel G. Young, JD, LLM
Posted on November 08, 2022
A fragile global economy and political uncertainty continue to fuel the United States’ status as the world’s most attractive location for foreign investment. However, investors chasing positive returns, high yields and portfolio diversification often face a tricky U.S. tax system that may provide tax-savings opportunities in some instances and costly income-tax traps in others.
Contrary to popular belief, a person who is treated as a U.S. resident for U.S. tax purposes may not necessarily be a permanent resident of the country. Non-U.S. persons will generally pay U.S. income tax only on U.S.-source income, or income effectively connected with a U.S. trade or business, whereas foreign individuals may inadvertently become subject to U.S. taxes on their worldwide income when they meet certain tax-residency tests. Similarly, a foreign investor may escape U.S. taxation on their worldwide income when they plan appropriately in advance of stepping on U.S. soil.
For income-tax purposes, the U.S. categorizes foreign individuals either as resident aliens (RAs) or non-resident aliens (NRAs) based on whether they meet certain tax-residency thresholds.
Substantial Presence Test
The U.S. considers foreign persons to be U.S. tax residents subject to the same income tax laws as U.S. citizens when they have a “substantial presence” in the country. More specifically, the U.S. will impose taxes on an individual’s worldwide income when he or she is physically present in the states for 183 days or more during a tax year, or a minimum of 31 days during a calendar year and 183 days or more over the past three years. It is important to recognize, however, that there are various nuances contained in the tax code that could unintentionally satisfy the substantial presence test. For example, the requisite 183 days in the U.S. need not occur consecutively. In addition, days spent traveling into and out of the country generally count as full days of physically presence, unless the individual is commuting to the U.S. for work from a residence in Canada or Mexico.
While foreign individuals should be diligent to limit the number of days they spend in the U.S., there are other methods they may pursue to garner an exemption from the substantial presence test and avoid U.S. resident alien tax treatment.
Closer Connection/Tax Home
Foreign persons who meet the substantial presence test but were in the U.S. for fewer than 183 days in the current year may be treated as non-resident aliens for U.S. income tax purposes when they maintain a tax home in a foreign country and can demonstrate that they had a closer connection to that country than they had to the U.S. A tax home may be a house where an individual resides, or it may apply to the location of one’s business or employment. The IRS’s definition of a closer connection is more ambiguous, but it does consider various facts and circumstances to determine if such a link exists. This includes the types of forms the individual files, the country of residence designated on those forms and the following factors:
- the location of an individual’s permanent home, which must always be available to that person during the calendar year
- the location of the individual’s family members
- the location of the individual’s personal belongings, such as clothing, jewelry and automobiles
- the location of the social, political and religious organizations with which the individual associates
- the location where the individual conducts business activities, other than his or her tax home
- the jurisdiction where the individual holds a driver’s license
- the jurisdiction the individual votes
Meeting these qualifications should prove simple for many foreign investors seeking to maintain their status as non-resident aliens for U.S. tax purposes. However, if you applied or took other steps during the year to change your status to that of a U.S. lawful permanent resident (i.e., a green card holder), you cannot claim the closer-connection exception. Prudent investors should seek the advice of U.S.-based tax advisors before taking any action that could lead to significantly different tax liabilities than they had planned.
If the closer-connection exception is not an option due to the number of days spent in the U.S., individuals may have another chance to qualify as non-resident aliens for U.S. income tax purposes and avoid having to file and pay taxes on their worldwide income.
For example, consider an individual investor who qualifies as a resident of both the U.S. and another country and is subject to the tax laws of both jurisdictions. Should a tax treaty exist between those countries, a tie-breaker provision may allow the investor to file a U.S. tax return and make an election to benefit from potentially more advantageous tax treatment in the foreign country. While the taxpayer will not be considered a U.S. income-tax resident responsible for paying tax on his or her worldwide income, he or she may instead be considered an income tax resident for other provisions of the tax code and have a requirement to file information reporting forms in addition to a U.S. tax return.
Students, Teachers and Trainees
Citizens of foreign countries may exclude from the substantial presence test some of the days and years they are physically in the U.S. if they or their immediate family members have visas to study, teach or train in the United States. This includes F visas, J visas, M visas and Q visas. Generally, the exemption is available for five years, but any portion of a calendar year counts as a full year. For example, an individual who entered the U.S. on a qualifying student visa in October of 2020 and remains there until May 2025 would have the benefit of the exemption for 2020 through the end of 2024. However, because the student entered the country late in 2020, days in the U.S. after January 1, 2025, would be counted toward his or her substantial presence test.
To qualify for an F-1 visa, individuals must be enrolled as full-time students in a U.S. college/ university, high school, elementary school, seminary, conservatory or other academic institution that culminates in a degree, diploma or certificate of completion. In addition, foreign investors may qualify for an F-1 visa and exclude the days they are present in the U.S. when they are enrolled in a language-training program, whether that be English, Spanish, Hebrew or Mandarin. However, the student visa exception can get tricky. U.S. tax authorities may review an individual’s compliance with the visa requirement and reserve the right to disallow the exemption.
The J-1 visa applies to individuals who participate in a U.S. work-study exchange program that is sponsored by a nonprofit or educational entity, including an au pair program, summer camp, graduate medical school or research institutions. In addition, J-1 visas are often used by foreign students completing internships in the U.S. or foreign professionals in the U.S. for career training.
Foreign persons must take the time to plan far in advance of their intent to invest, study, work or conduct business in the United States to minimize the risks of being classified as U.S. resident aliens for income tax purposes. Should they fail to do so, they may be liable for U.S. taxes on all wages, interest, dividends, rental income and income from all other sources they earn throughout the world. Planning is also beneficial for individuals who obtain a favorable visa and may become subject to taxes on capital gains or face other potential pitfalls that will trigger U.S. tax liabilities. In addition, care should be taken to avoid engaging in activities that may violate the terms of the visa. An attorney and tax advisor with experience in international tax issues for individuals and businesses is the best resource to begin the planning process.
About the Author
Joel G. Young, JD, LLM, provides tax consulting, income and estate tax planning and compliance services for high-net-worth families and closely held businesses that have international operations. For more information, contact him in the firm’s West Palm Beach office at 561-361-2050 or by email at email@example.com.