How to calculate Residential Status for tax purposes in USA

Given the increase in global mobility of employees, tax consultants come across clients who are citizen /resident of another country or even multiple countries. Situation can become complicated when multiple countries have overlapping tax residency rules resulting in double taxation on the same income.

A prime example of such cases is a country like USA which accommodates a significant chunk of Indian NRI population. This article introduces the reader to basics of taxation of such persons under the tax laws of USA, overview of Double Tax Avoidance Agreement (DTAA) between India and USA, impact of new regulations like FATCA, and some tax compliances that such persons should keep in mind.

Introduction

Every country has its own tax code to decide on the taxability of income of a person and levy tax accordingly. Income can be taxable either basis the source and/or a person’s residential status. As far as the USA is concerned, tax administration is managed by the Internal Revenue Service (IRS) www.irs.gov which is a part of the US Department of Treasury. Let us first get a broad overview of the tax residency rules under the IRS rules & then we can proceed to other issues like double tax situations, DTAA etc.

Tax residency under the IRS rules

Unlike the Indian rules where tax residency is primarily a function of a person’s physical stay in India, as per the USA tax rules, it is also a function of citizenship. USA follows a concept of “citizen” and “alien”. So, if you are a US citizen (USC), you are a resident by default and your global income is taxed irrespective of the number of days of your physical stay in the USA in the financial year. If you are not a citizen, you are known as an “alien” & you’ll have to pass through the following additional tests to ascertain whether you are a “resident” or a “non-resident” alien:

Green card test: The person has at any time during the year was a “lawful permanent resident” of the United States (in common language, said to be having a “green card”)
Substantial presence test: Both the conditions mentioned below need to be satisfied:
Physical presence in United States for atleast 31 days in the year, and
Physical presence in United States for atleast 183 days during the 3-year period including this year, counting all days of presence for this year, 1/3rd of last year and 1/6^th of last year.

Example: You were physically present in the United States on 120 days in each of the years 2013, 2014, and 2015. To determine if you meet the substantial presence test for 2015, count the full 120 days of presence in 2015, 40 days in 2014 (1/3 of 120), and 20 days. in 2013 (1/6 of 120). Because the total for the 3-year period is 180 days, you are not considered a resident under the substantial presence test for 2015.

Days of Presence in USA

Below is the IRS guidance on the days of presence in USA –

You are treated as present in the U.S. on any day you are physically present in the country, at any time during the day. However, there are exceptions to this rule. Do not count the following as days of presence in the U.S. for the substantial presence test:

Days you commute to work in the U.S. from a residence in Canada or Mexico if you regularly commute from Canada or Mexico.
Days you are in the U.S. for less than 24 hours, when you are in transit between two places outside the United States.
Days you are in the U.S. as a crew member of a foreign vessel.
Days you are unable to leave the U.S. because of a medical condition that develops while you are in the United States.
Days you are an exempt individual (see below).

The term United States (U.S.) includes the following areas:

All 50 states and the District of Columbia.
The territorial waters of the United States.
The seabed and subsoil of those submarine areas that are adjacent to U.S. territorial waters and over which the United States has exclusive rights under international law to explore and exploit natural resources.

The term does not include U.S. territories or U.S. airspace.

Exempt Individual

Below is the IRS guidance on exempt individual –

Do not count days for which you are an exempt individual. The term “exempt individual” does not refer to someone exempt from U.S. tax, but to anyone in the following categories:

An individual temporarily present in the U.S. as a foreign government-related individual under an “A” or “G” visa, other than individuals holding “A-3” or “G-5” class visas.
A teacher or trainee temporarily present in the U.S. under a “J” or “Q” visa, who substantially complies with the requirements of the visa.
A student temporarily present in the U.S. under an “F,” “J,” “M,” or “Q” visa, who substantially complies with the requirements of the visa.
A professional athlete temporarily in the U.S. to compete in a charitable sports event.

If you exclude days of presence in the U.S. for purposes of the substantial presence test because you were an exempt individual or were unable to leave the U.S. because of a medical condition or medical problem, you must include Form 8843, Statement for Exempt Individuals and Individuals With a Medical Condition, with your income tax return. If you do not have to file an income tax return, send Form 8843 to the address indicated in the instructions for Form 8843 by the due date for filing an income tax return.

If you do not timely file Form 8843, you cannot exclude the days you were present in the U.S. as an exempt individual or because of a medical condition that arose while you were in the U.S. This does not apply if you can show, by clear and convincing evidence that you took reasonable actions to become aware of the filing requirements and significant steps to comply with those requirements.

Closer Connection Exception to the Substantial Presence Test

Even if you met the substantial presence test you can still be treated as a non-resident of the United States for U.S. tax purposes if you qualify for one of the following exceptions:

The closer connection exception. Please refer to Closer Connection Exception to the Substantial Presence Test .
The closer connection exception available only to students. Please refer to The Closer Connection Exception to the Substantial Presence Test for Foreign Students.

Now, if any of the above tests (green card/substantial presence) is positive, you qualify as a “resident alien”. If both tests are negative: you are a non-resident alien. Further, rules offer a non-resident alien spouse of a USC/resident alien a choice to be treated as a resident alien, subject to certain conditions.

The taxability of income on the basis of the residential status goes as follows:

USC/Resident Alien: Your worldwide income is taxable irrespective of place of stay during the US financial year which is Jan 1 – December 31. In case of foreign incomes (for e.g. income from salary in India), you can claim a Foreign Earned Income Exclusion (FEIE) of upto USD 1,20,000 (for 2023) and certain foreign housing related deductions subject to fulfilment of conditions.
Non-Resident Alien: Only the US source incomes or those from conducting a trade or business in the United States (like working for a US employer) are includible in taxable income. You are also subject to a flat 30% withholding tax on that income unless you file sufficient documentation with payer institution.

Taxation based on residential status under USA tax law

Similar to the Indian tax rules, there are no exemptions limits depending upon the filing status of the taxpayer, like single, married filing separate, married filing jointly, head of household etc. The taxation starts at a flat 10% from USD 1 onwards.

Some additional points may be noted as follows:

Calculation of gross income for return filing purposes is BEFORE any FEIE exclusion.
If you choose to file on a calendar year basis, due date for filing return is April 15 of the year following the previous year. For USC/resident aliens living outside the United States, an automatic 2 month extension is applicable.
In case of dual residency situations (tax resident of both India and USA), taxpayer can choose to determine his residency w.r.t. DTAA rules & it will override the residency rules of both countries.

Some more tax pointers

Following are some tax compliances that tax consultant can bring to the notice of USC/NRI:

If you’re staying out of USA and do not have any US income, it does not mean that you don’t need to file any tax return. Evaluate your tax situation properly & if required, file the return with the IRS in time. For this, you can consult a tax consultant who is knowledgeable about US non-resident alien taxation. After filing return, maintain sufficient hard copy documentation at your end: copy of tax return, W2 & W4 forms, proof of deductions claimed etc.
In case of US connected income, you must let your employer/ financial institution know about your so your residential status vide the W-8 form series so that it does not withhold any tax or does at a reduced treaty rate. In the case of latter, additional information like US ITIN or Indian PAN and certain declarations need to be made.
If you are a resident alien or choose to be so for any year, you need to file Form 8938 to report the ownership of specified foreign financial assets if it exceeds the specified threshold.

References & Additional Reading:

IRS Pub. 54: Tax Guide for U.S. Citizens and Resident Aliens Abroad
IRS Pub. 519: US Tax Guide for Resident Alien
IRS Pub. 901: US Tax Treaties
IRS Topic 851: Tax Rates

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