Nonresident alien

What Is Nonresident Alien?

A nonresident alien refers to an individual who is not a U.S. citizen or U.S. national and who has not met either the green card test or the substantial presence test for tax purposes. This classification is a critical component of international taxation, as it dictates how an individual's income is taxed by the U.S. government. Unlike U.S. citizens and resident aliens, nonresident aliens are generally only taxed on income effectively connected with a U.S. trade or business, or on certain types of U.S. source income that are fixed, determinable, annual, or periodical (FDAP).

History and Origin

The classification of individuals for U.S. tax purposes, including the definition of a nonresident alien, stems from U.S. federal tax law, primarily governed by the Internal Revenue Code. The Internal Revenue Service (IRS) provides comprehensive guidance in publications such as Publication 519, "U.S. Tax Guide for Aliens," which details the criteria for determining an individual's tax status¹¹. This framework evolved to address the complexities of taxing individuals who derive income from the U.S. but do not reside there permanently or are not U.S. citizens.

Furthermore, the treatment of nonresident aliens is significantly influenced by bilateral tax treaties between the United States and various foreign countries. These treaties, often based on models like the OECD Model Tax Convention, aim to prevent dual taxation and facilitate international trade and investment by defining taxing rights between countries¹⁰. The existence of these treaties can modify the default tax rules that would otherwise apply to a nonresident alien, reducing or exempting certain types of income from U.S. tax.

Key Takeaways

• A nonresident alien is an individual who is neither a U.S. citizen nor meets the green card or substantial presence tests for U.S. tax residency.
• Nonresident aliens are generally taxed only on U.S.-source income and income effectively connected with a U.S. trade or business.
• Tax treaties between the U.S. and other countries can reduce or eliminate U.S. tax on certain types of income for nonresident aliens.
• The IRS Publication 519 and Topic 851 are primary resources for understanding the tax obligations of nonresident aliens.
• Filing requirements for a nonresident alien typically involve Form 1040-NR.

Formula and Calculation

The determination of whether an individual is a nonresident alien often hinges on the "substantial presence test." If an individual does not meet this test (and does not have a green card), they are considered a nonresident alien. The test involves a calculation of days present in the U.S. over a three-year period. You meet the substantial presence test if you are physically present in the United States for at least 31 days during the current year and 183 days during the three-year period that includes the current year and the two immediately preceding years, calculated as follows:

If the sum of these weighted days is less than 183, and the individual does not hold a green card, they typically retain their nonresident alien status. Exceptions may apply for certain exempt individuals such as students, teachers, or foreign government employees.

Interpreting the Nonresident Alien

Understanding the status of a nonresident alien is crucial for both individuals and entities interacting with them financially. For individuals, this status directly impacts their U.S. tax liability. Unlike resident aliens who are taxed on their worldwide income, a nonresident alien's tax obligations are limited to specific categories of U.S.-sourced income⁹. This distinction means that income earned outside the U.S. by a nonresident alien is generally not subject to U.S. taxation.

For businesses and financial institutions, correctly identifying a nonresident alien is essential for compliance with withholding tax regulations. Payments made to nonresident aliens, such as interest, dividends, rents, and royalties, are often subject to a 30% flat tax rate, which must be withheld at the source unless a tax treaty provides a reduced rate or exemption⁸. Proper interpretation ensures adherence to IRS guidelines and helps individuals avoid potential issues related to tax avoidance or penalties for incorrect filing.

Hypothetical Example

Consider Maria, a citizen of Spain, who comes to the U.S. on a tourist visa from January 1 to March 31 of the current year (90 days). She spent 30 days in the U.S. in the first preceding year and 60 days in the U.S. in the second preceding year.

To determine if Maria is a nonresident alien, we apply the substantial presence test:

• Current year: 90 days
• First preceding year: 30 days / 3 = 10 days
• Second preceding year: 60 days / 6 = 10 days

Total for the test: (90 + 10 + 10 = 110) days.

Since 110 days is less than 183 days, and assuming Maria does not hold a green card, she qualifies as a nonresident alien for U.S. tax purposes. Therefore, she would only be taxed on any U.S. source income she earned, such as certain types of investment income from U.S. assets, not her income earned in Spain. She would file Form 1040-NR to report any U.S.-sourced income.

Practical Applications

The classification of a nonresident alien has significant practical implications across various financial sectors:

• Investing: Nonresident aliens investing in U.S. markets are typically taxed differently on U.S. capital gains and dividends compared to U.S. citizens or resident aliens. For instance, capital gains from the sale of U.S. stocks are generally exempt from U.S. tax for nonresident aliens, unless connected to a U.S. trade or business or if the individual is present in the U.S. for 183 days or more during the year of sale⁷. However, proposed legislation can impact these rates, particularly for sovereign investors or those from countries deemed to have "unfair foreign taxes"⁶.
• Real Estate: Taxation on U.S. real property interests for nonresident aliens is governed by the Foreign Investment in Real Property Tax Act (FIRPTA), which generally requires withholding on dispositions of such interests.
• Employment and Business: Nonresident aliens working in the U.S. or operating a business here are subject to U.S. income tax on their effectively connected income, often at the same progressive rates as U.S. citizens. For those not engaged in a U.S. trade or business but receiving U.S. income, a flat 30% withholding tax typically applies to fixed, determinable, annual, or periodical income, unless reduced by a tax treaty⁵.
• Estate Planning: The estate tax implications for nonresident aliens are distinct from those for U.S. citizens or residents, generally applying only to U.S.-situs assets.

Limitations and Criticisms

While the nonresident alien classification provides a framework for international taxation, it comes with limitations and points of criticism. The complexity of determining tax status, especially with the nuances of the substantial presence test and numerous exceptions, can lead to confusion and inadvertent non-compliance. Individuals may mistakenly assume their status or miscalculate their days of presence, leading to incorrect filings or penalties.

Furthermore, the interaction between U.S. tax law and bilateral tax treaties can be intricate. While treaties are designed to prevent tax evasion and double taxation, understanding which treaty provisions apply and how they override domestic law requires specialized knowledge. This complexity can be a barrier for individuals and small businesses navigating cross-border financial activities, often necessitating professional tax advice. Critics also point to the potential for different tax treatments to be perceived as inequitable or to create loopholes, though the stated intent of such classifications is generally to align taxation with economic ties to the taxing jurisdiction.

Nonresident Alien vs. Resident Alien

The primary distinction between a nonresident alien and a resident alien for U.S. tax purposes lies in their tax obligations and how their worldwide income is treated.

Confusion often arises when individuals spend significant time in the U.S. but believe their visa status (e.g., tourist, student) automatically designates them as a nonresident alien. However, U.S. tax residency is determined by the specific tax tests (Green Card Test and Substantial Presence Test), not solely by immigration status. An individual's status can also change from nonresident to resident (or vice-versa) within the same tax year, resulting in a "dual-status" tax year with specific filing rules⁴.

FAQs

What income is taxed for a nonresident alien?

A nonresident alien is generally taxed only on income derived from U.S. sources or income effectively connected with a U.S. trade or business³. This includes wages for work performed in the U.S., U.S.-sourced interest, dividends, rents, and royalties.

How do I know if I am a nonresident alien?

You are generally a nonresident alien for U.S. tax purposes if you are not a U.S. citizen and do not meet either the green card test (holding a lawful permanent resident card) or the substantial presence test for the calendar year. The substantial presence test involves counting days physically present in the U.S. over the current and two preceding years.

Do nonresident aliens have to file a tax return?

Yes, a nonresident alien must file a U.S. income tax return (typically Form 1040-NR) if they were engaged in a trade or business in the U.S. during the year, or if they had U.S.-source income on which the tax liability was not fully satisfied by withholding². Filing is also required if you want to claim a refund of overwithheld tax or claim certain deductions or tax credits.

What is the purpose of tax treaties for nonresident aliens?

Tax treaties are agreements between the U.S. and other countries that aim to prevent double taxation of income and to reduce tax liability for certain types of income for residents of either country. For nonresident aliens, these treaties can reduce or eliminate U.S. tax on specific income types, such as pensions, interest, dividends, or scholarships, depending on the terms of the treaty with their country of residence.

Can a nonresident alien become a resident alien?

Yes, an individual's tax status can change. A nonresident alien can become a resident alien by obtaining a green card (meeting the Green Card Test) or by spending enough days in the U.S. to satisfy the substantial presence test¹. If the status changes during the year, the individual is considered a "dual-status alien" for that tax year.