Generally, nonresident taxpayers are taxed solely on their U.S. source income. There are limited circumstances where the U.S. will also tax specific types of foreign source income earned by a nonresident alien. As those situations are rare, they are beyond the scope of this discussion’s intention to give you a general overview of the U.S. tax system.
There are two separate classifications in U.S. tax law for U.S. source income. In a previous discussion on Residency, we covered the most common types of income earned by nonresident individuals and the rules for determining whether the income is considered to be U.S. sourced or foreign sourced. Once you have made the appropriate sourcing in each category, it is necessary to further classify all items of U.S. source into one of the following types:
- Trade or business income (active income), or
- Investment income (passive income)
The distinction between these two types of income is important because each is taxed differently.
Trade or Business Income
Trade or business income is generated through an endeavor which demands a certain level of active participation. Wages earned as an employee or compensation derived as a self-employed individual are examples of trade or business income. Other activities also considered U.S. trade or business income include selling products in the U.S. through a U.S. based office, ownership of a U.S. business (corporation, partnership or otherwise).
Income which is classified as trade or business income is taxed on a net income basis using graduated tax rates. Net income is determined by accumulating the gross trade or business income and reducing it by allowable deductions which are attributable to this gross income.
If you own a business in the U.S., your business may deduct most expenses that are directly related to it. These business deductions include wages paid to employees, rents paid, depreciation of assets, marketing and advertising costs, taxes, insurance, utilities, etc. Normally the income and related expenses will flow through to your U.S. tax return on either schedules C or E depending on the business’ choice of form (sole proprietor, corporation, partnership, etc).
While an employee may indeed incur similar expenses to that of a business owner, the employee is often reimbursed for these by his/her employer. Only unreimbursed employee business expenses may be deducted on one’s individual tax return, and when done so only as an itemized deduction. Any expenses that are personal in nature are usually not deductible unless they qualify as adjustments to gross income or as itemized deductions.
Adjustments to Gross Income
Similar to U.S. residents, nonresident aliens can claim certain adjustments, deductions, from gross income. They are:
- Retirement Related (IRA, SEP, SIMPLE & qualified plan contributions)
- Health Related (Medical savings account & Self-employed health insurance)
- Unreimbursed deductible moving expenses
- Penalty incurred on early withdrawal of savings
- Environmental (deduction for clean-fuel vehicles)
- Education Related (Student loan interest deduction, Scholarship and fellowship grants exclusion)
It is common for nonresidents to have these types of deductions. Also note that these expenses must relate to income being reported on the return to be deductible.
Nonresident aliens can also claim the following itemized deductions:
- State and local income taxes
- Gifts to U.S. charities
- Casualty and theft losses
- Unreimbursed employee expenses and miscellaneous deductions (subject to limitations)
|Please note that nonresidents are not allowed to take the standard deduction.|
Generally, nonresidents are only allowed their own individual exemption. However, residents of Canada and Mexico are not subject to this general rule. These nonresident aliens may claim additional exemptions for those individuals who qualify as dependents (see discussion of Dependents on www.demostax.com).
|Warning! - a U.S. social security number or taxpayer identification number is REQUIRED for each individual for which an exemption is claimed or the return will be rejected. If you need assistance obtaining a taxpayer ID for a dependent, please consult your tax advisor.|
Your employer may wish to send you to the U.S. for a “temporary assignment”. Typically, most foreign nationals will not establish a U.S. based tax home during such a short term stay. A temporary assignment is defined as one where the tax home (principal place of work or employment) does not change, it remains in your home country. If the intent of the assignment is to return to your original tax home within one year, the assignment is considered to be temporary in principle (all other assignments are considered indefinite or long-term).
The tax advantage of a temporary assignment is that certain employer-provided benefits and per diems are not considered taxable wages to the employee. Some of these expenses are lodging, meals, travel, and certain other items related to the assignment. During a long-term assignment, these are typically considered taxable compensation.
If these expenses, which are directly related to the short term assignment, are not paid or reimbursed by the employer, you are allowed to deduct the costs as an itemized deduction (subject to certain limitations).
After reducing the trade or business income by any allowable itemized deductions and the personal exemption(s), the net trade or business income is subject to the graduated tax rates. The rates at which net trade or business income is taxed depends on your filing status. If you are a married nonresident alien, generally the married filing separately status and rate schedule applies to your net trade or business income. However, if you find yourself in the situation that you are married to a U.S. citizen or resident and you do not meet the U.S. requirements to be a resident, you may elect to be treated as a resident and therefore file a joint return with your spouse.
If you are not married, you must use the “single taxpayer” tax rate schedule.
U.S. sourced investment income is taxed at a flat rate of 30% on a gross basis, meaning that no deductions or exemptions are allowed against this income. The most typical types of income which fall into the “Investment Income” category are interest, dividends, and royalty income.
The flat tax of 30% is usually collected through a tax withholding mechanism. The burden to withhold the tax is placed upon the payor of the income. For example, a U.S. corporation will withhold the tax from any dividends it pays to a nonresident taxpayer and remit it to the U.S. government on behalf of the individual.
The 30% tax rate can be reduced or eliminated if a tax treaty is in effect between the U.S. and the country of residence of the taxpayer. A listing of current treaties is found in Publication 901. We have included a link to this publication in Section IV. If you are a nonresident taxpayer and your only U.S. source income consists of investment income, you are not required to file a U.S. tax return provided the withholding tax has been properly withheld. In most cases, the withholding tax satisfies your U.S. tax liability.
Special Rules for Investment Income
Portfolio Interest Exemption – For many nonresidents, interest earned from certain debt instruments issued by a U.S. based entity will not be subject to the withholding tax. To qualify for this exemption, the following requirements must be met:
- The nonresident taxpayer cannot have a substantial ownership stake (10% ownership or more) in the U.S. entity paying the interest.
- The obligation generating the interest income must have been issued after July 18, 1984.
- Some countries do not have an adequate system of information exchange with the U.S. to prevent tax evasion by U.S. taxpayers. Most “developed” countries do have adequate systems. However, the IRS maintains a list of countries which it finds to be inadequate. The recipient of the income can not be a resident of a “inadequate” country.
U.S. Bank Deposits – Interest earned from deposits in U.S. banking institutions is exempt from the U.S. withholding tax mentioned earlier. Note that this income can not be connected to a U.S. trade or business in order to qualify for this exemption.
Real Estate Rental Income – is typically considered investment income. As a result, the gross rental income is subject to the full 30% withholding tax (unless reduced by a treaty). Since this could discourage foreign investment in U.S. real property by presenting an undue tax burden on nonresidents, there is an election available to treat this as trade or business income. Thus allowing the nonresident landlord to be taxed on a net basis using graduated tax rates. Because the landlord is taxed on a net basis (gross rental income less related deductible costs), this will often result in a lower U.S. tax liability. If you own U.S. real property and lease it, you should seek the advice of a U.S. tax advisor regarding this election and whether it is beneficial in your specific situation.
Disposition of U.S. Real Property – Unlike other types of capital gains or losses, any gain or loss from the sale of real property located within the United States is automatically regarded as trade or business income. The gain or loss is therefore taxed on a net basis at the graduated tax rates. However, it is common that 10% of the gross sales price will be withheld as remitted to the IRS. This is required unless it creates an undue hardship on the part of the nonresident taxpayer. In that case, it is in the interest of the nonresident taxpayer to contact a knowledgeable tax advisor to assist them in reducing or eliminating this withholding requirement for that transaction. The appeal to reduce or eliminate the withholding on the transaction must be made before the transaction is completed and money is withheld. Once the money has been withheld you must file a tax return to receive back any monies owed to you as a refund..
Filing Requirements and Procedures
The filing requirements for nonresidents are as follows: if you earned wages which were subject to U.S. income tax withholding, you should file your U.S. tax return (Form 1040NR) by April 15th of the following year (201D). If you did not receive wages subject to withholding, you have until June 15th of the following year (201D) to file Form 1040NR. If you cannot file your return by the appropriate due date, you may file an extension as discussed in Section I. Form 1040NR and any supporting schedules should be signed and sent to:Department of the Treasury Internal Revenue Service Center Austin, TX 73301-0215 U.S.A.
State Income Taxes
Each state, county and municipality in the United States has the right to impose its own Income Tax. Most states do exercise this right, while few counties or municipalities do so. Therefore, you may have to contend with State and possibly local taxing authorities while working in the U.S. While the rules vary from state to state, they usually follow the same principles as the Federal tax system and quite often either mimic it in format or use it as a starting point in their own calculations. Each state has its own filing requirements. However, if you work in a state, even for a short period of time, it is likely that you will have an obligation to file a tax return there. This is the case even if you are not considered to be a resident of the state.
This concludes our general discussion of nonresident alien taxation in the United States.