Tax season can be a confusing and challenging time of year for businesses. This can be especially true for businesses who employ nonresident aliens, as nonresident alien tax can become complicated.
Thousands of nonresident aliens are employed in the United States each year and many of them work for small business owners.
Helping business owners navigate the complexities is an ideal opportunity for tax and accounting professionals to strengthen their role as a trusted advisor. This requires that firms have the right tools and resources in place to efficiently and accurately address client questions and concerns and ensure compliance.
Let’s begin by taking a closer look at the basics of what defines a nonresident alien.
Table of contents:
- What is a nonresident alien?
- Nonresident alien taxation
- Case study of nonresident alien taxation
- Nonresident alien tax software
What is a nonresident alien?
As outlined by the IRS, a person is considered a nonresident alien if they have not passed the green card test or the substantial presence test for the calendar year (Jan. 1 to Dec. 31).
Passing the green card test means that a person is a lawful permanent resident of the United States at any time during the calendar year. People generally have this status if the U.S. Citizenship and Immigration Services (USCIS) issued them a Permanent Resident Card, Form I-551, also known as a “green card.”
There are several categories for green card eligibility, including but not limited to:
- Those who are immediate relatives of United States citizens.
- Refugees and asylum seekers.
- Those who have specific skill sets and knowledge that may make them eligible for an I-551.
- Those randomly selected through the Diversity Immigrant Visa Program.
Those who have a green card are allowed to live and work permanently in the United States.
Then there’s the substantial presence test, which is a calculation that determines the status (i.e., resident or nonresident) of a foreign national for tax purposes in the United States.
To meet this test, individuals must be 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 years immediately before that, counting:
– All the days present in the current year, and
– 1/3 of the days present in the first year before the current year, and
– 1/6 of the days present in the second year before the current year.
To illustrate this policy, consider the following example:
John was physically present in the United States for 120 days in each of the years 2019, 2020, and 2021. To determine if he meets the substantial presence test for 2021, count the full 120 days of presence in 2021, 40 days in 2020 (1/3 of 120), and 20 days in 2019 (1/6 of 120). Since the total for the three-year period is 180 days, he is not considered a resident under the substantial presence test for 2021.
What is the difference between a nonresident alien and a U.S. resident alien?
Those who have not met the green card or the substantial presence tests outlined above are nonresident aliens. On the other hand, those who are a resident alien for U.S. tax purposes have established their permanent residency status in the United States.
Understanding and filing the correct status is important as each category comes with significantly different tax consequences.
Employers must collect from each recipient who will be paid by their organization either a Form W-9 as a certificate of U.S. status or a Form W-8BEN as a certificate of foreign status. This withholding certificate also serves as proof of solicitation of a U.S. taxpayer identification number — a U.S. social security number (SSN) or individual taxpayer identification number (ITIN).
These forms should be collected from the individual at the time of hire. If they are a foreign national, the employer also will need to collect information about the individual’s immigration status and days of presence in the United States in the current tax year and two prior tax years to determine their tax residency status.
In short, the key difference in taxation is that nonresident aliens are typically only taxed on their U.S.-sourced income.
The U.S. tax obligations for resident aliens, however, are much the same as those of a U.S. citizen. They are taxed on their worldwide income and have access to the same tax deductions and credits.
Nonresident alien taxation
As mentioned earlier, nonresident aliens are typically only taxed on their U.S.-sourced income. Furthermore, they are subject to two different tax rates:
- Effectively connected income (ECI). ECI is earned in the United States from the operation of a business in the United States, as well as personal service income earned in the United States like wages or self-employment income. It is taxed at the same graduated rates as for a U.S. citizen.
- Fixed or determinable, annual, or periodic (FDAP) income. FDAP — which is passive income such as interest, dividends, rents, or royalties — is taxed at a flat 30% rate, unless a tax treaty specifies a lower rate.
What is the importance of an income tax treaty?
The United States has income tax treaties with several foreign countries. For nonresident aliens, these treaties can often reduce or even eliminate U.S. tax on various types of personal services and other income like interest, capital gains, dividends, pensions, and royalties. However, each individual treaty must be reviewed to determine whether specific types of income are exempt from U.S. tax or taxed at a reduced rate.
In terms of deductions, nonresident aliens can deduct certain itemized deductions (generally not standard deductions) if they receive income “effectively connected” with their U.S. trade or business. These deductions include:
- State and local income taxes,
- Charitable contributions to U.S. non-profit organizations,
- Casualty and theft losses from a federally declared disaster, and
- Other itemized deductions.
Similarly, nonresident aliens who receive “effectively connected” income may be able to claim some credits. These credits include:
- Foreign tax credit
- Child and dependent care credit
- Retirement savings contributions credit
- Child tax credit
- Credit for other dependents
- Adoption credit
- Credit for prior-year minimum tax
What tax form does a nonresident alien file?
A nonresident alien engaged in a trade or business in the United States must use Form 1040-NR for filing a U.S. tax return. The lines on Form 1040-NR are arranged so that, in most instances, they are for the same tax items as the lines on 2021 Forms 1040 and 1040-SR.
The IRS noted that though filers will need to file Form 1040-NR, as well as Schedule OI (Form 1040-NR), they may not need to file the numbered schedules (Schedules 1 through 3 (Form 1040)), or Schedule A (Form 1040-NR) and Schedule NEC (Form 1040-NR).
However, if their return is more complex (for example, they claim certain deductions or credits or owe additional taxes, or they have U.S.-source income not effectively connected with a U.S. trade or business), they will need to fill out and submit one or more of those schedules.
Who is exempt from filing 1040-NR?
There are three main instances when an individual would not need to file a 1040-NR:
- The individual was a nonresident alien student, teacher, or trainee who was temporarily present in the United States under an “F,” “J,” “M,” or “Q” visa, and has no income that is subject to tax under section 871 (i.e., otherwise reportable on the form 1040NR).
- A student or business apprentice who was eligible for the benefits of Article 21(2) of the United States-India Income Tax Treaty, they are single or a qualifying widow(er), and their gross income (for 2021) was less than or equal to $12,550 if single ($25,100 if a qualifying widow(er)).
- They were a partner in a U.S. partnership that was not engaged in a trade or business in the United States during 2021 and the Schedule K-1 (Form 1065) includes only income from U.S. sources reportable on Schedule NEC (Form 1040-NR), lines 1 through 12.
There are several factors that must be taken into consideration, so it is always advisable that nonresident aliens turn to a tax and accounting professional before making a decision on to how, or if, to file.
Are nonresident aliens exempt from Social Security tax?
Nonresident aliens are generally not exempt from Social Security tax.
According to the Social Security Administration (SSA), it is required to withhold a 30% flat income tax from 85% of a nonresident alien’s Social Security retirement, survivors, or disability benefits. This results in a withholding of 25.5% of their monthly benefit.
The one potential exemption from this tax (or a lower rate) is if it is specified in a U.S. tax treaty.
Differences between nonresident alien employees vs. independent contractors
It is important for businesses to be aware that employing nonresident alien independent contractors is very different from independent contractors who are U.S. citizens or resident aliens.
When a nonresident alien independent contractor provides services in the United States, the payments received are U.S.-source income. To ensure tax compliance, there are several general rules that businesses should keep in mind. These include:
- Businesses must withhold 30 percent of the money they pay nonresident alien independent contractors for their personal services unless the nonresident alien provides an IRS-approved withholding agreement or Form W-8 for reduced withholding.
- The nonresident contractor must provide businesses two copies of a letter from the IRS that states the amount of the final payment (up to $5,000) is exempt from withholding; or they must provide a Form 8233 — not Form W-4 — to claim a tax treaty exemption from all or part of the required withholding.
The rules are the same as they are for taxes withheld for U.S. citizens or resident aliens when making tax deposits or paying the tax withheld for nonresident aliens.
Case study of nonresident alien taxation
To further illustrate the importance of ensuring compliance with nonresident alien tax return requirements, let’s explore the following case study:
The case of Maria Esther Montiel v. United States calls into question the limitation period for filing a refund claim when a nonresident alien erroneously files a tax return as a U.S. resident but later determines that they should have filed as a nonresident alien.
Montiel, a citizen and resident of Mexico, filed suit on Nov. 7, 2013, after her refund claims for overpaid income taxes in 2007 and 2008 were denied by the IRS.
On March 16, 2008, Montiel filed a Form 1040 for the tax year 2007. The form designated Montiel’s filing status as “resident alien,” and she listed a family member’s address in California as her own, causing the form to be filed at the IRS’s Fresno Service Center.
Subsequently, Montiel determined that she was a “nonresident alien” for federal tax purposes and should have filed a Form 1040-NR for 2007. She filed an amended return on June 10, 2011.
The IRS denied her request. According to the IRS, Montiel had to file her amended form by April 15, 2011, that is, within three years of filing her income tax return on April 15, 2008, or within two years of paying her 2007 taxes.
Similar events also took place for the 2008 tax year. Once again, the request was denied by the IRS, given that the amendment was submitted June 13, 2012 — more than three years after April 15, 2009.
Montiel then brought suit in the Court of Federal Claims seeking a refund for taxes overpaid for 2007 and 2008. The IRS argued that the Court of Federal Claims lacked subject matter jurisdiction, and filed a motion to dismiss Montiel’s suit.
The Court determined that Montiel had “presented triable issues concerning the court’s jurisdiction.” It denied the government’s motion to dismiss the suit and ordered a trial to determine whether it had jurisdiction.
In a written observation, the Law Office of Charles W. Cope, PLLC stated: “Nonresident aliens who erroneously file a U.S. tax return as a U.S. resident should file their Form 1040NR and companion refund claim prior to April 15 of the third year following the year in which they filed their original tax return. Should they fail to do so, Montiel demonstrates that they probably will have to pursue an expensive action in the courts in order to claim a refund with no guarantee of success.”
Nonresident alien tax software
Nonresident alien tax can get complicated. And when businesses make payments to foreign workers, the IRS pays close attention.
Ensuring compliance means leveraging software that analyzes immigration, tax, and treaty rules to make sure clients are withholding and filing those taxes correctly. Enter the Thomson Reuters International Tax Navigator.
Thomson Reuters International Tax Navigator produces all the required IRS withholding certificates, as well as 1042 tax returns and 1042-S reporting forms. Plus, professionals get the most extensive library for nonresident alien tax and immigration-related issues, including a searchable FAQ database with answers from leading international tax experts.
Don’t navigate the complexities of nonresident alien tax alone. Turn to a solutions provider that takes the guesswork out of foreign tax compliance and sets your firm, and your clients, on the right path.
To learn more about other corporate tax topics, check out our blog on fiduciary tax.