How Nonresident Taxes Work


Hisashi Ueta, a Japanese student at Massachusetts General Hospital, lies down to get a better angle as he takes a picture of his wife. Foreign students like Ueta are exempt from certain taxes as they're considered nonresident aliens.
Hisashi Ueta, a Japanese student at Massachusetts General Hospital, lies down to get a better angle as he takes a picture of his wife. Foreign students like Ueta are exempt from certain taxes as they're considered nonresident aliens.
Jessica Rinaldi for The Boston Globe via Getty Images

Aliens are living among us. For all you know, your neighbor could be an alien, or the student sitting next to you in class, or the doctor writing your prescription. "Alien," after all, is the term that the United States government uses to describe anyone living in America who is not a U.S. citizen. By that measure, E.T. was not only an extraterrestrial, but also an alien.

A nation of immigrants, the U.S. welcomes foreign citizens to live legally as temporary or permanent workers, students, teachers, researchers and the occasional power forward for a professional basketball team.

The IRS also welcomes the tax dollars of foreigners living and working in the U.S. For tax purposes, the IRS distinguishes between non-U.S. citizens living in America permanently and those who are only visiting or studying in the U.S. temporarily:

  • Resident aliens are taxed on both U.S. income and income from foreign sources, and file the same 1040 income tax return as U.S. citizens
  • Nonresident aliens only pay taxes on U.S. income and are exempt in some cases from Social Security and Medicare contributions. Nonresident aliens file a modified 1040NR income tax return

How does the IRS determine who is a resident alien and who is a nonresident alien? There are two basic tests. If you pass either of these tests for any part of the tax year, you are a resident alien. If not, you're a nonresident alien [source: IRS]:

  1. "Green card" test – This one is easy. If you have been granted status as a Lawful permanent resident by the U.S. Citizenship and Immigration Services in the form of an alien registration card or "green card," then you are automatically considered a resident alien
  2. Substantial presence test – Get out your No. 2 pencils, because this one requires some math. The IRS considers you a resident alien if you lived in the U.S. for more than 183 days during the past three years. Instead of simply counting those days, the IRS gets tricky. First, count all of the days you lived in the U.S. this year. Then add one-third of the days you lived in the U.S. in the previous year. Lastly, add one-sixth of the days you lived in the U.S. the year prior to that. If the total is greater than 183, you are a resident alien, regardless of whether or not you have a green card

Keep reading to find out what kinds of tax breaks and exemptions are available to nonresident aliens, and to find out how much foreign athletes pay in taxes.

Taxable Income for Nonresident Aliens

The good news is that if you qualify as a nonresident alien, the IRS only wants to collect income tax on money that you made in the United States. To make things simple — hah! — the IRS has identified two broad categories of nonresident income that are subject to U.S. taxes:

  • Effectively connected income (ECI) – If you have a job in the U.S. or run your own business, that income is "effectively connected" to an American trade or business
  • Fixed, determined, annual or periodical (FDAP) income – This category captures everything that isn't ECI, including dividends and interest on investments, alimony, Social Security benefits (85 percent) and miscellaneous income like scholarships and sales commissions

Why does the IRS differentiate between ECI and FDAP income? Because the feds tax the two types of nonresident income at different rates. Effectively connected income is taxed at the same graduated income tax rates that U.S. citizens pay. The more you earn in ECI, the higher your effective tax rate will be. The biggest difference between resident and nonresident tax rates is that married nonresidents cannot file jointly [source: IRS]. The only way a nonresident can file jointly is if they are married to a U.S. citizen or resident, at which point they would file a regular tax return.

FDAP income is taxed at a flat rate of 30 percent [source: IRS]. It's important to note that FDAP is not the same as a capital gains tax. Non-U.S. citizens only have to pay capital gains tax on the sale of stock and other capital assets if they reside in the U.S. for 183 days or more during the tax year. That capital gains tax rate is also 30 percent.

To further confuse things, there's a completely separate capital gains tax for the sale of real property by a foreigner, regardless of his or her status as a resident or nonresident alien. If a non-U.S. citizen sells a piece of U.S. real estate, 10 percent is withheld from the sale price as a capital gains tax [source: IRS]. Higher tax rates apply to real property sold or distributed by foreign corporations.

Withholding and Deductions for Nonresident Aliens

There are substantially different rules for resident and nonresident alien taxpayers when it comes to withholding taxes and claiming tax deductions and exemptions.

For example, both U.S. citizens and resident aliens are required to have income taxes withheld from each paycheck. A nonresident alien, however, can submit IRS form W-8ECI to claim that income from a specific source is effectively connected income (ECI), which is exempt from withholding [source: IRS].

Likewise, self-employed U.S. citizens and resident aliens must pay self-employment tax in April to cover their contributions to the Social Security and Medicare trust funds. Nonresident aliens are exempt from the self-employment tax. However, nonresident aliens employed by a U.S. business do have to pay into the Social Security and Medicare system [source: IRS]. Certain exemptions for foreign teachers and researchers apply.

When it's time to file taxes in April, nonresident aliens complete the 1040NR. As we mentioned earlier, they cannot file as married filing jointly. They also can't file as head of household. The only available filing statuses are single, married filing separately and qualifying widow(er).

Nonresident aliens cannot claim a standard deduction, but are allowed to itemize deductions related to their effectively connected income (ECI). For example, nonresident aliens can deduct charitable contributions, state and local taxes, unreimbursed medical expenses and expenses related to a U.S. business [source: IRS].

Nonresident aliens can also claim other common deductions for expenses like IRA contributions, student loan interest, self-employed health insurance premiums, health savings account contributions and moving expenses [source: IRS].

In most cases, nonresident aliens can only claim one personal exemption, but no exemptions for spouses or dependents. Residents of Mexico and Canada, however, can claim a spousal exemption (if the spouse has no earned income) and dependent exemptions for all qualifying children and relatives. Tax treaties with India and South Korea also allow spousal and dependent exemptions in certain cases [source: IRS].

The IRS enforces tighter limits on late filing for nonresident aliens. U.S. citizens and residents have up to three years to file a late tax return and still claim refunds and tax credits [source: IRS]. Nonresidents have a maximum of 16 months to file a return or forfeit all refunds and credits [source: IRS].

Foreign Students, Diplomats and Entertainers

Green card holders are considered resident aliens and taxed the same as U.S. citizens.
Green card holders are considered resident aliens and taxed the same as U.S. citizens.
Epoxydude/Getty Images

United States colleges, universities and research centers are magnets for ambitious students and scholars from around the world. The federal government recognizes the advantages of having the world's best minds working on American soil. For this reason, the U.S. Department of State extends temporary visas to students and scholars, and the IRS offers certain tax breaks and exemptions to income earned during their stay.

For starters, the IRS allows foreign students, teachers, trainees, employees of international organizations, and diplomats and their families to qualify as nonresident aliens even if they spend more than 183 days in the country. The IRS calls these visa holders "exempt individuals," not because they are exempt from taxes, but because they are exempt from counting days of presence in the U.S. [source: IRS]. That's a huge tax advantage, because nonresident aliens only have to pay income tax on wages earned from U.S. sources.

Secondly, any student, scholar, trainee or diplomat holding a qualified visa is exempt from withholding Social Security and Medicare contributions from their paychecks. Self-employed individuals with the same visas are also exempt from the self-employment tax [source: IRS].

There's a catch when it comes to capital gains tax, though. The tax law says that any nonresident alien residing in the U.S. for 183 days or more is liable for a 30 percent taxation of capital gains [source: IRS]. In this case, there are no exemptions for students, scholars and diplomats. Each day of residence counts toward the total.

Foreign athletes temporarily in the U.S. for sporting events are among the list of "exempt individuals" for counting their days of presence, but that's where the tax breaks end. Both foreign athletes and entertainers are subject to a flat 30 percent income tax withholding on all earnings during their stay, unless they have a really good tax lawyer who can navigate the IRS rules, which even the agency admits are "complex."

For lots more information about tax exemptions and creative (but legal) tax deductions, check out the related HowStuffWorks articles on the next page.

Author's Note: How Nonresident Taxes Work

My family and I lived abroad in Mexico for six years. Two of my children were born in Mexico, but both my wife and I are passport-carrying Americans. While in Mexico, my wife worked for an international school and the staff there handled all of the paperwork for Mexican income taxes. I worked as a freelance writer for American newspapers and magazines, so I didn't bother paying income tax in Mexico. Researching this article, though, I'm starting to wonder if I should have. Sadly, skirting income tax is a proud tradition in Mexico, so it's unlikely that anyone would ever come after me for a few spare pesos. In the meantime, I'll continue to live by my credo: Ignorance of foreign tax laws is bliss.

Related Articles

Sources

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