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September 13, 2023 
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0 comments US Taxes For Foreigners - Resident Alien vs Non Resident Alien Tax Differences
In this video we are going to talk about how the USA taxes foreign nationals. There is a difference on how the USA taxes resident aliens from non-resident aliens.
DISCLAIMER
This video is intended for education purposes and should not be taken as legal, financial or tax advice. You should consult with a professional about your unique situation before acting on anything discussed in these videos. Freedomtax Accounting and Multiservices Inc., Freedom Insurance Financial Inc., Freedom Realty Source Inc., and Freedom Immigration International Inc. are providing educational content to help small business owners and individuals become more aware of certain issues and topics, but it cannot give blanket advice to a broad audience. Neither Freedomtax Accounting and Multiservices Inc., Freedom Insurance Financial Inc., Freedom Realty Source Inc., and Freedom Immigration International Inc. nor its members can be held liable for any use or misuse of this content.
Transcription:
Hello from Freedom Group. In today’s video, we are going to be talking about taxes for aliens, but not the aliens that you’re thinking of. The IRS, fortunately, or unfortunately, uses the term aliens to refer to people who are not US citizens or have some status here in the United States. That is the term that we’re going to be using a lot in this video. But there are two different kinds of aliens. There are non-resident aliens and resident aliens. Which one of the two you are has tax implications? We are going to talk about that today and try to clarify. We’re just going to touch the tip of the iceberg because this is a super profound topic. There are a lot of intricacies in the law, and as everybody knows, nothing with the IRS is simple. I am going to share my screen so that you can take a look at a presentation, a PowerPoint. This way, it makes it a little easier if we can see it visually. We are going to touch base right here. We’re going to start with the tax implications of being an alien, a non-resident, or a resident alien. As I said, there are two types.
Here is how you can identify which type you may be. A US resident alien means that the person has a green card. There are two tests that we utilize to determine if you are a US resident alien or non-resident. If you have a green card already issued, then you pass the green card test and you are considered a resident alien. You’re not a citizen yet, but you live here, you reside here, so you are a resident alien. You may not have a green card, but then there’s this thing called the substantial presence test that also is going to help determine if you are a resident alien. If you pass either one of these two tests, you are considered to be a US person for tax purposes, just like us citizens or the people that have a permanent status here in the US. If that is the case, even though you are not a citizen of the United States of America, you are considered a US tax person, and you are taxed on a worldwide income. That’s like a snippet of what a US resident alien is, okay? The non-resident alien is a foreigner who resides outside of the US.
They don’t have a green card. They don’t pass the substantial presence test. Now, these people, are not going to be taxed on their worldwide income. They’re going to be taxed on two different types of US-sourced income, and that is what’s called FDAP, which is an acronym for fixed, determinable annual, periodical income, and ECI. We’ll get into what those types of incomes are shortly. The green card test, we already touched upon, but if you are a lawful permanent resident of the US at any time if you have been given the privilege, according to the immigration laws, of residing permanently here in the US as an immigrant, you generally have the status of the US citizenship and immigration service issued you a permanent resident card, which is also known as the green card. That’s a pretty simple test. Either you have that or you don’t. Now, the substantial presence test is a little bit trickier. This you have to do math to figure out, and that’s not something we all necessarily like to do. But let me try to explain it to you in a simple way so that you can understand it. A lot of foreigners come and go.
They don’t live here, but they come and go to conduct business regardless of what type of business they’re doing. You have to count according to this calculation here. This is calculated over a three-year period. You’re going to take 31 days during the current year. Then you’re also going to look two years prior, immediately prior to this year. We’re looking at 23, 22, and 21. We are going to look at those years and you’re going to count. This year, you’re going to count 31 days. Last year, you’re going to count a third of the days that you were present in the US. Then the year prior to that, you’re going to count a sixth of the days that you were present. I’m sure I’m losing some of you, but let me give you an easier example. You were physically present in the US 120 days in each of these years, ’21, ’22, and ’23. To determine if you meet the substantial presence test, you’re going to count, you were here 120 days in ’23, but only 31 of those days count, okay? Then you’re going to count out of the 120, a third of the days of 120, so 120 divided by three, is 40 days in 2022.
So even though you were here, 120, due to the math, they’re going to count 40 of those days for the substantial presence. Then in 2021, it’s going to be 20 days, which is a sixth of 120. So even though you were present more than those days, the equation is what we’re going to use to determine if you meet the 183 days. Since the total for the three-year period is 180, you are not considered to be a resident under the substantial presence test. Let’s go to the next one. This is going to be a little bit easier than this example to understand. Now, we’re going to look at 2021. You had 120 days. You were here a sixth of that. Or if you want to do a decimal, that’s going to give you 20 days in ’21. In 2022, same 120 days, but we’re taking a third of them or multiplying it by 0.33. That’s going to give you 40 days. In 2023, it says 100%. You were here 120 days, but it only counts 31 of those days. However, even if you count the full 120 in 2023, that’s still 180, and you’re supposed to be at 183.
In this scenario, the person would fail the substantial presence test, which makes them a non-resident alien. All right. So if you do not pass the green card test, if you don’t have one issued to you and you do not pass the substantial presence test, you are considered a US person for tax purposes. Out of all of your income, you’re only taxed on the FDAP and on the ECI income. Stay with me. I’m going to explain what those are in just a second, okay? If you are a US person, then you’re treated just like the citizens are. You have to pay taxes and everything, not only the US but worldwide income as well. Congratulations. Two types of income, FDAP. Here you can see it. It stands for fixed, determinable, annual, and periodic. What do those words mean? We’ll go into it in more detail in just a second. These types of income are taxed at a flat 30%, or if there’s a treaty with your country, it’s going to be taxed at the treaty rate. When you have this type of income, the kicker here is that you’re taxed at 30% and you cannot write off deductions against this type of income.
So no netting is allowed. That’s not necessarily good news. That is a high tax rate. With effectively connected income, this is income that you received during the tax year that is effectively connected to the United States, okay? And this type of income, you are allowed to write off deductions against it, and it’s taxed at the regular graduated rates. So on a personal level, right? The tax rate starts at 10% and goes up to 37%. You may be at 37, but that’s if you’re making a lot of money, which would be great. But if not, typically you’re going to be way under that 30% and you can write off expenses. Effectively, connected income is definitely better to deal with. In order to give you more clarification, you can get all this from the IRS website, but I’ve printed out these sheets so we can review some of the topics. Because again, this goes really deep, but we’re not going to go so deep because I don’t want to lose you guys. I just want you to understand the difference between being a non-resident alien and being a resident alien. Maybe you never knew the difference or the implications of this.
Let’s start with F. Dept income. I’m going to just talk about a few things out here. I’m not going to read through the whole paper because that would be quite boring. But you can definitely go back and read it, read through it, digest it, read it again, and learn it. Let’s start here. Fixed determinable annual periodic is income except gains derived from the sale of real or personal property. This is houses, cars, jewelry, and artwork. Items of income excluded from gross income without regard to the US or foreign status of the owner of the income. This is less common, but such as tax-exempted municipal bond interest and qualified scholarship income. Here’s the really good key paragraph that’s going to help you understand it. Income is fixed when it is paid in amounts known ahead of time. Think about that. Your salary is based on and calculated ahead of time. You know what you’re going to get paid. Whether that’s a commission or a certain flat amount, you know what you’re going to get paid. It is determinable whenever there is a basis for figuring the amount to be paid. For example, per hour, commission, things like that, or an agreement, like a rental agreement.
Income can be periodic if it is paid from time to time. It doesn’t have to be consistently paid month after month or week after week in order to be considered periodic. It could happen here and there. It does not have to be paid annually or at regular intervals as I just said. Income can be determinable or periodic, even if the length of time during which the payments are made is increased or decreased. They’re specifying this so that people don’t try to manipulate how or when people get paid in order for it not to be considered FDAP, because again, FDAP is taxed at 30%. Okay. Tax treatment of FDAP, which is not ECI, is taxed at 30% of the treaties. There are no treaties with every country, but there are treaties with quite a bit, and you can find that information on the IRS website. It applies to the income, the FDEP income, or gains from US sources, but only if they’re not ECI. Now, this is very important because there are a couple of exceptions here. 30% applies or the treaty rate, and it’s applied to the gross amount that you’re getting. Here’s the key, deductions and netting are not allowed against this type of income.
Let’s look at some examples, and I’m going to touch upon the more common ones. The whole list is included, but the more common ones are if you get compensation if you get commissions or you’re paid for your time working for a company, and if you are a non-resident alien, that’s supposed to be taxed at 30%. Actually, the company that’s paying you is supposed to withhold it. It’s not even that they give you all of the money, and then when you do your taxes, you pay 30%. No. It’s supposed to be that if you are working for a company or you are a business owner paying a non-resident alien, you’re supposed to withhold 30% of their pay and pay them the net, and you are the withholding agent. That is another topic in and of itself. You can also see that on the IRS website and you’re supposed to withhold 30% of the gross amount that is due to them. Besides salaries or compensations, you also have in here dividends interest, original issue discounts, pensions, and annuities alimony, and real property income such as rent. This is a big topic because there’s at least here in this area, we’re in Kasimi, Florida, Orlando, Central Florida.
We have so many people who are investing in property and renting it, and that is a type of income that has its intricacies. It could be a sales commission paid or credited monthly. We’re over here. Again, I’m touching on the more common ones. It could be a commission paid on a single transaction. It doesn’t have to be repeated. If it’s paid on a single transaction, it’s able to be calculated beforehand, which is part of the description or the definition. It could be a distribution from a partnership that is FDAP income. Super important. There’s a lot of information here that you can go back and look through. Again, we’re just tapping or scratching the surface here. Many treaties contain provisions that reduce or eliminate taxation on capital gains. The capital gains that we’re talking about, it says it here in case you’re wondering if you sell a house here like a rental property. Let’s see. It says these rules do not apply to the sale or exchange of U.S. Real property interest. That’s where FERP the withholding comes in, and we’ll do other videos on FERPTA. That’s another world—and that’s subject to the sale of any property that is effectively connected with a trader business in the U.S.
S. Those are the highlights of this page, but you can go to the IRS website and read the whole thing. Now ECI. Let’s touch upon ECI a little bit. Effectively Connected Income. Let’s read this one here. This is good. Generally, you must be engaged in a trade or business during the tax year to be able to treat your income received in that year as ECI. You want your income to be considered ECI as much as possible because then the 30% tax rate isn’t at the plate. You usually are considered to be engaged in a US trade or business when you perform personal services in the US. You are personally here providing a service. Whether you are engaged in a trade or business in the US depends on the nature of your activities. Somebody who never sets foot here like an Amazon seller, doesn’t have ECI because they never set foot. They don’t have ECI if nothing connects them to the US. They don’t have an office here if they don’t move here if they don’t have inventory here if they are completely removed from the US, then that is not ECI. So deductions are allowed against ECI, and it is taxed at the graduate rate.
This is better because the graduation rate, like I said, is 10-37. That’s based on how much income you’re earning. You could be taxed at 10, 12, or 18%, but not 30. So that just the tax rate itself is more favorable and the fact that you can write off deductions. Deductions are allowed against ECI, and it’s tax at the graduated rates. That’s definitely a very big thing to consider. Now, the houses, right? A lot of people invest in real estate and they’re going to rent it. There are certain kinds of FDAP income that can be treated as ECI,—and I think the most common one is the rental income. Rental income, as default, is supposed to be FDAP, taxed at 30%. No expense is taken. However, you can elect to have it treated as ECI. Why? Because it says it can be treated as ECI because of the asset use test, this is in the case of rental properties, the income must be associated with the US asset used in or held for use in the conduct of a US trade or business. The house is obviously here in this conducting business in the US. You can elect to have it treated as ECI.
This right here is important too. You are considered to be engaged in a trade or business in the US if you’re temporarily present in the US as a non-immigrant on any of these visas: the F, the J, the M, the Q. The taxable part of any US source, scholarship, or fellowship grant received by a non-immigrant is also treated as ECI. Let’s see what else I highlighted here. If you’re a member of a partnership that at any time during the year is engaged in a trader business in the US, you’re considered to have ECI. The partnerships are usually LCs with two or more people. That’s the most common formal partnership agreement. Let’s see here. You are usually engaged in a US trade or business when you perform personal services in the US. Again, if you’re literally here performing a service, then that is effectively connected to income. This is an important one here, gains and losses from the sale or exchange of US real property interest, whether or not they are capital assets are taxed as if you are engaged in trade or business in the US. You must treat the gain or loss as effectively connected with that trade or business.
That’s a popular one as well. Income from the rental of real property may be treated as ECI if the taxpayer elects to do so. A lot of people just assume that you can deduct it and have it been considered ECI. Most people don’t even know what ECI means, but this is something that you must elect to do. I find this is something that property managers don’t know because the same as what I mentioned about the withholding agents, property managers are supposed to be withholding agents and they’re paying rent to a non-resident alien. They are supposed to withhold 30% of the rent and pay the balance to the landlord or the owner of the house. That 30%, they are responsible for sending that to the IRS. But I see so many people, so many property management reports at the end of the year, and nobody’s withholding the 30%. That’s something to consider. Let’s go back to the PowerPoint. Okay, so disregarded entities. Let’s go back to… Now we’re talking about foreign-owned, sole member, or LLCs. When an LLC has only one member, it’s called a disregarded entity. The business itself does not have a tax filing requirement.
It’s going to fall on the owner. If the owner has a tax requirement, then they have to file their tax 40 and are. Again, this is based on if you’re a resident or non-resident. That’s where all this rests upon. If you do not have any effectively connected income or any income that is considered FDAP, then you have no tax obligation and neither does your LLC because the LLC doesn’t have an obligation. It falls on you. If you don’t have either one of these types of income, then you are not subject to any taxes in the US. This may sound crazy, but it’s true. Amazon sales, for example, or if you own a property outside of the US and you rent it in your country, but you’re using the US LLC as a way to collect money or whatnot, you’re not connected to the US at all. You can make a ton of money and not have to file or pay taxes. It’s crazy, but that’s how it works. For small member LLCs, again, if you don’t have any ECI or FDAP, you don’t have a tax requirement, but you must file 1120 pro forma with form 5472 every year.
Now, what is this? 5472 is a form that must be presented to the IRS with information on any majority owner or sole owner if they’re a foreigner of an LLC. This is the case with partnerships and corporations too. But as a sole member, you’re guaranteed to need to do it because you’re the only member and you’re a foreigner. That form cannot be submitted to the IRS by itself. You have to include it in 1120, which is the tax return for a corporation. However, the IRS calls sole member LLCs that are foreign-owned. They’re not considered disregarded entities. They’re considered corporations for this purpose of the information filing. This is something that even though you don’t have to do a tax return, you have to file the 1120 pro forma, which is basically the first five pages of the 1120 with information regarding the business address, EIN, information on the owner, and any contributions or distributions that the owner has put or taken out. That’s it. But it’s not to calculate tax or anything. It’s just information. There are big fines and penalties for not doing so. There are big penalties, a $25,000 penalty, and the due date to do this every year is April 15.
Now, to be honest, the IRS has not been very proactive about calling people out that don’t do this. We’ve never seen a case, and we have many foreigners as clients. However, because the IRS is changing their tune and they are increasing the number of audits that are being done, we have to tighten things up. If you haven’t been doing this, know that this is a requirement if you are a non-resident alien. If you’re a resident alien, again, you’re in our boat and you have to file taxes on all your money, so there’s no question there. That’s easy. The non-resident alien is a sensitive or intricate topic. Back to the rental income. If you are an individual who owns a house in your name or you have a sole member of LC and you have a rental property, Schedule E with expenses is typically where you want to report rental income, right? That’s how it works. But it’s not automatic. Again, rental income is considered FDAP, and it’s supposed to be taxed at 30%. There’s no space there to write off your expenses. It actually goes into the tax return in another section that doesn’t go into Schedule E.
Now, you can elect for the rental income to be ECI with a written statement. It has to be submitted with the tax return stating, and this you only have to do one time. You have to submit a statement stating that you intend to use this property that is in the US and is producing ECI to be taxed as ECI. That way you can write off all your deductions and you can be at the graduated tax rates. As I said before, property managers are supposed to withhold the 30%. Unless, say you do buy a property and you are dealing with a property manager who actually is going to withhold the 30%, and you’re like, Wait a minute. No, I have the intention of getting this treated as ECI. Then you would have to fill out a form W-8 ECI and give it to the property manager so that they don’t withhold. But I see very few property management companies doing this. What happens if you haven’t done it? If you have not included these statements in your tax return electing to have that rental income treated as ECI, you can include it now like this year, and go back three years from the due date or two years from the year the tax was due.
You can file, we’re coming into soon 2024, and we’re going to be filing 2023’s taxes. You can include the statement in 2023’s taxes and include ’22 and ’21. Audits are going to be on the rise. We’ve already seen one come in. You need to be proactive about this, you need to be aware and you need to make the right steps to ensure that if you are audited, you’re not going to be found to be owing the 30% tax on the rental income. The good news is that one of the auditors that we spoke to in the IRS said that this is something that they haven’t done in the past because they lack manpower, honestly, but now they’ve hired a lot of new agents, a lot of new auditors. However, they’re not going to go back and audit you six years ago for your rental income. If they audit you, they’re going to audit you in this year, last year, more recent years, okay? That’s where that number one bullet point there, that first one that says you can file it this year and make it effective going back a total of three years. That’s good. If you haven’t been doing it with this year’s tax return, go ahead and include that statement and word it to be effective three years back, okay?
If electing ECIs is a treatment for rent, that is. Electing ECI allows you to use deductions and expenses, but you can’t slack on filing your taxes. Some people, don’t do their taxes right away by June 15th, which is the deadline for 1040 an hour. Some people drag their feet and they wait for whatever reason. You have 16 months from the due date to file your return to be able to elect this. If you have a 2021 tax return and you still haven’t filed that year’s taxes, you’re disqualified from it being ECI, even if you write the statement because you’re outside of the 16 months from the due date. Don’t drag your feet, file your taxes. Make sure you’re on time. Make sure you have that statement because if not, they’re going to disallow it or they’ll allow it in the moment because when we submit taxes to the IRS, they’re going to accept it. But if they audit, they’re going to come back and find you were not eligible to use expenses that year. That’s the time frame they get 16 months from the due date of that tax return. For 2023, the due date is June 15.
You have 16 months from that date to file your 2023 taxes and still be able to elect ECI status. There’s an exception for the 16-month rule, and that is if the IRS ends up catching what you’re doing and sends you a letter 10 months from the due date instead of 16 months, then you can no longer use it. Say you get the letter and then you want to go ahead and contact your account and file your taxes, it’s too late. You can’t use your expenses. Once you get that letter, it’s too late, even if it’s under 16 months. Be careful about that. There’s so much to learn. We’re going to keep putting videos out because it’s murky waters. It’s very difficult to understand sometimes, and it’s so much easier if somebody’s just digesting it and giving it to you in layman’s terms. We’re doing our best to put out these videos, as we have for years, to further help and inform the community to make sure you do things the right way. We want to help you avoid problems and make sure that you’re filing on time, however, using all the deductions that are legally available for you to pay the least amount of tax as possible.
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