The ABC’s Of Immigration – Tax Obligations For Foreign Students
[This week we are pleased to present a guest ABC’s article by international tax guru Steven Weister. This article on tax issues for students complements nicely the recent series of articles we've been running on work options for F-1 students. Note that questions on the topic should be directed directly to Steven at the email address below rather than to us.]
Steven Weiser is a tax lawyer with a practice focusing on international tax matters. His contact information and information on his practice can be found on his web site at http://www.lw-law.com/.
Among those of us who never pursued an overseas education it is difficult to imagine the concerns and anxieties foreign nationals face when pursuing a higher education in the United States. Taxes are probably the last thing such students are concerned about, but when that first paycheck, scholarship check or loan disbursement check is received and taxes are withheld the student is left wondering where all his or her money went. Unfortunately, taxes are a fact of life and all students will eventually have to deal with them either during or after school. Having a basic understanding of the impact U.S. tax laws may have on a foreign student can help to alleviate some of the anxieties, concerns or questions that might surface later on.
When considering the impact U.S. income taxes may have on such a student, the analysis should always begin with determining whether the student is a “resident alien” or “non-resident alien” for U.S. tax purposes. The analysis is important primarily because the U.S. employs different methods for taxing resident and nonresident aliens.
Resident Alien vs. Nonresident Alien
An individual who is not a U.S. citizen is classified as a resident alien if he or she meets (i) the lawful permanent resident test, (ii) the substantial presence test or (iii) such alien elects to be treated as a resident. The lawful residence test is fairly straightforward in its application. Generally, this test is satisfied if the person has obtained a green card (hence, the lawful permanent resident test is also known as the “green card test”).
The substantial presence test is a bit more complicated in application. Under this test an individual is treated as a resident alien if such individual is present in the U.S. (i) for at least 31 days during the current year, and (ii) for a total of 183 “adjusted” days during the current and two preceding calendar years. For purposes of applying the 183-day test, a day of presence in the U.S. during the current year counts as a full day; a day of presence in the preceding year counts as 1/3rd of a day; and, a day of presence in the second preceding year counts as 1/6th of a day. This can best be summarized through the following example:
X, an alien individual, is present in the U.S. for 122 days during 2000, 122 days during 2001, and 122 days during 2002. X was not a permanent lawful resident of the U.S. during any of those years and was not present in the U.S. in any year prior to 2000.
X is not a resident for 2000 because X is present on only 122 days during that year and the preceding two years. X is not a resident for 2001 because the total period of residence for 2000 and 2001 is 162 2/3 days (122 days in 2001, and 40 2/3 days in 2000). X is a resident for 2002 because she was present in the U.S. for at least 31 days in 2002, and was in the U.S. for 183 days during 2002 and the preceding two years (122 full days in 2002, 40 2/3 days in 2001, and 20 1/3 days in 2000).
Since most school years begin in August or September, it is likely that most foreign students will not meet the substantial presence test during the first tax year they are in school. Physical presence in the U.S. from August 1 through December 31 only totals 153 days.
Nor will many of these students every meet the substantial presence test due to special exceptions to the substantial presence test, including one that allows “exempt individuals” to exclude certain days of presence from the above calculation. Exempt individuals include certain teachers, trainees or students. To verify exempt individual status Form 8843 should be filed with the Internal Revenue Service (Philadelphia Service Center).
An exempt teacher, trainee or student is an individual temporarily admitted to the U.S. as a nonimmigrant under specified provisions of the Immigration and Naturalization Act, more particularly, “F,” “J” and “M” visa holders and their immediate family members. The individual must substantially comply with the terms of such visas. Failure to comply with the terms of these visas, or engaging in activities considered prohibited by the Immigration and Naturalization Act can result in the loss of exempt individual status. Furthermore, the Internal Revenue Service has been granted the power to make an independent assessment as to whether an individual has complied with the terms of the individual’s visa. Unauthorized employment or not being engaged in a course of full-time study may be treated as a failure to comply with the individual’s visa requirements even if the Immigration and Naturalization Service has not sought to revoke the individual’s visa.
An individual may not exclude days of presence as an exempt teacher or trainee if the individual has been exempt as a teacher, trainee or student for any part of two of the prior six calendar years. In the case of a temporary F or J visa holder whose compensation is paid by a foreign employer, the preceding sentence is modified by providing that the individual may not exclude days of presence if the individual has been exempt as a teacher, trainee or student for any part of four of the prior six calendar years.
Y is temporarily present in the U.S. during the calendar year as a teacher. Y holds a “J” visa, and has not received compensation from a foreign employer. Y was treated as an exempt student for two of the prior six calendar years. Even if this is the first year that Y seeks exempt individual status as a teacher, Y will not be an exempt individual because Y was exempt as a student for at least two of the prior six years.
An individual cannot exclude days of presence as an exempt student if the individual has been exempt as a teacher, trainee or student for any part of more than five calendar years, unless the approval of the Internal Revenue Service (“IRS”) is obtained. Generally, the IRS wants to insure that the individual does not intend to reside permanently in the U.S. Factors important to the IRS in making this determination include whether a student has maintained a closer connection with another country and whether the individual has taken steps to secure a green card.
Finally, if an individual fails both the “green card” and substantial presence tests, the individual can make an election to be treated as a resident. To qualify for the election the individual must not have been a resident during the prior calendar year and must be a resident under the substantial presence test for the following calendar year. The individual must also meet several minimum presence tests during the year of election as well. Most foreign students should not attempt to make this election, as it will ordinarily have adverse tax consequences. Students often prefer nonresident alien status on account of the associated exemption from employment taxes (see below).
If residency status changes during a year the individual effectively has two tax years, one as a nonresident and one as a resident. If an individual acquires a green card during a year (but does not meet the substantial presence test) resident status begins on the first day of U.S. presence as a lawful permanent resident. Similarly, if the substantial presence test is met, residency generally begins on the first day of U.S. presence. In the case of an individual making the election to be treated as a resident, the residency starting date is the first day of the calendar year of which the individual is treated as a resident.
Okay, So I Know That I Am A Resident or Nonresident Alien, But What Does That Really Mean?
Foreign students who are treated as resident aliens are taxed on their worldwide incomes in a manner identical to that of U.S. citizens. Annual income tax returns must be completed and income tax should be paid to the U.S. government.
On the other hand, the process of taxation is entirely different for individuals treated as nonresident aliens. Two separate U.S. income tax regimes apply to nonresident aliens. The first regime applies to certain limited types of U.S. source income that are not effectively connected with a trade or business operated within the U.S. The second regime applies to income that is effectively connected with the conduct of a U.S. trade or business. It should be noted from the outset, that the terms of most student visas prohibit students from engaging in work for wages or salaries, or from engaging in business while in the U.S. Nevertheless, for tax purposes nonresident alien students admitted to the U.S. under F, J or M visas are always considered engaged in a U.S. trade or business. Although on first glance this hardly seems logical, the rule is actually designed to work for the benefit of such students by placing them in a position that is more tax advantageous.
Income of a nonresident alien that is not effectively connected with the conduct of a U.S. trade or business is generally exempt from U.S. income tax unless it is from sources within the U.S. and falls within the definition of “fixed or determinable annual or periodical gains, profits, and income” (otherwise known as “FDAP”). FDAP includes wages and compensation, interest, dividends, rents and royalties received from U.S. sources, but does not include capital gains and other income realized from the sale of property. The tax on FDAP is applied at a flat rate of 30 percent and is usually collected by the payor of income who withholds this tax from the nonresident alien and remits the tax to the Internal Revenue Service (“IRS”). The tax is applied against the gross amount of income, meaning that no deductions are allowed in arriving at the taxable amount.
Salaries, wages and compensation from U.S. sources are included in FDAP and payments of such to nonresident aliens are subject to either (i) the 30 percent withholding tax, or (ii) wage withholding on the same basis as U.S. citizens and residents. Wages, salaries and compensation are U.S. source if such payments relate to services performed in the U.S. However, if such compensation does not exceed $3,000 for a tax year the income is treated as foreign source, and not subject to withholding, if (1) the nonresident is temporarily present in the U.S.; (2) the nonresident is not present in the U.S. for more than 90 days during the tax year; and (3) the employer is either a foreign person not engaged in business in the U.S., or is a foreign office of a U.S. employer. Most students will fail to qualify for this exemption. Still, because the performance of services in the U.S. generally gives rise to the existence of a U.S. trade or business (and because nonresident student aliens holding F, J or M visas are always considered engaged in a U.S. trade or business), payments for such services are often not subject to the withholding tax and are instead taxed under the effectively connected income rules (see below).
Many students are surprised to learn that their scholarships and grants may be includable in FDAP income. Taxable scholarships and grants received by nonresident aliens are subject to the withholding tax if the payor of the scholarship or grant resides in the U.S.; however, the rate of tax is reduced to 14 percent. Generally, scholarships and grants are taxable to the extent not used for qualified expenses, which include tuition and fees required to enroll in school. Therefore, amounts used for living expenses are generally taxable. To the extent a scholarship or grant is provided by your educational institution, the school may actually withhold tax from that portion of the scholarship or grant payable towards expenses such as room and board.
Income of a nonresident alien that is effectively connected with the conduct of a U.S. trade or business (otherwise known as “effectively connected income” or “ECI”) is subject to taxation on a “net basis,” meaning that the nonresident may take into consideration certain allowable deductions when computing taxable income. Additionally, tax is payable following the close of the tax year at normal, graduated tax rates, as opposed to having it withheld at the time of payment at a flat 30 percent rate.
Ordinarily, a U.S. trade or business exists if profit oriented activities are carried on directly or through agents, on a regular, substantial and continuous basis in the U.S. The performance of personal services in the U.S. at any time during a tax year is a U.S. trade or business. A limited exception identical to that under the FDAP rules above, applies for nonresident aliens in the U.S. for short periods of time that provide limited services ($3,000 or less). The ECI analysis can be very complex and a qualified tax professional should always be consulted when dealing with these rules.
Items ordinarily included in FDAP are instead treated as ECI if one of two tests is satisfied. The first test is satisfied if the FDAP type income arises from assets used or held in the conduct of the U.S. business. The second test is satisfied if the activities of the U.S. trade or business were a material factor in producing such income. Ordinarily, nonresident students admitted to the U.S. under F, J or M visas that receive income from wages, tips, scholarships and grants are subject to tax as if such income is ECI.
Many students find it necessary if the terms of their visas allow, to finance their education, at least in part, with a paying job. Generally, services performed as a nonresident alien admitted into the U.S. under a F, J, or M visa are not covered under the U.S. social security program if the services are performed in accordance with the terms of the visa. These individuals are exempt from social security and Medicare withholding taxes, a point often missed by many employers and employees (especially off-campus employers). Employment taxes are always withheld in cases in which services performed are not for the purpose for which the student was admitted to the U.S.
All students treated as resident aliens are, however, covered under the social security and Medicare programs and subject to withholding and employment taxes, unless a tax treaty between the U.S. and student’s home country provides an exception.
What Tax Forms To Complete and When
Resident and nonresident aliens file different types of income tax returns. Resident aliens complete Forms 1040, 1040A or 1040EZ, the same forms completed by U.S. citizens. The due date for filing such returns is April 15 of the year following the year in which income was earned (e.g., April 15, 2004 for the tax year ending December 31, 2003). Automatic extensions to June 15 are granted to a resident alien residing outside the U.S. on April 15. Additional extensions to August 15 can be obtained by filing Form 4868 with the IRS.
Nonresident aliens needing to file tax returns should use Forms 1040NR or 1040NR-EZ. Returns should be filed if a nonresident alien was considered engaged in a U.S. trade or business; therefore, students admitted to the U.S. under F, J or M visas should always file a tax return. Nonresident aliens that were employees and subject to U.S. income tax withholding should file their returns by April 15. Nonresident aliens that were not employees receiving income subject to income tax withholding should file a return by June 15.
In all cases, failing to file a tax return by the due date, may result in the denial of allowable deductions and tax credits, thereby potentially increasing the amount of any tax liability.
Students departing the U.S. permanently should generally file a special Form 1040-C.
Residents and nonresident aliens should always let their employers know of their status. Resident aliens should file IRS Form W-9 with their employers. Nonresident aliens should provide their employers with Form W-8233 or Form W-8BEN to establish that they are foreign persons. All employees should provide their employers with a Form W-4 (click here to view Form W-4 in pdf format: http://www.visalaw.com/03may2/w4.pdf). In the case of nonresident aliens, the W-4 will establish that taxes should be withheld at the same graduated rates as resident aliens and U.S. citizens. Special rules apply to nonresidents filing out Forms W-4. All nonresident aliens should (i) claim single status on Form W-4 (regardless of actual marital status), (ii) claim only one allowance on line 5 (except residents of Canada, Mexico, Japan or South Korea), (iii) request that the employer withhold an additional $7.60/week on line 6, and (iv) do not claim “Exempt” on line 7.
All tax forms can be obtained from the IRS website (http://www.irs.gov/).
The Effect of Tax Treaties
The U.S. has income tax treaties in effect with many countries. If you are a resident or citizen of such a country you may qualify for certain benefits that reduce or eliminate the need to withhold income or employment taxes. For example, the tax treaty between the U.S. and the People’s Republic of China provides the following:
A student, business apprentice or trainee who is or was immediately before visiting [the U.S.], a resident of the [P.R.C.] and who is present in the [U.S.] solely for the purpose of his education, training or obtaining special technical experience shall be exempt from tax in the [U.S.] with respect to:
(a) payments received from abroad for the purpose of his maintenance, education, study, research or training;
(b) grants or awards from a government, scientific, educational or other tax-exempt organization; and
(c) income from personal services performed in [the U.S.] in an amount not in excess of 5,000 United States dollars or its equivalent in Chinese yuan for any taxable year.
The benefits provided under this Article shall extend only for such period of time as is reasonably necessary to complete the education or training.
Treaty provisions are not limited to simply determining whether income is taxable in one country or not. They may also provide special rules for determining whether the individual is considered a resident alien or not. Also, treaty provisions often reduce the rate at which taxes are withheld upon the payment of certain types of income.
Students wishing to take advantage of treaty benefits should file Form 8233 with their employers to reduce or eliminate the withholding of income taxes. Students must also attach a statement to Form 8233. Examples of these statements can be obtained from IRS Publication 519 (available through the IRS website). The same documentation should be use for students receiving otherwise taxable scholarships and grants.
Alien students with U.S. source income should always consider consulting with a qualified tax professional as the tax rules affecting these students is unfortunately very complex. Generally, in the case of nonresident students admitted to the U.S. under F, J or M visas, income taxes on wages, salaries and even scholarships are often due and annual tax returns should be filed. Students may be exempt from the payment and withholding of employment taxes. Always consider and determine if a tax treaty exists between the U.S. and a student’s home country, as such treaty may provide additional tax benefits.
Lastly, the IRS has made available Publication 519, a U.S. tax guide for resident and nonresident aliens. This publication is highly informative and should be reviewed by all students prior to entry into the U.S. Publication 519 is available through the IRS website.
Disclaimer: This newsletter is provided as a public service and not intended to establish an attorney client relationship. Any reliance on information contained herein is taken at your own risk.