Chapter 2 – Nonresident Aliens

Filing Status

Individuals who are nonresident aliens at any time during the tax year normally are not eligible to claim head-of-household status and generally may not file a joint tax return with a spouse.

Unmarried individuals must use one of the applicable “single” filing statuses and compute tax on their income effectively connected to a U.S. trade or business using the tax table or rate schedule applicable to single individuals.

Married individuals must use one of the applicable “married” filing statuses and compute tax on their income effectively connected with a U.S. trade or business using the tax table or rate schedule applicable to married filing separate individuals.

Personal Exemptions

Nonresident aliens may, in general, only claim one personal exemption when computing tax on income effectively connected to a U.S. trade or business.  Under certain circumstances, however, nonresident aliens from Mexico, Canada and South Korea may be eligible to claim additional exemptions for a spouse and/or a dependent child.

For high-income taxpayers, the amount allowed to be claimed for personal exemptions is reduced by 2% for every $2,500, or part of $2,500, the taxpayer’s income is above a statutory threshold.  The applicable threshold is determined by one’s filing status.

Note:  Personal exemptions for a spouse or qualifying dependent may only be claimed if such person is not being claimed as a personal exemption by someone else.

Income Subject to U.S. Taxation

Nonresident alien status individuals are typically subject to U.S. tax on income from U.S. sources.

Sourcing of Income

The “source” of income is, in general, determined by referencing the geographic location where the related services were performed or where the income-producing asset was located.  The location from which the income is paid or when the income is paid is not a relevant factor in determining the sourcing of income.


Example:

Jan, a German citizen, is employed and paid by a German company and earns annual compensation equivalent to US$100,000.  During the tax year, John works 40% of the time in Germany and the other 60% in the United States.  Assuming John’s wages are earned evenly throughout the tax year, John would have US$60,000 of U.S. sourced income (US$100,000 X 60% = US$60,000) and US$40,000 of German sourced income (i.e., non-U.S. sourced) during the tax year.


Taxation of U.S. Source Income

Once the U.S. source income has been calculated, the manner in which it is taxed depends on the category of income it is.  There are two categories for U.S. sourced income:

  1. Income Effectively Connected with a U.S. Trade or Business

(i.e., compensation and business income)

And

  1. Income Not Effectively Connected with a U.S. a U.S. Trade or Business

(i.e., investment income).

The term “trade or business” has never been unequivocally defined in U.S. tax law.  In general, however, its meaning as it relates to nonresident aliens depends on the nature of the activities undertaken and economic interests within the United States.

Income Effectively Connected with a U.S. Trade or Business

Nonresident aliens are taxed separately on income arising from the activities of—or assets used in—a U.S. trade or business. This income, less allowable deductions, is taxed at the graduated rates that apply to U.S. citizens and resident aliens.

Examples of income effectively connected with a U.S. trade or business typically include:

  • Compensation received for personal services,
  • Profits from the operation of a business within the United States,
  • Income from a partnership engaged in a U.S. trade or business,
  • Income from real property operated as a business,
  • Income from real property held for investment (e.g., a residential rental property) IF a special election is made to treat the income from such property as business income,
  • Income from the sale or disposition of U.S. real property interests and,
  • Income from the sale of certain business-related capital assets.

Note:  If an individual is no longer engaged in a U.S. trade or business but continues to receive income effectively connected to that business, the income the individual receives may still be considered effectively connected and taxed accordingly.

Adjustments and Deductions from Effectively Connected Income

Unlike the flat tax on gross income not effectively connected with a U.S. trade or business, the tax on effectively connected income is applied to a nonresident individual’s net taxable income.

The adjustments and deductions available to a nonresident alien in computing his or her net taxable income are, however, limited compared to those available to a U.S. citizen or resident alien.

Below is a listing of the potential adjustments and deductions a nonresident may claim if qualified to do so.

Adjustments
  • Educator expenses
  • Health savings account contributions
  • Moving expenses
  • Deductible part of self-employment tax
  • Certain self-employed retirement plans
  • Self-employed health insurance costs
  • Penalty on early withdrawal of savings
  • Scholarship and fellowship grants
  • Individual Retirement Account (IRA) contributions
  • Student loan interest
  • Domestic production activities
Itemized Deductions
  • State and local income taxes paid
  • Gifts to U.S. Charities
  • Casualty and Theft Losses
  • Job Expenses and Certain Miscellaneous (If exceeds of 2% of individual’s adjusted gross income)
  • Other Miscellaneous Deductions

Most adjustments and deductions may only be claimed to the extent they are connected with the effectively connected income.  Also, certain adjustments and itemized deductions may be disallowed if an individual is a high-income earner or fails to file his or her personal income tax return in a timely manner.

Note:  The Standard Deduction is not allowed to nonresident aliens.  See Chapter 3 – Resident Aliens for definition of the Standard Deduction.

Income Not Effectively Connected with a U.S. Trade or Business

A nonresident alien’s U.S.-source income that is not effectively connected with a U.S. trade or business is taxed at a flat rate of 30%.  This tax rate is applied to gross income; no deductions are permitted in arriving at the taxable portion of this category of U.S. source income.  The provisions of an income tax treaty, if available, may reduce the applicable tax rate, however.

Examples of income not effectively connected with a U.S. trade or business typically include:

  • Alimony received from a U.S. resident,
  • Dividends,
  • Gambling winnings (exceptions exist),
  • Interest income, including certain original issue discounts,
  • Rents and royalties from investment properties and,
  • S. Social Security (85% of certain benefits).

Exceptions

Interest income is excluded from U.S. taxation if it is from:

  • Deposits (including certificates of deposit) with persons in the bank business.
  • Deposits or withdrawable accounts with mutual savings banks, cooperative banks, credit unions, domestic building and loan associations and other savings institutions chartered and supervised as savings and loan or similar associations under U.S. federal or state law.
  • Amounts held by an insurance company under an agreement to pay interest on them.
  • Obligations of a state or political subdivision, the District of Columbia or a U.S. possession.
  • Other obligations qualifying as “portfolio interest”.

Capital Gains

Except in the case of real property investments, a nonresident alien’s U.S.-source net capital gains (i.e., capital gains in excess of capital losses from the sale of investment/personal property) are not subject to U.S. taxation.  The general exemption for capital gains applies regardless of the number of transactions or amount of gain realized during the year.

Exception

Nonresident alien students and scholars as well as alien employees of foreign governments and international organizations who, at the time of their arrival in the United States, intend to reside in the United States for longer than 1 year are subject to the 30 percent taxation on their capital gains during any tax year (usually calendar year) in which they are present in the United States for 183 days or more, unless a tax treaty provides for a lesser rate of taxation.  The 30% nonresident alien tax applies to such individuals even if they are nonresident alien status under the substantial presence test.

Payment of Nonresident Alien 30% Tax

The United States has extensive withholding provisions to ensure the collection of income taxes imposed on nonresident aliens. Ordinarily, the 30% (or lower treaty rate) will be deducted from payments made to the nonresident alien.  If withholding is not deducted at source, the nonresident alien must file a tax return and pay the tax due.  Otherwise, the withholding agent (the person paying the income) is liable for the tax.  A tax return may be filed after year-end to request a refund of excess withholding.

Tax Credits

In general, nonresident aliens are eligible to claim the same credits against income tax as resident aliens.

Income Tax Treaties

Most tax treaties will either eliminate or reduce withholding requirements on U.S. income, such as dividends, interest, and royalties, received by nonresident aliens. Therefore, the applicable treaty, if any, should be reviewed to determine whether the flat 30% tax rate is reduced for the specific type of income.  It is also necessary to establish that the recipient is a qualified resident of the treaty partner country.

Tax treaties may also exempt nonresident aliens from U.S. taxation on the following types of income:

  • Compensation received from a foreign employer that is not engaged in a U.S. trade or business if the employee is in the United States for fewer than 183 days. Some treaties also contain a dollar threshold for tax exemption.
  • Pensions from former foreign employers.
  • Compensation and pensions received by teachers who are temporarily in the United States.
  • Foreign income received by students and trainees who are in the United States for maintenance, training, and education.