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How are Resident and Nonresident Aliens Taxed in the U.S., and What Is U.S. Source Income?

By September 21, 2022Immigration
A tree of income and tax resources

The tax consequences of being characterized as a resident alien or a nonresident alien can be significant. As we discussed in that earlier post, a foreign national visiting the U.S. is a resident alien for tax purposes if they meet either the green card or the substantial presence test, meaning that those visiting the United States do not need a green card in order to face significant tax consequences.

Background

In an earlier post, we discussed how the Internal Revenue Service (IRS) characterizes those inside the United States who are not U.S. citizens as either “nonresident aliens” or “resident aliens” for tax purposes. Remember that the terms “resident alien” and “nonresident alien” as used in this post and by the IRS are tax terms, not immigration terms. In this post, we will take a closer look at how resident and nonresident aliens are taxed in the U.S., including what counts as U.S. source income.

How are resident aliens taxed?

Resident aliens are largely taxed in the same way as a U.S. citizen, meaning that their worldwide income is subject to U.S. tax. They must report to the IRS all dividends, interest, wages, income from rental properties, other compensation from services, and any other income, whether or not it originated from within the U.S. Resident aliens are subject to the same graduated tax rates that also apply to U.S. citizens. The graduated tax rates can be found in the Instructions for the IRS Form 1040.

Are resident aliens eligible for any exclusions from their gross income?

Resident aliens might be eligible for certain exclusion from their gross income. If, over a consecutive 12-month period, they are physically present in a foreign country for at least 330 full days, the resident alien could qualify for the foreign earned income exclusion. The exclusion was $108,700 in 2021.

Additionally, a resident alien might be able to exclude or deduct certain foreign housing amounts.

Finally, if a resident alien is a national of a country that has an income tax treaty with the United States, the resident alien might qualify for an exclusion based on that treaty.

How are nonresident aliens taxed?

While resident aliens are taxed on their worldwide income, nonresident aliens are typically taxed only on income they receive from sources within the United States or from trade or business conducted in the United States. In this post, we call this “U.S. source income.”

To determine their tax burden, a nonresident alien will therefore want to determine what portion of their income is U.S. source income.

How can I determine whether income is U.S. source income or not?

The rules for determining whether a source of income is U.S. source income are different depending on the type of income – for example, whether the income is from interest, dividends, wages or salary, rents, a property sale, or another source. Below, we discuss a few of the most common categories of income, and how to determine whether each is U.S. source income. Please note that there are exceptions within each of the categories listed below. Please consult a qualified tax professional to determine whether and how these exceptions apply to you.

Interest

In general, the source of interest income is determined by the residence of the entity paying the interest. As a result, the following sources of interest would be considered to be from a U.S. source (this list is not exclusive or comprehensive):

  • Interest on bonds, notes, or other obligations of U.S. residents or domestic corporations in the United States
  • Interest paid by a domestic or foreign partnership or foreign corporation that is engaged in a U.S.trade or business at any time during the tax year
  • Interest from a U.S. state, the District of Columbia, or the U.S. government

Note that the place of payment or the manner in which the payment is made is not relevant to determining the source of interest income.

Dividends

In general, the source of dividend income is determined by whether the corporation paying the dividend is a domestic corporation (in which case the dividend is U.S. source income) or is a foreign corporation (in which case the dividend is foreign source income).

Income from Rent

In general, the source of income from renting property depends on whether the property is located in the United States. If the property is located in the United States, income generated from renting the property is generally U.S. source income.

Sale of Real Property

Income from the sale of real property (including land, buildings, and other property that is attached to land, for example) is treated similarly to income from the rental of property. Specifically, any gains, profits, or income from real property that is located in the United States is generally treated as U.S. source income. Income from real property that is not located in the United States would generally be foreign source income.

Sale of Personal Property

Whereas real property is generally attached to land, personal property is usually not. Personal property includes, for example, furniture, machines, and equipment.

To determine whether income from the sale of personal property is U.S. source income, it is necessary to determine whether you have a “tax home” in the United States. If you do have a tax home in the United States, income from the sale of personal property is generally U.S. source income; if you do not have a tax home in the U.S., income from personal property is generally foreign source income.

What is a tax home? A tax home is different from your family home, or the place where you live. In contrast, a tax home is where your main place of business or employment is. In other words, it is where you permanently work as an employee or self-employed individual. If you do not have a main place of work or business, your tax home is the place where you usually live (and therefore could be the same as your family home).

Income from Work or Personal Services

In general, any compensation (including a salary or wages) received from services that were performed in the United States is U.S. source income.

If you receive compensation for work performed both inside and outside the United States, you would compute the proportion of your compensation that is U.S. source income by using the “time basis” formula. Importantly, the time basis formula is also applied in most cases of self-employment.

What is the time basis formula? To compute your time basis compensation, you would simply divide the number of days you worked or provided services within the United States during the year by the total number of days you worked or provided services during that year. You would then multiply that number by your total compensation during that same period.

For example, Alex, a resident of Colombia, worked 240 days for a U.S. company during the year, and earned a total of $100,000 for his work. Of these 240 days, he worked within the U.S. for 60 days and in Colombia for the remaining 180 days. To compute Alex’s U.S. source income, he would first divide the number of days he worked in the U.S. (60 days) by the total number of days he worked (240 days). This results in 0.25. Next, Alex would multiply 0.25 by his total compensation for the year, $100,000. This results in $25,000 in U.S. source income.

What about fringe benefits? Fringe benefits are a form of compensation related to work that is generally supplemental and in addition to an employee’s salary or wage. It can include housing (for example, a rented apartment or a hotel room), transportation (for example, a company car), education, subsidized meals, or other benefits. The total income in the time basis formula would exclude the value of any fringe benefits. Instead of using the time basis formula to determine whether any received fringe benefits are U.S. source income, you would apply the “geographical basis.” Typically, this would consider the location of your principal place of work – meaning the place where you spend most of your time at work. If Alex spends most of his time at work in Colombia, for example, the geographical basis test would suggest that his fringe benefits are generally not U.S. source income.

Summary

The IRS has published a helpful table (below) that summarizes the rules used to determine whether a certain type of income is U.S. source income or foreign source income. Again, while this is a helpful summary, it is always recommended that a qualified tax expert be consulted in order to advise on the specific circumstances at issue.

I have determined what part of my income is U.S. source income. How do I figure out my tax rate?

Once you have determined what part of your income is U.S. source income, the next step is to determine whether the U.S. source income is “effectively connected with a U.S. trade or business.” If the income is effectively connected with a U.S. trade or business, it is generally taxed at the graduated tax rates that also apply to U.S. citizens and resident aliens (as mentioned before, the graduated tax rates can be found in the Instructions for the IRS Form 1040). If the U.S. source income is not effectively connected with a U.S. trade or business, it is generally taxed at a flat 30% rate (or at a lower rate if there is a relevant tax treaty). The flat 30% rate can apply, for example, to fixed income, which can include interest, dividends, and certain compensation. Again, it is important to work with a qualified tax professional to ensure that you navigate your circumstances, and how U.S. tax law applies to them.

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