Who is Subject to U.S. Taxation?

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    Marion A. Keyes,

    A number of U.S. citizens have arrived in Costa Rica with the mistaken belief that living or working in a foreign country relieves them of their ongoing obligations to file tax returns and remit taxes to the U.S. Internal Revenue Service.  Not so.  The long arm of the “Taxman”[1] reaches further than you might think.

    From the perspective of the U.S. Internal Revenue Service, international transactions are grouped into two broad categories, outbound and inbound transactions.  The term “outbound transactions” refers to U.S. residents and citizens doing business and investing abroad whereas “inbound transactions” refers to foreign taxpayers doing business and investing in the U.S.

    The taxation of outbound transactions is relatively simple.  The worldwide income of U.S. citizens and residents – wherever they may currently reside – is taxed at the same rates as taxpayers who reside in the U.S.[2] Included within this category are corporations created or organized in the U.S., and nonresident aliens who are treated by the IRS for tax purposes as being U.S. residents.

    There are three ways that a Costa Rican citizen will be deemed to be a U.S. resident for U.S. tax purposes: 1) filing an application for a U.S. “Green Card,”[3] 2) affirmatively making an election on an IRS Form 1040NR.[4] or 3) meeting the elements of the “Substantial Presence Test.”[5]

    1. With respect to filing an application for a Green Card, the IRS has decided that this is a sufficient enough nexus to the United States that an individual should be be taxed as a U.S. resident.
    2. It should similarly not come as a surprise that the IRS will tax your income as a U.S. resident if you affirmatively make an election with the IRS to be taxed in this manner.
    3. The “Substantial Presence Test,” however, is a bit more slippery.  Under the Substantial Presence Test, a Costa Rican citizen would be taxed by the IRS as a U.S. resident if they are physically present in the U.S. for: a) at least 183 days in a taxable year; or 2) at least 31 days in a taxable year, and they are present in the U.S. for a total of 183 days over a three-year period.  The three-year, 183-day calculation is based on each day in the current year counting as a full day, each day present in the first preceding year counting as 1/3 of a day, and each day in the second preceding year counting as 1/6 of a day.[6] This mechanical formula has trapped a number of unwary businesspersons working on medium-term projects in the U.S. who had no intention of becoming U.S. citizens and were surprised to find out that the IRS treated them as U.S residents.

    The reason why it is important to determine if a person is a U.S. resident or a nonresident is that they will be subject to different tax regimes by the IRS.  If a taxpayer is deemed to be a U.S. resident, then they will be taxed the same as a U.S. citizen.  If, however, an individual is a non-resident, then they will only be taxed on their U.S. source income.

    With respect to “inbound transactions,”  if a nonresident individual is engaged in a U.S. trade or business, then income that is effectively connected to that trade or business is subject to tax at the standard U.S. graduated tax rates on a net basis (after deductions and credits reduce Gross Income to Taxable Income).[7] If the income is not attributable to a U.S. trade or business, and it is U.S. source income – usually passive income – then the income is subject to U.S. tax on a gross basis (currently set at 30%).[8]

    With these basic rules in mind, an individual or business should have a better idea of whether or not they are subject to U.S. taxation.

    Let me tell you how it will be

    There’s one for you, nineteen for me

    ‘Cause I’m the taxman …[9]

    Marion A. Keyes is a U.S.-based tax attorney who focuses on International Taxation, Asset Protection, and Estate Planning.  He speaks English and Mandarin Chinese fluently and has enough Spanish that he has talked his way out of Costa Rican speeding tickets on no less than three occasions (“Me encanta este pais.”).  Marion can be contacted via his website at where he blogs on a number of tax law issues.

    [1] Kudos to the late George Harrison and his 1966 Beatles’ song, “Taxman.”

    [2] In a later article, I will explore the ameliorating effects of the U.S. Foreign Tax Credit, the limits on methods of depreciation available for property used outside of the U.S., and other differences.  For now, it is helpful to understand that the starting point, i.e., “Gross Income,” is the same.

    [3] 26 U.S.C. § 7701(b)(1)(A)(iii) and (4).

    [4] 26 U.S.C. § 7701(b)(1)(A)(iii) and (4).

    [5] 26 U.S.C. § 7701(b)(1)(A)(ii).

    [6] There are some exceptions to this test found at Internal Revenue Code, Section 7701(b)(3)(B) and some rules for how to count days found at Internal Revenue Code, Section 7701(b)(7), but this is the broad brushstrokes outline for the Substantial Presence Test.

    [7] 26 U.S.C. § 871(b).

    [8] 26 U.S.C. § 871(a).

    [9] Harrison, George. “Taxman.” Revolver. Capitol Records. 1966.

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