Leave the USA, Cash In, and Come Back? Here's a Gotcha For You

Leave, cash in your gains, and return

We see people toggle from U.S. resident to nonresident and back to resident status. They do this so they can harvest large income items or capital gains as a nonresident of the USA, thereby avoiding U.S. income tax.

What IRC §7701(b)(10) says

Just so you have it handy, here is the offending Code section, IRC §7701(b)(10):

IRC §7701(b)(10) applies only to non-U.S. citizens (“aliens” in tax law lingo) who follow a specific pattern:

1. Become U.S. tax residents;
2. Leave the U.S. and become U.S. tax nonresidents; and then
3. Become U.S. tax residents again within a specified timeframe.

How to analyze your exposure to this risk

Here is a seven-step procedure to determine whether you have a tax problem under IRC §7701(b)(10).

Step 1: You are an alien

You must be a non-U.S. citizen (an “alien” in tax terminology).

Step 2: You are a resident alien

You are a “resident alien” for U.S. tax purposes, meaning you satisfied either:

• The substantial presence test (IRC §7701(b)(1)(A)(ii)); or
• The green card test (IRC §7701(b)(1)(A)(i)).

Step 3: You were a resident alien in three consecutive calendar years

You must have been a resident alien for at least one day during each of three consecutive calendar years (the “initial residency period”). IRC §7701(b)(10)(A) says (emphasis added):

This is subtle. You can satisfy this requirement in 367 days:

Step 4: Identify your residency termination date

We need to know when your initial residency period ended.

Determine the last day you were considered a resident alien during your initial residency period, using the residency termination rules in IRC §7701(b)(2)(B) and the accompanying regulations.

Step 5: Calculate the safety buffer period end date

After your initial residency period ends, you must remain a nonresident for a definite amount of time to be safe from the U.S. income tax as mandated by IRC §7701(b)(10). Let’s arbitrarily call this the safety buffer period.

The Code uses stilted language, but read it slowly and it’s easy to understand what it means. IRC §7701(b)(10)(B) says (emphasis added):

Look at your residency termination date. In my example, it is January 2, 2024. Now look for the first calendar year that begins after January 2, 2024. Duh, it’s 2025.

So the second calendar year beginning after the close of the initial residency period is 2026, and the third is 2027.

Calendar years always end on December 31, so in my example, the close of the third calendar year beginning after the close of the initial residency period is December 31, 2027.

Step 6: Determine your residency recommencement date

At some point you return to the United States and recommence your status as a resident alien for income tax purposes. You either spend too many days in the United States (substantial presence test) or you get a green card (lawful permanent resident), so you’re a resident alien.

The rules for determining your residency commencement date can be found in IRC §7701(b)(2)(A) and the companion regulations.

Write down that date.

Step 7: Compare safety buffer period end date to residency recommencement date

If you became a resident alien again (Step 6) before the closing date of the three full calendar years after your initial residency period ended (Step 5), then IRC §877(b) applies to you during your entire nonresident period.

IRC §7701(b)(10), flush left text says (emphasis added):

If you became a resident alien again (Step 6) after the closing date of the three full calendar years after your initial residency period ended, then you are safe. IRC §877(b) does not apply to you.

Tax consequences if IRC §877(b) applies

If IRC §877(b) applies to you (because you returned to the USA too soon and became a resident for income tax purposes again) here’s what it means for your tax bill.

Normal income types subject to U.S. tax

Nonresidents are normally subjected to U.S. income tax on two categories of U.S. source income:

• Effectively Connected Income: Business profits, U.S. wages, connected rental/royalty income; and
• Fixed, Determinable, Annual, or Periodical Income: U.S.-source interest, dividends, rents, royalties, certain capital gains.

See, IRC §§871, 872(a), 877(b)(1).

These continue to be taxed to you while you’re a nonresident. The only difference is the tax rate that is applied to those income items. See below, under Higher tax rates.

Additional income types subject to U.S. tax

If you fall afoul of the IRC §7701(b)(10) rule, there are additional types of income that will be treated as U.S. source income, even though they are really foreign-source income. You will pay tax on them. See IRC §§877(b)(1), 877(d). Normally, nonresidents would not be subject to U.S. tax on these items, so this is where you feel the pain.

• U.S. property gains: Gains from selling property (except stocks/bonds) located in the U.S. IRC §877(d)(1)(A).
• U.S. securities gains: Gains from selling U.S. corporate stock or debt obligations of U.S. persons/government entities. IRC §877(d)(1)(B).
• Controlled foreign corporation (CFC) Income: Income or gain from stock of a foreign corporation if it was a CFC where you owned > 50% while you were a U.S. resident. (Note: this rule is manky and nearly incoherent in the context of IRC §7701(b)(10), because it was written with expatriation in mind). IRC §877(d)(1)(C).

By far the most important of these is the sale of stock of U.S. corporations. It could be publicly traded stock (cash in those NVDIA gains) or it could be the stock of a privately-held start-up company, as in my example above. Ordinarily, nonresidents do not expect capital gain tax on sale of such stock, but with IRC §7701(b)(10), capital gain tax is imposed.

Higher tax rates

IRC §7701(b)(10) imposes the IRC §877(b) tax only if it is higher than the default U.S. tax rates applicable to a nonresident alien. The flush left language of IRC §7701(b)(10) says, in relevant part:

Thus, you calculate the income tax under IRC §§1, 55 (regular income tax and alternative minimum income tax) and also calculate the income tax under IRC §871. Pay the higher of the two.

Deductions

You may only claim deductions that are “connected with” the income included in your tax base under IRC §877(b)(2).

Planning considerations

How can you bail out of the U.S. income tax system, cash in your chips tax-free, then return to the USA to live?

• If you never have three consecutive calendar years in which you held U.S. resident alien status (the “initial residency period”), you are safe from the application of IRC §7701(b)(10).
• If you need three consecutive full calendar years of nonresident status, look to use the closer connection rules or claim treaty nonresident status under an applicable income tax treaty.
• Or (and this is bombproof and cannot be recommended more highly) do not accidentally or intentionally become a “resident alien” for U.S. income tax purposes for three full calendar years. Don’t get a green card, and don’t run afoul of the substantial presence test. Keep it simple. Fun exists outside the USA. Go find it.