The Substantial Presence Test, the Closer Connection Exception, and FBAR Filing Requirements

Here’s a quick answer to a semi-frequent filing requirement question, this time about the FBAR (FinCEN Form 114).

The substantial presence test, the closer connection exception, and the FBAR filing requirement

A person spends too many days in the United States, triggering resident alien status for U.S. income tax purposes because of the substantial presence test. But the person qualifies for the closer connection exception to the substantial presence test. Resident alien status is prevented—under the Internal Revenue Code, which is Title 26 of the United States Code.

But is the FBAR filing obligation—created under the Bank Secrecy Act in Title 31 of the United States Code—also extinguished? If yes, how do you come to that conclusion?

I’ll show you how to come to that conclusion, and give you an outline of how to write it up for your workpapers.

Facts

Assume your client is a nonresident individual who ran afoul of the substantial presence test by spending too many days in the United States in a three-year period. IRC §7701(b)(1)(A)(ii). Your client will be a resident alien, taxed on worldwide income and required to file all of the wonderful paperwork that the IRS requires.

You consider the closer connection exception to the substantial presence test. IRC §7701(b)(3). Your client’s facts satisfy the exception’s requirements, thereby negating the substantial presence test. Phew! The client is a nonresident alien for U.S. income tax purposes. You file Form 8840 for the client to eliminate the risk of resident alien status.

But then you remember a little oddity: income tax obligations are determined under Title 26 of the United States Code, but the FBAR filing obligation is created by a statute under Title 31 of the United States Code. You proved to your satisfaction that the closer connection exception saved the client from filing Form 1040 (under Title 26).

But that didn’t prove that the client is safe from being required to file FinCEN Form 114 (under Title 31). You need to make a separate analysis to prove that your client is also exempt from the FBAR filing requirement.

For now, let me show you how you prove—from the basic law—why a person who satisfies the substantial presence test and claims the closer connection exception does not have an FBAR filing requirement.

1. Only a “United States person” has a potential FBAR filing requirement

Only “United States persons” are required to file FinCEN Form 114. And the filing requirement is imposed only if that United States person owns or controls foreign financial accounts with aggregate value above $10,000.

31 CFR §1010.350(a) states the general rule:

The aggregate value of the foreign financial accounts must exceed $10,000 in order to trigger the filing obligation. This threshold is found in the Instructions for FinCEN Form 114.

2. A “resident of the United States” is a “United States person”

“United States person” is defined for FBAR purposes at 31 CFR §1010.350(b). It includes U.S. citizens, “residents of the United States,” and certain types of entities.

We only care about “resident of the United States,” defined at 31 CFR §1010.350(b)(2):

3. A “resident of the United States” is a “resident alien” under IRC §7701(b)

You become a “resident of the United States” for FBAR filing purposes if you are defined as a “resident alien” by the Internal Revenue Code. 31 CFR §1010.350(b)(2). You use a special, funky definition of “United States” when determining resident alien status.

4. Satisfy the “substantial presence test” and you become a “resident alien”

The Internal Revenue Code lists three ways you can become a resident alien: by having a green card, by making a first-year election, or by satisfying the substantial presence test. IRC §7701(b)(1)(A).

Let’s focus on the substantial presence test.

The substantial presence test is described in IRC §7701(b)(3). It is comprised of two requirements to be satisfied, and two exceptions to be disproved.

The two requirements are day-counting requirements, and the two exceptions deal with people with medical conditions (which I will ignore) and people who are in the USA for less than half of the year (the closer connection exception, which I will analyze).

An individual satisfies the day-counting portion of the substantial presence test by physical presence in the United States for 31 days or more in the current year and the weighted average of days of presence in the United States for the current and two prior years works out to be 183 or more. IRC §7701(b)(3)(A).

5. Satisfy the “closer connection exception” and you fail the “substantial presence test”

Days of presence, alone, are not sufficient to satisfy the substantial presence test. Before you can say that the substantial presence test makes your client a resident alien because of the substantial presence test, you must:

• Prove that the day-count requirements of IRC §7701(b)(3)(A) apply; and
• Prove that the closer connection exception of IRC §7701(b)(3)(B) will NOT apply.

If you satisfy the closer connection exception, you simply do not satisfy the substantial presence test, end of story. IRC §7701(b)(3)(B) says:

The quoted paragraph says that closer connection exception applies if all of these are true:

• The client spent fewer than 183 days in the United States in the current year;
• The client had a tax home in a foreign country for the entire current year; and
• The client had a closer connection to the foreign country than to the United States.

I will assume you can show all three of those facts are true, and the client files Form 8840 to document that position.

6. Conclusion

Now for the grand finale. Let’s connect all of these tax rules in a chain and prove that a non-U.S. citizen who satisfies the day-count requirements of the substantial presence test and also satisfies the requirements of the closer connection exception to the substantial presence test does not have an obligation to file FinCEN Form 114.

This is an outline of what to put in a memo to the file so you can show why you didn’t prepare FinCEN Form 114 for the client.

Facts

State the facts that you are relying on to advise your client about the FBAR filing obligation.

• The client has ownership or control over foreign financial accounts worth more than $10,000 (because otherwise you wouldn’t be analyzing FinCEN Form 114 filing obligations because there would be no filing requirement). 31 CFR §1010.350(a).
• The client does not have green card immigration status. IRC §7701(b)(1)(A)(i), to show why the client does not attain resident alien status because of visa status.
• The client did not make the first-year election and you are advising the client to not make the first-year election. IRC §7701(b)(1)(A)(iii), to show that the client did not attain resident alien status for that reason.
• The individual was in the United States for at least 31 days in the current year. IRC §7701(b)(3)(A)(i), satisfying the first prong of the day-count requirements of the substantial presence test.
• The weighted average for days of presence for the current and two prior years is calculated to be 183 or more. IRC §7701(b)(3)(A)(ii), satisfying the second prong of the day-count requirements.
• The client spent fewer than 183 days in the United States in the current year. IRC §7701(b)(3)(A), showing the client satisfied the first requirement of the closer connection test.
• The client has a tax home in a foreign country. IRC §7701(b)(3)(B)(i), showing the client satisfied the second requirement of the closer connection test.
• The client has a closer connection to the other country than to the United States. IRC §7701(b)(3)(B)(i), showing the client satisfied the third requirement of the closer connection test.

The applicable rules

Let’s start from the top and restate the rules:

• If you are a United States person and you have ownership/control over foreign financial accounts with an aggregate value of more than $10,000, you have an FBAR filing obligation. 31 CFR §1010.350(a).
• You are a United States person if you are a “resident of the United States.” 31 CFR §1010.350(b)(2).
• You are a “resident of the United States” if you are a “resident alien under 26 U.S.C. §7701(b).” 31 CFR §1010.350(b)(2).
• You are a “resident alien” if you satisfy the “substantial presence test.” IRC §7701(b)(1)(A)(ii).
• You satisfy the “substantial presence test” if you (1) satisfy the day-count rules and (2) do NOT satisfy the “closer connection exception.” IRC §7701(b)(3).

The facts and the rules, applied

Does the client have an FBAR filing obligation? Let’s solve this by applying the rules from the bottom up.

• The substantial presence test is not satisfied. Reason: the closer connection exception says so. Take your facts from above (number of days of presence, facts showing the tax home in a foreign country, facts showing a closer connection to that foreign country) and show why the substantial presence test fails—because the closer connection exception succeeds. You will secure the closer connection exception’s application by filing Form 8840.
• If the substantial presence test is not satisfied, the client is not a resident alien as defined by IRC §7701(b). This is a mechanical application of IRC §7701(b).
• If the client is not a “resident alien” as defined by IRC §7701(b) (found in Title 26, United States Code), the client is not a “resident of the United States.” This is a mechanical application of the rule at 31 CFR §1010.350(b)(2).
• If the client is not a “resident of the United States”, then the client is not a “United States person.” This is a mechanical application of 31 CFR §1010.350(b).
• Your conclusion: Since the client is not a “United States person,” the client cannot have a FinCEN Form 114 filing obligation created by 31 CFR §1010.350(a).

Afterword

It seems like a lot of work. And it is.

But I think it is important for you to build the skill of dissecting tax law to this level of precision. When you do, you can see each link in the logic chain, and verify that it is true. You will reach your conclusions with confidence.

And you will be able to distinguish (with confidence) what the correct rule of law is for FBAR filing requirements for a person who satisfies the substantial presence test but does not satisfy the closer connection test. Ordinarily, you would use an applicable income tax treaty to claim treaty nonresident status in the United States to avoid U.S. income taxation as a resident.

Does the treaty eliminate the FBAR filing obligation for someone who takes the treaty nonresident reporting position? Why did you answer this? If the reason is “I read it on the internet” or “My favorite LLM told me so,” are you sure you have the right answer?

I am inclined to record a little video demonstration of how you can use symbolic logic to analyze tax law—using this example and showing the FBAR filing obligation outcomes.

See you in a couple of weeks with the next installment of the draft Field Guide to U.S. Income Taxation of U.K. SIPPs.