This newsletter is inspired by a geek with a hat. Swizec is someone whose blog I follow from afar. I also watch for him on Hacker News, where he pops up from time to time. Interesting guy, does interesting things.
So when he wrote a blog post about his international tax catastrophe, I read it with interest.
In brief, Swizec came to California from Slovenia, spent too much time here, and became a resident for tax purposes for multiple years. He ended up with a massive tax bill for Federal and State income tax.
As a bonus multiplier, he ended up owing tax in Slovenia, too.
The Possible Income Tax Outcomes
Let’s pretend that you are a traditional self-employed person (software developer, lawyer, accountant, consultant, whatever).
You are hired as an independent contractor by a U.S. company to perform services. You do the work and get paid. That is your only income for the year.
What is your U.S. income tax exposure?
The two factors that matter are:
- Your resident (or nonresident) status in the United States for income tax purposes; and
- Where you are on Planet Earth when you do the work.
The location of the company that pays you is irrelevant for determining your personal U.S. income tax exposure.
Here is the ubiquitous 2×2 matrix.
|Did the Work Inside USA||Did the Work Outside USA|
|U.S. Tax Resident||Taxable in USA||Taxable in USA|
|U.S. Tax Nonresident||Taxable in USA||Not taxable in USA|
In a perfect world, you avoid U.S. resident status (as defined for income tax purposes) and you do all of the work outside the United States. Result: no U.S. income tax.
Becoming a resident of the United States, however, changes everything.
How You Become a Resident
How do you become a U.S. resident for income tax purposes? Swizec’s blog post tells you.
You become a resident of the United States for income tax purposes if you spend too many days in the United States in any particular year.1
The “too many days” idea is called the substantial presence test2 in U.S. tax law.
Counting the days means computing a weighted sum, with more weight allocated to more recent years.
The formula looks at your days in the United States for the current year and the two prior years. Do some simple division and addition. If the result of your arithmetic is equal to or greater than 183, you are a tax resident of the United States for the current year.
Example 1 – You Are Not a Resident
Every year you spend precisely 120 days in the United States. You want to know if you are a tax resident of the United States for calendar year 2017. Here is the math:
Year Days In the USA Divide By Result 2017 120 1 120 2016 120 3 40 2015 120 6 20 Total 180
The weighted sum of days of presence in the United States for the previous three years is 180. Since 180 is less than 183, you are not a resident of the United States for calendar year 2017.
Example 2 – You Are a Resident
Every year you spend precisely 122 days in the United States. You want to know if you are a tax resident of the United States for calendar year 2017. Here is the math:
Year Days In the USA Divide By Result 2017 122 1 122 2016 122 3 40 2/3 2015 122 6 20 1/3 Total 183
The weighted sum of days of presence in the United States for the previous three years is 183. The test for resident status is “equal to or greater than 183”. Since you are “equal to”, you are a resident of the United States for calendar year 2017.
Understand the math. You can control your (tax) destiny by controlling your location on Planet Earth.
What If You Successfully Remain a Nonresident?
If you successfully remain a nonresident of the United States, how will the U.S. (attempt) to tax you?
- Residents are taxed on all of the income they earn, from any point on Planet Earth or beyond.
- Nonresidents are only taxed on income that they earn from U.S. sources.
Nonresident, Taxed on U.S. Source Income
Back to Swizec, again. He was physically working in the United States, as an independent consultant or employee. Even if he had successfully avoided U.S. resident status, he would have been taxable in the U.S. on the income he earned as an independent consultant or employee.
The tax rates that apply to the income would be identical — as a resident or nonresident.
Resident or nonresident status does not generally make a difference to tax liability if you work in the United States.
It is not enough to focus on “resident or nonresident”. You must also focus on the impact of either status. Sometimes, the tax cost is identical.
But even if the tax cost is the same as a resident or nonresident, you should try to avoid resident status. The U.S. tax system imposes a metric (potty-mouth word)-ton of paperwork requirements on its residents. Nonresidents are largely exempt from this additional paperwork burden.
If You’re a Resident and Wish You Weren’t
What if you spend too many days in the United States and the substantial presence test (the three year weighted sum computation) says you are a resident of the United States?
There are two ways to take yourself out of resident status and make yourself a nonresident:
Closer Connection Exemption
This is a way for you to prove to the IRS that you really live in another country — you have a “closer connection” to another country than you have to the United States — even though you spent a lot of time in the United States.3 See Form 8840 for all of the questions you must answer.
To qualify for the closer connection exemption, all three of these statements must be true:
- The result of the substantial presence test math is 183 or more;4 and
- During the tax year, you spent 182 or fewer days in the United States;5 and
- You prove to the IRS that you have a closer connection to another country, as compared to your connection to the United States.6
This is an excellent way to avoid resident status, if you qualify. You are a nonresident for all purposes–for computing your tax obligations to the U.S., and for the other paperwork requirements that are
visited upon the iniquitous imposed on U.S. residents and citizens.
Income tax treaties are the second way to revert to nonresident status if you are a nonresident who spends too many days in the United States.
How Treaties Work
Treaties have a “tie-breaker” in them. Typically it is in Article 4.
If you think of tie-breaker treaty rules as a series of “if/then” statements, you’re not wrong.
Let’s look at the U.S./Slovenia income tax treaty (PDF), for kicks. Article 4(2), to be precise:
“2. Where by reason of the provisions of paragraph 1, an individual is a resident of both Contracting States, then his status shall be determined as follows:
a) he shall be deemed to be a resident of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident of the State with which his personal and economic relations are closer (center of vital interests);
b) if the State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either State, he shall be deemed to be a resident of the State in which he has an habitual abode;
c) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident of the State of which he is a national;
d) if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement.
The if/then logic goes like this:
- If you have a permanent home in only one country, that is your country of residence for tax purposes. If you have permanent homes in both countries, go to the next criterion.
- You are a resident where your personal and economic relations are closer. If you cannot answer that question with clarity and conviction, move on to the next test.
- You have permanent homes in both countries, and you cannot tell where your “center of vital interests” happens to be. Look at your “abode”. You are a tax resident of the country in which you have your “abode”.
- You have permanent homes in both countries, your “center of vital interests” is in neither or both places, and your abode is unclear. Now you look at your citizenship. You are a resident of the country where you are a citizen.
- If you are a citizen of neither (or both) countries, give the question to the governments of the two countries and let them wrestle for the privilege of taxing you as a resident.
Back to Swizec for a second. His (competent) accountant determined that the treaty would not work for him. Whatever the facts happened to be, the if/then logic pointed to U.S. resident status.
Even though a treaty exists between the United States and your country, you must read it carefully.
The “if/then” conditions may point you toward being a U.S. resident rather than a resident of your home country.
You’re a Resident: Foreign Tax Credit
If you are a U.S. resident and you are paying tax in another country, too . . . well, you are sad.
The foreign tax credit idea says “if you have a dollar of income taxed in the United States and in another country, the United States will allow you to reduce the tax payable in the U.S. by the amount of tax paid to that other country on that double-taxed income.”
Easier said than done. Swizec apparently found out that he could not reduce his U.S. tax bill by the amount of tax he paid in Slovenia. I do not know the reason why.
The foreign tax credit can be enjoyed by invoking the rules of the Internal Revenue. It can also be enjoyed by invoking the provisions of the income tax treaty.
There is a basic requirement, however, that may trip you up: the tax paid in the other country must be an income tax. You cannot offset a U.S. income tax liability with a foreign tax credit for a tax paid that is not an income tax. Most common? The other country’s equivalent of Social Security taxes.
The other basic requirement of the foreign tax credit is that it must have been taxed in both places.
The concept of a foreign tax credit is nice, but there are many hoops to jump through before you are permitted to use it.
Some Planning Ideas
Swizec is evidently a full-time resident of the United States now, living and working here. He shut down his Slovenian sole proprietorship. He is a full tax resident of the United States.
But for the rest of you, the future Swizecs, here are a few suggestions.
You Plan to Stay a Nonresident
The most cost-effective tax strategy is to remain a nonresident and do remote work. If you perform the services while you are outside the United States, the U.S. cannot tax you.
Be careful about the number of days that you are physically in the United States in a calendar year, so you avoid becoming a resident.
If you are in the United States, do what you can to prove that you were not “working” so that the U.S. cannot tax you as a nonresident for work performed while in the United States. (There is an “under 90 days and $3,000” exemption that you should strive to use, if you can. Or, a treaty might protect you from U.S. taxation. But better to not get into the problem area in the first place, if you can.)
If you will earn more than $3,000 in income for working while you are in the United States, it may be worth doing a bit of tax engineering.
You will enter the United States and work on semi-frequent gigs. But you will spend most of your time living in your home country. You will earn more than $100,000 for the jobs you perform in the United States (i.e., enough to make all of this fancy stuff cost-effective).
It may well be worth your while to set up a little U.S. corporation. You are the only employee of your U.S. corporation. Your customers pay the corporation, not you.
Your corporation pays you a salary as an employee, and reports zero taxable income at the end of the year.
Your U.S. corporation will file a boring and simple corporation tax return. You will file a boring and simple individual tax return that shows your U.S. salary and nothing else. If possible, you apply for waiver of U.S. social security taxes under an applicable totalization agreement.
The advantage of this set-up is that you have isolated all of the U.S. activity in its own self-contained universe. It is just like asbestos in an old building: encapsulate the toxic substance so it cannot pollute the environment. 🙂
You Will Become a Resident
If, like Swizec, you plan to become a U.S. resident, find a tax professional who knows their stuff. The transition from your tax system to the U.S. tax system means you must learn all new rules. And those rules are complicated.
Plan ahead, get good advice. This will not prevent taxation, but it will prevent unpleasant surprises. Specifically, I would watch out for these points:
- Know the first day of your resident status in the United States. Anything earned before that day will probably not be taxed in the United States.
- Know about foreign tax credit and whether it will work for you.
- Know the U.S. paperwork requirements that will apply to you when you become a U.S. resident. Strive to simplify your life before you become a U.S. resident in order to reduce that paperwork. (Paperwork = accounting fees and tax return risk).
- Be sure to make tax payments so you do not get caught at the end of the year owing an enormous amount of money in tax. (Trust me, I know this one first-hand).
Other Stuff I Didn’t Touch
Immigration Status and Right to Work
I didn’t talk about visa status. Almost anyone can enter the United States with a tourist visa. An independent contractor could be on the ground in the USA and do work. That is not permitted for people here on a tourist visa.
If you file a U.S. tax return (as a resident or nonresident) reporting that you worked in the United States, you may not be able to return to the United States in the future because you violated the terms of your visa.
Social Security or Self-Employment Tax
If you are a nonresident (for income tax purposes) but you work in the United States, watch out for the impact of Social Security tax (if you are an employee). Nonresidents who receive self-employment income (i.e., they are independent contractors) will not pay the self-employment tax.7
It is possible to use treaties to make you a resident of your home country for social security taxes, thereby avoiding having to pay those taxes to the United States. This is usually a good idea because if you continue to pay into the system in your country, you continue to qualify for medical and other benefits. Also, it is unlikely that you — as a nonresident — will pay enough into the U.S. system to collect the old age pension from the government when you retire. Problem: there are far fewer treaties for these taxes than there are for income tax.
- There are two other ways for a noncitizen to become a resident of the United States for income tax purposes. One is to become a lawful permanent resident (i.e., get a green card). IRC §7701(b)(1)(A)(i). The other way is to choose resident status by making a tax election. IRC §§7701(b)(1)(A)(iii), 6013(g), 6013(h). We will let those rabbits chase themselves. ↩
- IRC §§7701(b)(1)(A)(ii), 7701(b)(3). ↩
- IRC §7701(b)(3)(B). ↩
- If the result of the math was 182 or less, you would be a nonresident. There would be no need to use the closer connection exemption to make you a nonresident, since you would be a nonresident already. ↩
- IRC §7701(b)(3)(B)(i). ↩
- IRC §7701(b)(3)(B)(ii). ↩
- IRC §1402(b). Hat tip to reader Gary Lubowiecki for his comments and discussion on this point. ↩