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Edward Tanenbaum Alston & Bird LLP, New York, NY
The facts in a recent Tax Court decision involved a Canadian citizen, who was a full-time student at the University of Waterloo in Canada during the years 2008 – 2012. The taxpayer was not married.
The University was recognized as an institution eligible to participate in the Federal Family Educational Loan program by the U.S. Department of Education and the University issued a form verifying that the taxpayer paid $5,123 in education expenses in 2012.
With the encouragement of the University, the taxpayer pursued paid internships in the United States during 2010 and 2011. The facts indicate that he was present in the United States during these internships for 120 days in 2010 and under 120 days in 2011 but was present in the United States for about 190 days in 2012. The taxpayer filed as a nonresident in each of the 2010 and 2011 years and (correctly) filed as a U.S. resident for 2012. On his return, he claimed American Opportunity and Lifetime Learning credits against his tax due under the authority of §25A which makes these credits available to eligible students who pay qualified tuition expenses.
The IRS asserted that the taxpayer was not entitled to claim the education credits since the taxpayer was not a U.S. resident for the entire 2012 taxable year as required by §25A(g)(7). The taxpayer, on the other hand, argued that he was entitled to the credits since he met the substantial presence test under §7701(b)(3) in 2012.
The Tax Court determined that, while the taxpayer was “substantially present” in the United States for the 2012 taxable year, he did not meet the requirements of §25A(g)(7) since he was not a U.S. resident for all of 2012. The amount of the credits involved was quite insignificant, which is obviously the reason the taxpayer appeared pro se. Moreover, the facts are clear cut and the relevant law is clear cut and the decision hardly breaks new ground. Nonetheless, the court reviews a number of residency related rules that are instructive and worthy of review.
First, as mentioned, §25A(g)(7) provides that the credits are not allowed if a taxpayer is a nonresident alien individual for any portion of the taxable year unless the individual elects to be treated as a resident alien under the provisions of either §6013(g) or §6013(h).
These two sections refer to the ability of a nonresident alien to make a joint return with his/her spouse. The general rule is that a joint return may not be made if either spouse was a nonresident alien at any time during the year. However, under §6013(g), a nonresident alien can file jointly if an election is made to treat the nonresident alien as a resident of the United States for the taxable year. Similarly, under §6013(h), a nonresident alien who later becomes a resident of the United States in that year may elect to be treated as a U.S. resident for the taxable year. Depending on the facts of each case, and the relative tax positions of the spouses, these elections might make sense. The taxpayer in this case was not married and he could not avail himself of either election.
So, if the taxpayer was “substantially present” in the United States for the 2012 taxable year and, as such, was deemed a resident of the United States in 2012, why did he fail the requirements of §25A(g)(7)?
A taxpayer becomes a U.S. tax resident if he meets the green card test, the “substantial presence” test, or makes the special first-year election. §7701(b)(1). (The taxpayer did not meet the requirements for making the special first-year election, in particular, the requirement that he not be one who otherwise meets the substantial presence test.) The substantial presence test is met for the current year being tested if the individual is present in the United States in the current year for at least 31 days and the number of days present in the current year plus 1/3 of the number of days present in the preceding year plus 1/6 of the days present in the next preceding year equals 183.
The taxpayer in this case met the substantial presence test in the 2012 taxable year but was he a resident of the United States for the entire taxable year as is required by §25A? For that, we would need to know exactly when he started his residency in the United States in 2012.
Under the special rule for first year of residency, provided the individual is not a resident in the preceding year, the individual is treated as a resident of the United States only for the portion of the year which begins on the “residency starting date.” §7701(b)(2)(A)(i), §7701(b)(2)(A)(ii). The residency starting date for individuals meeting the substantial presence test is the first day during the year on which the individual is present in the United States.
The taxpayer in this case first entered the United States in 2012 on February 22. So, while he eventually met the substantial presence test for 2012, his residency starting date was only February 22 and, therefore, for purposes of §25A(g)(7), he was still a nonresident for a portion of the year.
These rules are especially instructive for pre-immigration planning purposes. The regulations under §871, in particular, Reg. §1.871-13(a), make clear that, in the case of an individual who is a nonresident at the beginning of a year but a resident at the end of a year, the individual is taxable for such year as though his taxable year were comprised of two separate periods, one consisting of the time during which he is a resident and a time during which he is a nonresident.
Thus, the regulations go on to say, the income tax liability is to be computed under two different sets of rules for respective periods of time. And, for purposes of §871, the regulations say that an individual is deemed to be a resident of the United States on the day he first becomes a resident of the United States. Section 7701(b)(4)(A) tells us that this day, for purposes of the substantial presence test only, is the first day in the year that the individual is present in the United States.
So, these rules provide the entree to some sophisticated tax planning for the implementation of pre-immigration arrival tax planning. Determining the residency starting date will be critical to advising whether and when the individual should accelerate income before establishing residency, defer loss recognition, embark upon sales or other basis step-up techniques, dispose of corporations that could be CFCs or PFICs, make check-the-box elections, etc.
So, we thank the taxpayer in this case for the primer on residency rules but we also advise him not to rely on IRS forms in the future for the totality of his advice nor to appear in Tax Court pro se.
This commentary also will appear in the November 2016 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, and in Tax Practice Series, see ¶7110, U.S. International Taxation — General Principles.
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