Tax Trap for Second-Time U.S. Residents

Practitioners need to be aware of a special tax trap for foreign individuals who become U.S. tax residents for a second time. These taxpayers include foreign nationals who came to the U.S. to work under an H, L, E or other nonimmigrant work permit. When the economy softened, most of these special visitors left. While here, they typically filed a return as a U.S. tax resident. Many were in the U.S. for at least three years; some were granted permanent residency visas (i.e., green cards).

The U.S. economy seems to be improving, prompting some of these individuals to return to the U.S. However, if they come back, they might have a tax surprise. Just as Sec. 877 imposes a tax on expatriates (unless tax avoidance was not a principal purpose of expatriation), Sec. 7701(b)(10) provides that an alien treated as a U.S. resident for at least three consecutive calendar years (the initial residency period) who ceases to be a U.S. resident, but becomes one again before three years after the end of the initial residency period, is subject to tax under Sec. 877(b), for the period after the initial residency period closed, until the day before the second residency began. 

Regs. Sec. 301.7701(b)-5(a)(2) provides that the three-year count includes the year of arrival and departure. If an individual is in the U.S. at least 183 days in the year he or she arrives in the U.S., or in the U.S. at least 183 days in the year he or she departs the U.S., each of those periods is treated as a resident year. For example, if an individual came to the U.S. in June 2001 and left the U.S. in July of 2003, he or she would be in the U.S. for three years.

Sec. 7701(b)(10)(B), like Sec. 877, provides that the tax does not apply if the individual would pay a higher U.S. tax as a nonresident alien. An individual subject to the Sec. 877 tax cannot claim treaty benefits to lower the U.S. tax. Under Notice 97-19, an individual subject to the Sec. 7701(b)(10) tax is entitled to treaty benefits in the intervening period. This tax applies without regard to the departing individuals net worth or previous earnings (i.e., the regular Sec. 877 tax takes these items into consideration).

Sec 877 alters the application of various source and recognition rules. Thus, for individuals subject to Sec. 7701(b)(10), the Sec. 877(d) special sourcing rules are:

1. Sales of property: Sales of property (other than stocks and bonds) located in the U.S. are U.S. sourced. This rule disregards the residence-of-the-seller rules in Sec. 865.

2. Sales of stocks and bonds: Stocks and bonds (including debt obligations) issued by a U.S. corporation or a U.S. obligor are U.S. sourced.

3. Income or gain from a controlled foreign corporation: Generally, such income or gain is U.S. sourced.

4. Certain exchanges: If the individual entered into an exchange after leaving the U.S., which would otherwise be tax free, he or she would lose tax-free status as to the gain. He or she could obtain a waiver of tax from the IRS via a special agreement. If the individual uses short sales, puts or other techniques to diminish the risk of ownership during the holding period, the holding period is suspended under Sec. 877(d)(3). This rule would apply, for example, if the individual held shares during the intervening period in a company acquired in a tax-free reorganization during the intervening period. Although the reorganization would be taxable to the individual, he or she could enter into a gain-recognition agreement (as provided in Notice 97-19) to defer the tax.

5. Special transactions: Sec. 877(d)(2)(E) gives the IRS the power to tax the removal of appreciated tangible personal property from the U.S., as well as any other occurrence that (without gain recognition) results in a change in the source of the income or gain from property from sources within the U.S. to sources outside of the U.S. If an individual left the U.S. and took antiques, artworks, wine collections, etc., the gains on these articles would be taxable on the date of removal from the U.S., at fair market value (FMV). Special basis rules apply to this computation. If the individual brought the articles to the U.S. when he or she first entered the U.S., he or she would use not less than the FMV on the date of entry as the cost basis. An irrevocable election would be required to avoid use of such basis. Notice 97-19 provides interim guidance until the IRS issues regulations.

Under Sec. 6012, an individual who leaves the U.S. and becomes a nonresident files U.S. income tax returns only if he or she has U.S.-source income not subject to withholding, or income connected with a U.S. business. An individual who becomes a resident within the intervening period must file Form 1040NR and certain schedules for the intervening period. Notice 97-10 allows the taxpayer an extension of time to file all the forms and schedules for the intervening period, until the due date of the return (including extensions) for the first residency period after returning.

To avoid unpleasant surprises, a returning foreign national should evaluate the effect of these rules before reestablishing U.S. residency.

From Thomas J. Spott, CPA, Spott, Lucey & Wall, Inc., CPAs, San Francisco, CA (Not Affiliated With Grant Thornton LLP)