The U.S. Tax System
If you are a J1 exchange visitor, you might be confused about how the US tax system works. Relax, so is everyone else! We have a tax system that virtually no one understands completely. It is vast, deep and murky. In the next few paragraphs I hope to provide some clarity in the small area that applies to you, at least at the shallow end. (By the way, welcome to America!)
First, if you are an individual who is not a US citizen, there is a special set of rules in the United States Internal Revenue Code (IRC) for you. You are defined as an “alien” in the Code (IRC Sec. 7701(b)). Perhaps because this term conjures up negative images (e.g. Men in Black), practitioners tend to use the softer term “foreign national” (or the less precise term “immigrant”) to describe you. Here I will stick with the technical term “alien” in order to demonstrate the legal differences between a resident and nonresident alien. After all, the rules apply to everyone who is not from here, even if you’re a slimy bug from Centauri B.
There are two kinds of aliens (for tax purposes that is): resident aliens and nonresident aliens. If you are classified as a resident alien, the tax rules that apply to you are substantially the same as for US citizens for each full year of residency. As a resident you are required to report your worldwide income on your US tax return, and, under certain circumstances report your foreign bank and investment accounts. You would file either Form 1040, Form 1040-A or Form 1040-EZ, and can claim all of the deductions and credits available for US citizens. Most treaty exemptions that apply to nonresidents are not available on the resident return (see below for more on that).
You might be both a resident alien and a nonresident alien during the same calendar year. This could happen the year you first arrive and the year you permanently depart. When you are a resident alien and a nonresident alien during the same calendar year, you are called a “dual status alien” (a topic for another day).
Resident aliens are defined in the IRC as anyone who:
- is a lawful permanent resident (green card holder), or
- meets the substantial presence test, or
- qualifies for the “first year election” (under IRC Sec. 7701(b)(4)) and makes the election to be treated as a resident in their first year present.
Substantial Presence Test. If you are subject to this test (see below under Exempt Individuals) you are a resident during the current calendar year if 1) you have been present in the United States for at least 31 days during the current year, and 2) the sum of the following equals 183 days or more:
- 1/6 of the number of days you were in the U.S. during the calendar year two years prior to the current year, plus
- 1/3 of the number of days you were in the U. S. during the calendar year immediately preceding the current year, plus
- the number of days you were in the U.S. during the current year.
For example, let’s say Jeff, an L1 visa holder, was not in the US during 2016, but spent 120 days in the US during 2017, and 140 days in the US during 2018. Jeff is a nonresident for US tax purposes in 2018 because (0 x 1/6) + (120 x 1/3) + 140 = 180 days, short of the magic number by three days.
Now let’s say Jeff was in the US for 150 days during 2017 rather than 120 days. The same calculation gives us 190 days, which exceeds 183 days. Jeff now passes the substantial presence test for 2018, and is treated as a resident for tax purposes from his first day present.
First-Year Election. In spite of not passing the substantial presence test, it’s possible to elect be classified as a resident anyway. If someone is present in the United States for 31 consecutive days, and for 75 percent of the time between the beginning of this 31 day period and the end of the year, they qualify. They also must actually meet the substantial presence test the following year.
For example, let’s say Alice, an H1b visa holder, arrives in the United States on October 1, and remains here through November 1. Alice remains in the United States at all times after November 1 through December 31, except for two weeks in December, when she returns to her home country for a visit. If Alice wishes to elect to be treated as a resident for the period October 1 through December 31, she can do so. She meets the tests for the first year election because 1) she was present in the United States for 31 consecutive days beginning on October 1, and 2) she was present in the United States for more than 75% of the days from October 1 through December 31 (total days between October 1 and December 31 = 91; Days present (91- 14) = 77; 77/91 = 84%).
This election allows Alice to be treated as a resident only for the part of the year from October 1 through December 31, making her a dual status alien for the year of arrival. However, if Alice is married, whether her spouse is a resident or nonresident, she and her spouse would then qualify for an election to file a joint resident return (IRC Section 6013(g) or (h)). This would allow Alice and her spouse to claim all of the deductions and credits allowable on a joint return, but they would also be required to report their worldwide income for the entire calendar year. Double taxation on foreign source income could be reduced or eliminated with the foreign earned income exclusion and/or the foreign tax credit (stuff way beyond the scope of this blog).
Before you get all excited about the many of tax planning opportunities these rules present, most J1 visa holders are nonresidents, even if they stay for an entire year. (What?) That’s because they are exempt from the substantial presence test, as we explain below.
Who Is a Nonresident Alien?
A nonresident alien is anyone who is not a citizen and does not meet any of the tests to be a resident alien. Some aliens, called “exempt individuals,” can be physically present in the United States but deemed not to be present for purposes of the substantial presence test. This applies to certain visa holders, at least for a limited number of years, making these individuals nonresident aliens.
Exempt Individuals. If you are an exempt individual, you are exempt from the substantial presence test, which means you can’t possibly pass it. This does not mean you are exempt from tax in the US (although you might be if a treaty exemption applies). Exempt individuals include:
- diplomats and employees of international organizations, and family members (usually A or G visa holders),
- J and Q non-student visa holders, and family members (called “teachers and trainees” but includes all non-student Js and Qs),
- F, J, M and Q student visa holders, and their family members, and
- professional athletes who are in the U.S. to compete in certain charitable events.
These folks are all exempt from the test and are automatically classified as nonresidents. They also do not meet the conditions for making the first year election, mentioned above, because the election requires at least 31 days of presence under the substantial presence test.
However, there is a limit on the number of years some of these people are considered exempt individuals. For J visa holders, the limitation is determined by whether they entered with a student or non-student visa.
Students: For any calendar year after the fifth calendar year for which a student was an exempt individual as a student, teacher or trainee (F or J), the students will no longer be exempt from the substantial presence test. This is a lifetime test, so any visit during the students entire life is considered for the five calendar years of exemption.
For example, if Francoise came to the US as a young child with her parents when they attended graduate school, and was an F-2 visa holder for three years, then returned for three years of graduate school herself as a J1 visa holder, she is a nonresident alien for the first two calendar years of graduate school, but that’s when her period of exemption runs out. She is subject to the substantial presence test during her third year of graduate school, and will be classified as a resident alien if she remains in the US for at least 183 days that year.
Teachers/Trainees: If a J1 teacher or trainee was in the US as an exempt individual for at least two years during the six years immediately preceding the current year, that person is not an exempt individual in the current year.
For example, Boris came to the US as a short-term J1 visitor during 2012 and 2014. If Boris returns for another short-term J1 visit in 2018, Boris is not an exempt individual in 2018 and is subject to the substantial presence test. Whether Boris is treated as a resident or nonresident for 2018 depends on whether he passes the test.
Tax Regimes for Nonresident Aliens
Unlike resident aliens, nonresident aliens report only income received from sources within the United States. There are actually two tax regimes for nonresidents. They can have 1) income that is effectively connected with a US trade or business, and 2) income that is not effectively connected. Income that is effectively connected is taxed at graduated rates, the same as income received by citizens and resident aliens (IRC Sec. 871(b)). Income that is not effectively connected with a US trade or business is generally taxed at a flat rate of 30% on the gross amount (IRC Sec. 871(a)).
Income that is effectively connected includes business income and personal service income. So if you earn a wage while working in the United States, you are taxed under the graduated rate structure (just like if you were a resident alien).
No More Personal Exemptions. For all individual tax returns (not just for nonresidents) the personal exemption has been repealed beginning in 2018 (at least until 2026). The personal exemption was an automatic deduction of $4,050 for 2017. The offsets for residents includes a dramatic increase in the standard deduction, a doubling of the child tax credit, and a new family credit of $500 for dependents who do not qualify for the child tax credit. Unfortunately, nonresidents do not benefit from these offsets. The only offset available to nonresidents is the lowering of the 15%, 25% and 28% tax brackets to 12%, 22% and 24%. Use our J1 Tax Refund Calculator to see if you will still get a refund.
Non-effectively connected income includes investment income, such as interest, dividends and capital gains. However, capital gains on anything other than the sale of real property are exempt for nonresident aliens who do not spend 183 days or more in the United States during the year. Of course, if they spent 183 days or more in the United States, they would not be nonresidents, except for (you guessed it) exempt individuals.
The best free source of information that you will find on all the tax rules that apply to nonresident aliens is IRS Publication 519, available at www.irs.gov.
Special Tax Exemptions for J-1 Exchange Visitors
You might be able to escape paying tax to the US government on wages earned in the United States. There are both statutory and treaty provisions to achieve this.
Special Social Security Tax Exemption. The employee portion of Social Security and Medicare tax is 7.65% of the employee’s wage. Employers pay an equal share. These contributions are for retirement benefits. Most nonresident aliens are subject to Social Security and Medicare tax on their wages, just like residents are, even though they might not spend enough time working in the U.S. to be able to claim the benefits. However, there is a special exemption in the IRC for F, J, M and Q visa holders who are not residents. Many small business employers (and even large business employers) are not aware of this exemption, so be sure you don’t pay this tax if you qualify for the exemption. Tell your employer you are exempt from Social Security and Medicare tax under Section 3121(b)(19) of the Code. If they don’t give you a refund, at least they will be impressed with your tax acumen. If your employer does not believe you, or is simply too lazy to file the paperwork, the IRS offers an alternative option to get a refund. Read about it at this page on IRS.gov.
Payments by a Foreign Employer. Generally, wages earned in the United States by a nonresident alien are subject to U.S. taxation, even if the wages are paid by a foreign employer. However, if you are a nonresident F, J or Q visa holder receiving compensation from a foreign employer, your income is exempt from U.S. tax under Section 872(b)(3) of the Code. Once you become a resident, this exemption goes away.
Treaty Exemptions. The United States has tax treaties with over 65 countries, and many treaties have benefits specifically for J-1 visa holders who were residents of those countries immediately before coming to the U.S. All of these benefits are for a specified period of time. An example is the treaty with Belgium, which has some juicy benefits in Article 19. A student or business apprentice from Belgium is exempt from tax on up to $9,000 per year of U.S. wages received while studying or training. A teacher or researcher is exempt from tax on all of their compensation paid by a U.S. educational or research institution. These exemptions last for two years from the time the individual first arrives in the United States.
Each treaty provides different benefits for teachers, trainees and students, or none at all. To determine if the treaty between the United States and your home country offers such benefits, go to United States Income Tax Treaties – A to Z on the IRS website. Tax treaties are pretty tricky, and you should seek professional help (like ours) to make sure you apply the treaty correctly. For example, while most treaty provisions are available only while you are a nonresident, some treaty provisions can be claimed even after you become a tax resident. This depends upon the treaty. Additionally, while most states honor treaty exemptions, some do not. That means you may not be subject to federal tax on your US wages, but will be subject to tax at the state level.
Looking for More?
Did you find this stuff so fascinating that you would like to read more? I see, that’s a no then? Well, I’ll just put some links here anyway in case you change your mind. Our Foreign National Tax Guide, on our companion site at www.Form1040nr.com, gives you a pretty comprehensive overview of the US tax regime for aliens. Also, if you are confused about your residency status in the US, Your Tax Residency is an interactive questionnaire that figures it out for you.