What’s the Resident/Non-Resident Income Tax Pullback Rule?

What’s the 3-Year Resident/Non-Resident Tax Pullback Rule?

What’s the 3-Year Resident/Non-Resident Tax Pullback Rule?

When a person is considered a U.S. person for tax purposes, they are taxed on their worldwide income. For many international taxpayers, this may include income generated overseas. Some taxpayers may have a significant amount of income generated from overseas, and depending on which foreign country the money is sourced from, they may not have to pay any taxes on the income generated abroad. Thus, when a U.S. person taxpayer anticipates an upcoming taxable event that may result in a significant amount of U.S. tax, one strategy they may entertain is to temporarily give up their U.S. person status, complete the taxable event overseas, and then become a US person again to avoid having to pay U.S. tax on that foreign income. Unfortunately, the IRS is aware of this scenario and has a pullback rule to prevent taxpayers from benefiting after relinquishing U.S. person status.

Let’s take a brief look:

What is 26 USC 7701(b)(10)?

(b) Definition of resident alien and nonresident alien

(1) In general

For purposes of this title (other than subtitle B)—

(10) Coordination with section 877 If—

• • • (A) an alien individual was treated as a resident of the United States during any period which includes at least 3 consecutive calendar years (hereinafter referred to as the “initial residency period”), and

    • (B) such individual ceases to be treated as a resident of the United States but subsequently becomes a resident of the United States before the close of the 3rd calendar year beginning after the close of the initial residency period, such individual shall be taxable for the period after the close of the initial residency period and before the day on which he subsequently became a resident of the United States in the manner provided in section 877(b). The preceding sentence shall apply only if the tax imposed pursuant to section 877(b) exceeds the tax which, without regard to this paragraph, is imposed pursuant to section 871.

Let’s work through the statutory definition piece by piece:

• “(A) an alien individual was treated as a resident of the United States during any period which includes at least 3 consecutive calendar years (hereinafter referred to as the “initial residency period”), and”

What does this mean?

This means the rule refers to a non-U.S. citizen who was treated as a U.S. resident for three consecutive calendar years. For example, David was transferred to the United States on an L-1 work visa and met the substantial presence test in all three years.

• “(B) such individual ceases to be treated as a resident of the United States but subsequently becomes a resident of the United States before the close of the 3rd calendar year beginning after the close of the initial residency period, such individual shall be taxable for the period after the close of the initial residency period and before the day on which he subsequently became a resident of the United States in the manner provided in section 877(b).”

What does this mean?

In the fourth year, David was no longer a U.S. person for tax purposes because he did not remain in the United States for at least 31 days (and did not meet the Substantial Presence Test). However, in the fifth year, David returns to the United States and meets the substantial presence test, so that he is considered a US person in that year.

In this type of scenario, even though David did not meet the substantial presence test during that fourth year (the year after he ceased being a U.S. person following the initial residency period), since he became a US person again in the 5th year (before the close of the 3rd calendar year beginning after the close of the initial residency period), the fourth year would also be taxable as a US person in accordance with section 877(b)

Removing the Legal Jargon

In other words, David cannot be US person for three years and then leave the United states for one year for example to execute a big taxable event overseas, and then return to the United states in the next year without being taxed as a U.S. person for that in between year in which technically he did not meet the substantial presence test so would not otherwise be taxed on his worldwide income had he not returned during the three-year after after the initial residency period ends.

• “The preceding sentence shall apply only if the tax imposed pursuant to section 877(b) exceeds the tax which, without regard to this paragraph, is imposed pursuant to section 871.”

What does this mean?

For this to be applicable, the tax imposed under section 877(b) must exceed the tax imposed under section 871 (tax on non-resident individuals).

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.

Contact our firm today for assistance.