Legal Resident vs Tax Resident: What's the Difference?

Legal Resident vs Tax Resident: What’s the Difference?

Who is a Legal Resident for Tax Purposes

Who is a Legal Resident for Tax Purposes: International tax law is complex. Each year, the IRS releases several different new and updated publications about international tax — and each year the information seems to get more and more complicated. This confusion has led to many misconceptions about how foreign income is taxed, who is taxable on their worldwide income, and what the terms Tax Resident and Legal Resident mean. The most popular misconception is that only U.S. Citizens or Legal Permanent Residents (aka “legal residents”), are subject to U.S. Tax on worldwide income — but that is incorrect.

There are actually three (3) categories of U.S. person taxpayers.

The three main categories of individuals who are considered Legal Residents or “U.S. Persons” for tax purposes, includes:

Tax resident for this article refers to residents for “income tax” purposes.

Legal Resident vs. Tax Resident

A resident for “Tax” purposes is not the same as a resident for “Legal” purposes.

For example, a person can reside in the United States as neither a U.S. citizen nor Legal Permanent Resident and still be considered a tax resident.

In fact, a foreign national person can be considered a U.S. tax resident even if they are in the United States legally or illegally — if they meet the substantial presence test.

Likewise, a person can legally visit the US as a resident, but not be considered a tax resident.

Who is a Tax Resident?

A tax resident generally means that an individual meets one of the three (3) different categories:

  1. U.S. Citizen
  2. Legal Permanent Resident (aka Green Card Holder)
  3. Substantial Presence Test (SPT)

What is the Substantial Presence Test?

The substantial presence test is a “counting days” test.

It generally means a person was present in the United States for at least 31 days in the current year and a minimum total of 183 days over 3 years, using the following equation:

  • 1 day = 1 day in the current year
  • 1 day = 1/3 day in the prior year
  • 1 day = 1/6 day two years prior

Example A: If you were here 100 days in 2016, 30 days in 2015, and 120 days in 2014, the calculation is as follows:

  • 2016 = 100 days
  • 2015 = 30 days/3= 10 days
  • 2014 = 120 days/6 = 20 days
  • Total = 130 days, so you would not qualify under the substantial presence test and NOT be subject to U.S. Income tax on your worldwide income (and you will only pay tax on money earned while working in the US).

Example B: If you were here 180 days in 2016, 180 days in 2015, and 180 days in 2014, the calculation is as follows:

  • 2016 = 180 days
  • 2015 = 180 days/3= 60 days
  • 2014 = 180 days/6 = 30 days
  • Total = 270 days, so you would qualify under the substantial presence test and will be subject to U.S. Income tax on your worldwide income, unless another exception applies.

Worldwide Income Tax Due

Tax Residents are taxed on their worldwide income.

This includes income generated in the U.S. or income generated abroad.

Let’s take the following example: Michael is a U.S. citizen. He resides in foreign country “B” and earns income from foreign country “C.” Under the worldwide income rules, the United States can tax Michael on all of the income he earned in country “C.”

Michael may have foreign tax credits to help offset the US tax liability and/or may qualify for the foreign earned income exclusion — but that does not change the fact that he is subject to U.S. income tax on his worldwide.

Illegal U.S. Residents & the IRS

The IRS wants their tax money.

Even when a person resides in legally in the United States, they are still subject to US tax on their worldwide Income.

In other words, even if a person has overstayed their visa or otherwise meets the substantial presence test, they are still required to include their worldwide income on their tax return.

Foreign Account & Asset Reporting

In addition to the worldwide income taxation rules, there are also foreign account, asset, and investment reporting requirements for tax residents as well.

Tax residents are required to disclose this information on a myriad of different international information reporting forms.

While the failure to properly disclose the account information on these forms may result in fines and penalties, the IRS has developed various offshore amnesty programs to assist with avoiding, reducing, and abating penalties.

Some of the more common forms include:

  • FBAR
  • FATCA form 8938
  • Form 3520
  • Form 3520-A
  • Form 5471
  • Form 8621
  • Form 8865

How to Avoid Offshore Fines and Penalties?

The IRS offshore tax amnesty programs assist Taxpayers who are already out of compliance for non-reporting, to safely get into compliance.

Some of the more common programs, include:

Golding & Golding: About Our International Tax Law Firm

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

Contact our firm today for assistance.