U.S. taxation of nonimmigrant students, teachers and trainees.

U.S. colleges, universities, vocational, high and language schools, and many U.S. corporations, sponsor educational programs that draw hundreds of thousands of foreign nationals to the U.S. each year to study, teach or perform research. These individuals face multiple tax filing obligations, including a tax return(1) and a supplemental annual statement.(2) Many may have little experience with voluntary self-assessment tax systems and limited English language proficiency. Because tax professionals generally have little experience with nonresident alien (NRA) tax matters, help is often difficult to find. This article discusses the U.S. compliance requirements of international, nonimmigrant, students, teachers and trainees.

Classifying Foreign Nationals

Foreign nationals who come to the U.S. are divided into two broad categories - immigrants and nonimmigrants - by the Immigration and Nationality Act,(3) which is administered by the Immigration and Naturalization Service (INS). Those who come to study, teach, engage in research or receive training and intend to return to their home country are nonimmigrants; they are granted visas of the following types: * "F": For an alien who is a bona fide student qualified to pursue a full course of study and who seeks to enter the U.S. temporarily and solely for the purpose of pursuing such a course of study at an established institution of learning, and his spouse and minor children.(4) * "J": For an alien who is a bona fide student, scholar, trainee, teacher, professor, research assistant, specialist or leader in a field of specialized knowledge or skill, or other person of similar description, who is coming temporarily to the U.S. to participate in a program for the purpose of teaching, instructing or lecturing, studying, observing, conducting research, consulting, demonstrating special skills, or receiving training, and his spouse and minor children.(5) * "M": For an alien with a residence in a foreign country which he has no intention of abandoning, who seeks to enter the U.S. temporarily and solely for the purpose of pursuing a full course of study at an established vocational or other recognized nonacademic institution (other than in a language training program), and his spouse and minor children.(6)

Resident and Nonresident Taxation

Under Regs. Sec. 1.1-1(a), individuals who are not U.S. citizens are aliens for Federal tax purposes. The taxation of an alien depends on whether he is a U.S. resident. Regs. Sec. 1.871-1 provides that resident aliens (RAs)) are taxed like U.S. citizens; thus, they are taxed on their worldwide income and allowed the same exclusions and deductions, personal exemption and choice of filing status as are U.S. citizens (dependency exemptions are permitted if the dependent meets a special residence test under Sec. 152(b)(3)). RAs may file Form 1040, 1040A or 1040ES.

In contrast, Sec. 871 provides that NRAs are taxed only on U.S.-source income. Under Sec. 871(b), such income that is "effectively connected" with a U.S. trade or business may be reduced by limited itemized deductions (Sec. 63(c)(6)(B) bars use of the standard deduction) and a personal exemption. Under Regs. Sec. 1.1-1(a)(2)(ii), such income generally is subject to tax at either the single or married filing separately rates. Sec. 871(a) provides that income not effectively connected with a U.S. trade or business (e.g., investment income and income from the sale of certain assets) is subject to a flat 30% tax rate. The benefits of tax treaties are available to NRAS, but not to RAs. NRAs file Form 1040NR, U.S. Nonresident Alien Income Tax Return.

Determining Resident Status

* Green card test

Aliens are U.S. residents if they meet a "green card" test or "substantial presence" test. Sec. 7701(b)(1)(i) provides that an individual granted the right to remain permanently in the U.S. is a lawful permanent resident(7); this right is granted by the INS through the issuance of a "green card." Lawful permanent residents are immigrants. Holders of F, J or M visas are, by definition, nonimmigrants and, therefore, cannot meet the green card test.

* Substantial presence test

The two-part substantial presence test of Sec. 7701(b)(3) counts the days the alien is physically present in the U.S. The alien must be present in the U.S. for at least 31 days in the current year, and for at least 183 days in the consecutive three-year period ending with the current year. The 183-day test counts all days of presence in the current year, one-third of the days in the immediately preceding year and one-sixth of the days in the second preceding year.

Example 1: A, an alien, was present in the U.S. for 122 days in each of 1995, 1994 and 1993. A counts 122 days in 1995, 40 2/3, (122 x 1/3) in 1994 and 20 1/3 (122 x 1/6) for 1993, for a total of 183. Therefore, A meets the substantial presence test and is an RA.

Example 2: B, an alien, was present in the U.S. for 28 days in 1995 and 365 days for each of 1994 and 1993. B is an NRA because, although she meets the 183-day part of the test, she was not present for 31 days in the current year.

Example 3: C, an alien, was present in the U.S. for 170 days in 1995, and 30 days in each of 1994 and 1993. C counts 170 days in 1995, 10 (30 x 1/3) days in 1994 and 5 (30 x 1/6) days in 1993, for a total of 185 days. Thus, C is an RA.

Special rules apply when calculating days under the substantial presence test. * Partial days: Regs. Sec. 301.7701(b)-1(c)(2)(i) provides that there are no fractional days. If an alien is present for any part of the day, it is counted as a full day, but fractional days resulting from the second- and third-year calculations are not to be upwardly rounded. * Excluded days: Days on which the alien is an "exempt individual" are not counted.(8) Under Regs. Sec. 301.7701(b)-3(b)(3) and (4), students, teachers and trainees on an F, J or M visa are exempt individuals. For teachers and trainees, the exemption lasts for two tax years (four years if they are being paid by a foreign employer). Regs. Secs. 301.7701(b)-3(b)(7) states that the exemption is lost if the teacher or trainee was present under an F or M visa for any part of two of the six preceding years. For students, the exemption period is five tax years, under Regs. Sec. 301.7701(b)-3(b)(4). However, Regs. Sec. 301.7701(b)-3(b)(7)(iii) states that the exemption can continue beyond that period if the student can establish to the satisfaction of the IRS District Director that he does not intend to remain permanently in the U.S.

Example 4: E, a nonimmigrant student on an F visa, arrives in the U.S. in fall 1995 to begin a full course of study at an accredited college. If E remains continuously engaged in his studies, he will be an NRA for 1995, 1996, 1997, 1998 and 1999, but an RA for 2000 if he cannot show permanent intent to remain.

Example 5: K is a nonimmigrant teacher in the U.S. on a J visa who arrived in the U.S. in May 1991. K begins teaching in the U.S. in 1995. Although 1995 is K's first year of teaching, she was present in the U.S. from 1991-1994 (i.e., four of the preceding six years) as a student with an F visa; thus, K is not an exempt individual for 1995, and will be an RA in 1995 under the substantial presence test.

A teacher, trainee or student is an exempt individual only as long as his activities are not inconsistent with his visa. Although the INS issued the visa, the IRS has the authority to determine, for tax purposes, if an alien is in substantial compliance with it. Regs. Sec. 301.7701(b)-3(b)(6) makes it clear that it will not suffice to show that the INS has not started visa revocation proceedings, as the IRS may make an independent determination of compliance. Under Regs. Sec. 301.7701(b)-8(a)(2), any individual with excluded days of presence in the U.S. must file an annual statement with his tax return. * Medical condition: Under Regs. Sec. 301.7701(b)-3(c), an individual is not present on any day that he was precluded from leaving due to a medical condition that arose while in the U.S. This exclusion applies only to the unintended days of presence.

Example 6: G was injured in an automobile accident on April 20 and was unable to leave on her scheduled flight to Europe on May 5, but recovered sufficiently to travel home on June 10. The days from May 6 to June 10 are excluded.

* Days in transit: An individual must exclude any day in which he is physically present in the U.S. for less than 24 hours and is between two foreign points in travel.(9) This exclusion is lost if the individual attends a business meeting or engages in activities that are inconsistent with travel during the stop in the U.S. * Closer connection exception: An exception may be used by an alien otherwise qualifying under the substantial presence test to attain NRA status.(10) The alien must show that (1) he was physically present in the U.S. for less than 183 days in the current year, (2) has a closer connection to a foreign country than to the U.S. and (3) has a tax home in that foreign country. This "closer connection exception" usually applies in the year an alien departs from the U.S. "Tax home" is defined by Regs. Sec. 301.7701(b)-2(c) as located at the alien's regular or principal place of business, if any; if none, then his regular place of abode. A facts-and-circumstances test under Regs. Sec. 301.7701(b)-2(d) determines the country of closer connection. The following contacts are considered: the location of (1) the permanent home, (2) immediate family, (3) personal belongings (e.g., autos, furniture, clothing and jewelry) and (4) social, cultural, political or religious organizations to which the alien belongs. Also considered are the location in which the alien conducts routine business, banks, votes and holds a driver's license, as well as the address used on important U.S. immigration documents. However, Regs. Sec. 301.7701(b)-2(d)(1)(f) provides that the closer connection exception may not be used by an individual who has taken formal steps to obtain a green card. Generally, it is difficult for a student, teacher or trainee to qualify for the closer connection exception, because the tax home usually follows the alien to the U.S. Under Regs. Secs. 301.7701(b)-2(d)(1)(g) and -8, an alien using the closer connection exception must file an annual statement with his tax return.

* Dual-status aliens

It is not unusual for an alien's status to change from RA to NRA (or vice versa) during a tax year, for various reasons (e.g., changes in visa classification, midyear arrivals and departures, or the issuance or abandonment of a green card). An alien is a "dual-status" alien in years in which residence status changes in midyear; special rules dictate how residency time periods are to be determined in such years. Regs. Sec. 301.7701(b)-4(a) provides that the residency start date is the first day of physical presence in the U.S. during the year in which the alien meets the green card or substantial presence test.

Example 7: H, a student from China, arrived in the U.S. in 1993 to study at a state university. On July 15, 1994, H was granted a green card. H was an NRA for 1993 and for the period Jan. 1 to July 14, 1994, and was an RA for the remainder of 1994.

Regs. Sec. 301.7701(b)-4 provides that the residency termination date is generally the last day of the alien's tax year. An exception applies to an alien who physically leaves the U.S. during the year to return to,a country to which he has a closer connection and a tax home. In such case, the residency termination date is the day the alien physically leaves the U.S., under Regs. Sec. 301.7701(b)-4(b)(2). Effect of treaty on residency status: Treaty residency tie-breaker provisions apply when an individual would be considered a resident of two countries simultaneously. Provisions in treaties that determine residency for tax purposes take precedence over the substantial presence test. Sec. 6114(a)(1) states that an alien who relies on a treaty provision is required to make disclosure on Form 1040NR.

Electing RA Status

In two instances, an NRA may elect to be treated as an RA to file a joint return with a citizen or resident spouse. A Sec. 6013(g) election is available to an NRA married to a U.S. citizen or RA to allow the filing of a joint return. Regs. Sec. 1.6013-6(a)(4) provides that the election is made by attaching a statement to the return. Once made, it continues until the earliest of the following: (1) revocation by both spouses in writing; (2) neither spouse is a U.S. citizen or resident; (3) revocation by death of the U.S. citizen or RA spouse; and (4) dissolution of the marriage. Once the election is revoked, it cannot again be made by the NRA.

According to Regs. Sec. 1.6013-7, a Sec. 6013(h) election may be made by an individual who was an NRA for part of the year, became an RA and, by the end of the year, married a U.S. citizen or RA. The election allows the filing of a joint return.

Computation of Taxable Income 

* Source of income

Sec. 871(b) provides that NRAS are taxed only on their U.S.-source income. A summary of the source rules that apply to nonimmigrant students, teachers or trainees follows(11):

Income Source Compensation Place where service is performed Dividends Residence of payer corporation Interest Residence of payer Rents Location of property Sale of personal Residence of seller property Sale of real property Location of real estate Scholarship Location of payer

Under Sec. 861(a)(3), compensation paid by a foreign employer to an NRA for services performed in the U.S. is foreign source if under $3,000 and the individual performing the services is in the U.S. for no more than 90 days. In addition, Sec. 872(b)(3) states that compensation paid by a foreign employer to a student, teacher, trainee or exchange visitor in the U.S. on an F, J or M visa is not U.S.-source income.

This rule should be distinguished from the exclusion for scholarships under Sec. 117. A scholarship paid by a foreign payer is excludible from U.S. income(12); on the other hand, a scholarship paid by a U.S. payer may be excluded from income under Sec. 117(b) only if the recipient is a degree candidate at an accredited college or university and only to the extent it is used for tuition, books, fees and related costs. A U.S. scholarship for room and board is not excludible.

* Effectively connected income

After income of an NRA is "sourced," it must be determined whether it is "effectively connected" with a U.S. trade or business. The significance of the classification can be seen in the flowchart on page 374. For this purpose, Secs. 1441(b) and 871(c) provide that compensation from employment is deemed earned in a trade or business; thus, it is effectively connected income (ECI). Many F, J and M visa holders will have compensation income from campus-related employment. Because the compensation is subject to Sec. 1441 withholding, the potential of a refund is often the motivation to comply with Federal return filing requirements. Scholarship income is also ECI, because Secs. 871(c) and 1441(b) provide that students are in a U.S. trade or business. Withholding on scholarships is a flat 14% rate under Sec. 1441(a) and (c). ECI, just as regular U.S. income, may be reduced by certain allowable deductions and a personal exemption. Net ECI is then subject to the single or married filing separately tax brackets.

Nonimmigrant, international, teachers, trainees or students may have dividends, rents, capital gains and other investment income; under Sec. 871(a), such income is non-ECI and is subject to a flat 30% tax rate. The 30% rate may be reduced by any existing treaty between the U.S. and the nonimmigrant's country. Under Sec. 871(i), non-ECI interest income from banks, savings and loans, credit unions and certain insurance accounts is excluded from gross income.

Sec. 873 and Regs. Sec. 1.873-1 limit deductions from ECI to those attributable to such income. Under Regs. Sec. 1.874-1(c), deductions and credits are allowed only if the NRA timely files a tax return.

Deductible trade or business expenses include:

* State and local income and property taxes. * Moving expenses (excluding expenses of moving from the U.S. to a foreign job site). * Traveling expenses while away from home (employed students and teachers qualify only if their course of study is one year or less). * Contributions to individual retirement accounts.

Deductible personal expenses include:

* Casualty losses, but only to property located in the U.S., and subject to the $100 per-casualty reduction and the 10% adjusted gross income limitation. * Charitable contributions. * NRAS cannot use the standard deduction. * Only one personal exemption is permitted; dependency exemptions are disallowed.(13)

Tax Treaties

NRAs may use the benefits of tax treaties between their home country and the U.S. Most tax treaties provide some exclusion for personal service income (compensation) earned during the period of study or training. Treaty exclusions must be scrutinized, as they differ from one country to another. The wording of the personal service income exclusion is generally of two types: the first type allows an annual exclusion of a given amount (e.g., between $2,000 and $5,000).(14) The second type sets a maximum exclusion that is lost if exceeded.(15)

Further, for the exclusion to be applicable, the treaty may require the payer or employer to be a foreign resident; in some treaties, the payer or employer can be a U.S. resident. Occasionally, an exclusion is allowed for payments by either a foreign- or U.S.-resident payer or employer.(16) In addition, treaties often provide for a reduction in the tax rate on non-ECI.(17)

Special considerations arise for students and trainees from India. Article 21(2) of the U.S.-India tax treaty provides that an Indian student or business apprentice is entitled during his education or training to the same exemptions, reliefs or reductions in respect of taxes as are available to U.S. residents, even though neither the treaty nor the Code extends resident status to such aliens. This provision is addressed in Rev. Proc. 93-20,(18) which states that an Indian student or business apprentice (presumably, the same as the trainee referred to in Sec. 7701(b)(5)(c)), although an NRA, can use the standard deduction, and spousal and dependency exemptions, if certain rules are met. Thus, Indian students would file Form 1040NR, but would alter it to provide for the standard deduction and applicable exemptions.

Reporting

NRAS file Form 1040NR. Under Sec. 6072(c), if the taxpayer had wage income subject to withholding, the return is due April 15; otherwise, it is due June 15. The instructions to Form 1040NR indicate that the return is to be sent to the Internal Revenue Service, Philadelphia, PA 19255.

Under Regs. Sec. 1.6012-1(b), all NRA students, teachers and trainees with F, J or M visas are deemed engaged in a U.S. trade or business; thus, they must file Form 1040NR, whether or not they have income. Under Sec. 6039E(a)(2), an alien who intends to apply for permanent resident status must show that all required tax returns were filed for the three-year period preceding the application.

As was previously discussed, most NRA students, teachers and trainees must also make an annual statement; the information required is set forth in Regs. Sec. 301.7701(b)-8 (an optional form is also available). Those using the closer connection exception may use Form 8840, Closer Connection Exception Statement for Individuals; exempt individuals with days of physical presence in the U.S. may use Form 8843, Statement for Exempt Individuals and Individuals With a Medical Condition. These statements must be filed with the return. Regs. See. 301.7701(b)-8 describes the penalties for failure to make the statement.

The situation of dual-status aliens (generally, F, J and M visa holders in their first or last year of U.S. physical presence) is more complicated - they must report as RAs for part of the year and as NRAs for the remainder. The return depends on the alien's status on the last day of the year. An alien who is an NRA on December 31 files Form 1040NR and attaches a statement containing the information necessary from the RA portion of the year; an alien who is an RA on December 31 files Form 1040 and attaches a statement for the NRA portion of the year.(19)

Departing Aliens

Generally, when aliens depart the U.S., they must obtain a Certificate of Compliance,(20) available from all IRS offices. Students, teachers and trainees are excluded from this requirement,(21) but must file Form 1040-C and pay any tax due. Form 1040-C is not a claim for refund; thus, the alien must file Form 1040 or 1040NR to obtain any such refund.

Income Tax Withholding and Employment Taxes

Generally, international students are not permitted to work. However, those with economic necessity may obtain an Employment Authorization Document, Form I-688B, from the INS that will allow part-time employment. Most students work in campus-related employment (e.g., libraries, food service, laboratories, etc.), but some find off-campus employment. Because NRAs are not taxed like U.S. citizens and are generally unfamiliar with U.S. tax law, significant errors frequently are made in income tax withholding. NRAs cannot use the standard deduction and are entitled to only one personal exemption, so that ordinary income tax withholding may result in underwithholding. On the other hand, withholding may be too high if no consideration is given to treaty exclusions for wages or for the nontaxable portion of scholarships. Another problem is Social Security withholding. NRAs with F, J and M visas are exempted from Social Security tax withholding by Regs. Sec. 31.3121(b)(19)-1, but it is often withheld in error.

Student-employees submitting Form W-4 should anticipate the possibility of underwithholding by claiming "single" status and reducing withholding allowances.

Form W-4 can also be used to counter overwithholding due to treaty exclusions. The alien must attach to Form W-4 Form 8233, Exemption From Withholding on Compensation for Independent Personal Services of a Nonresident Alien Individual, and a statement indicating eligibility.(22)

When the student receives scholarship funds subject to withholding, Form W-4 may be used to adjust the withholding. However, withholding may be reduced if the alien is entitled to additional exemptions, travel expenses, scholarship exclusions or other allowable deductions.(23) The scholarship payer reports to the student on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding.

When Social Security tax is withheld, the student should first attempt to obtain a refund from the employer. The employer's incentive to cooperate with this request is the knowledge that its share of the Social Security tax was also overpaid. The employer may refund the overwithheld tax and reduce its liability for a subsequent quarter by attaching a statement to Form 941, Employer's Quarterly Federal Tax Return. If the student cannot obtain a refund from his employer, he can file a refund claim on Form 843, Claim for Refund and Request for Abatement. The student should attach a copy of his Form W-2 and his INS Forms 1-94 and I-538 or I-20 to substantiate the refund claim and file the forms with the IRS office in which the employer's payroll tax return was filed. If the student cannot determine the identity of that office, the claim may be filed with the IRS's Philadelphia, PA office.

Conclusion

Every alien with an F, J or M visa has the obligation to file a return, and most must add an annual statement. It is hard to imagine a tax area with a more difficult compliance burden. The tax rules are complex and unique, the taxpayers may have little knowledge or tradition of paying taxes, and may not have proficiency in English. The fact that tax practitioners usually do not have the expertise to determine the law without the investment of significant time exacerbates the problem. The population of international, nonimmigrant, students, teachers, trainees and researchers is increasing and familiarity with the tax rules pertaining to them is crucial.

(1) Secs. 871(c), 6012(a)(1)(A), 6012(a)(1)(C)(ii) and 63(c)(6)(C). (2) Sec. 7701(b)(8); Regs. Sec. 301.7701(b)-8. (3) 8 USC Section 1101(15). (4) 8 USC Section 1101(a)(15)(F). (5) 8 USC Section 1101(a)(15)(J). (6) 8 USC Section 1101(a)(15)(M). (7) See Sec. 7701(b)(6) and Regs. Sec. 301.7701(b)-1(b)(1). (8) Sec. 7701(b)(3)(D) and (5); Regs. Sec 301.7701(b)-3. Instructions for 1994 Form 1040NR, p. 1, prove that "Q" visa holders (aliens participating in certain international cultural exchange programs) are treated as students, teachers and trainees and, thus, are exempt individuals for purposes of the substantial presence test if they otherwise so qualify, but may only exclude days of presence after Sept. 30, 1994. (9) Sec. 7701(b)(7)(C) and Regs. Sec. 301.7701(b)-3(d). (10) Sec. 7701(b)(3)(B) and Regs. Sec. 301.7701(b)-2. (11) Regs. Secs. 1.861-2 through -7; Rev. Rul. 89-67, 1989-1 CB 233. (12) Rev. Rul. 89-67, id. (13) See the U.S.-Japan Tax Treaty, Art. 4(5) and the U.S.-Korea Tax Treaty, Art. 4(7), for instances in which exemptions for spouse and children are permitted. (14) See, e.g., the U.S.-Cyprus Tax Treaty, Art. 21(1) and the U.S.-People's Republic of China Tax Treaty, Art. 20(c). (15) See, e.g., the U.S.-Canada Tax Treaty, Art. XV, 2(a). This type of provision is a condition, rather than an exclusion. If personal service income is less than $10,000, it is not subject to U.S. tax. But, if the income is more than $10,000, it is taxed in full in the U.S. See also IRS Pub. 597, Information on the U.S.-Canada Income Tax Treaty. (16) See IRS pub. 901, U.S. Tax Treaties, Table 2. (17) See id., Table 1. (18) Rev. Proc. 93-20, 1993-1 CB 528. (19) IRS Pub. 519, U.S. Tax Guide for Aliens, Chapter 6, "Dual-Status Tax Year." (20) Form 1040-C, U.S. Departing Alien Income Tax Return, or Form 2063, U.S. Departing Alien Income Tax Statement. (21) See Instruction for Form 1040-C; IRS Pub. 519, note 19. (22) Rev. Procs. 87-8, 1987-1 CB 366, and 87-9, 1987-1 CB 368, modified by Rev. Proc. 93-22, 1993-1 CB 535, set forth the desired language of the statement. See also IRS Pub. 519, note 19. (23) Rev. Proc. 88-24, 1988-1 CB 800.