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Certain foreign nationals may avoid penalties for underpayment of estimated tax by relying on 100% of prior year tax shown on dual status return.

Sec. 6654(d) provides that an individual generally can avoid penalties for underpayment of estimated tax if he makes estimated tax payments based on 100% of the tax shown on the return of the individual for the preceding tax year. (It appears that the tax shown on this return must be greater than zero.) This rule, however, does not apply if the preceding tax year was not a tax year of 12 months or if the individual did not file a return.

Many foreign nationals who arrive in the United States will file a dual-status return or a nonresident alien return in the year of arrival. The question is: Can they base their estimated tax for the second U.S. year on the 100% tax shown on their return for the first year? The authors believe that generally they may, since they meet the 12-month test under Sec. 6654(d)(1). The prior year of a dual-status alien is a tax year of 12 months, even though the alien is not in the United States for the full 12 months. Regs. Sec. 1.871-13(a) provides that the tax year of a dual-status alien comprises two separate periods, one while a resident alien and the other while a nonresident alien.

However, this exception does not apply (other than for the first required installment) to any taxpayer who meets all three conditions under Sec. 6654(d)(1)(C). 1. The modified adjusted gross income (AGI) for the current year exceeds the amount of the adjusted gross income shown on the return of the individual for the preceding tax year by more than $40,000 ($20,000 in the case of a separate return for the current year by a married individual). 2. The AGI shown on the return for the current year exceeds $75,000 $37,500 in the case of a married individual filing a separate return). 3. The taxpayer has made an estimated tax payment for any of the three preceding tax years excluding refunds applied as an estimated tax payment) or a penalty has been previously assessed for failure to pay estimated tax for any of these three preceding years.

Modified AGI is defined in Sec. 6654(d)(1)(D) as AGI for the current year with certain adjustments for passthrough items, gain from an involuntary conversion and gain from the sale or exchange of a principal residence.

For purposes of determining whether the above $40,000 threshold has been met, gross income for a dual-status year is comprised of (1) for the nonresident alien period, U.S.-source noneffectively connected income (e.g., dividends, interest, etc.) and income effectively connected with a U.S. trade or business (e.g., compensation for services performed in the United States) (Sec. 872), and (2) for the residency period, all income, regardless of whether U.S. or foreign source.

In contrast, the exemption from underpayment penalties under Sec. 6654(e) for an individual who did not have any U.S. tax liability for the preceding tax year is only applicable to an individual who was a U.S. citizen or resident throughout the preceding tax year.
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Author:Friedman, Steven M.
Publication:The Tax Adviser
Date:Jun 1, 1993
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