U.S. Withholding Treatment of Resident and Nonresident Aliens
By Daniel Ressler, Tax & Business Services
Foreign persons who work, or invest, within the U.S. maybe subject to U.S. income taxes based on their activities. Further, these same individuals may be taxed differently from one another based on certain criteria.
The criterion begins with addressing the status of resident alien vs nonresident alien. An alien is a taxpayer who is an individual that is not a U.S. citizen or U.S. national by birth. These types of individuals pay U.S. income taxes on their worldwide income, exactly how a naturally born U.S. citizen would pay income taxes. Resident aliens are allowed the same deductions, personal exemptions, standard deduction, and tax credits.
A nonresident alien is an individual who has not passed the green card test nor have they met the substantial presence test. The substantial presence test which is met by being present in the U.S. for 31 days during the calendar year or 183 days during a 3 year period which is comprised of the current year and the 2 years immediately before that. The 183 days is counted by adding all the days present in the U.S. then in the prior year taking 1/3 of the total amount of days and the year before that, taking 1/6 of the total days and adding each of the 3 years together. If your total is less than 183 days, then you are considered a nonresident alien and did not meet the substantial presence test, unless you choose to evoke certain other elections.
The gross basis withholding tax is typically subject to be withheld at 30%. A foreign person is subject to U.S. gross basis withholding tax on U.S.-source fixed, determinable, annual, or periodic income (FDAP). FDAP income is defined as but not limited to, “interest, dividends, rents, salaries, wages, salaries, wages, premiums, annuities, compensations, remunerations, or emoluments”. This type of income is passive in nature and is not subject to deductions. A U.S. withholding agent is required to collect the tax because they are primarily liable for the taxes. The IRS requires a U.S. withholding agent because foreign taxpayers are not subject to U.S. jurisdiction. If the U.S. withholding agents do not report the appropriate amount of tax withheld, then they are on the hook for additional penalties and interest. There are certain circumstances that the income is not considered FDAP. An example of income that is not considered FDAP is the sale or exchange of property or income derived from the conduct of a U.S. trade or business. This type of income is considered non-passive in nature which deductions can be used to offset.
All other income is considered effectively connected income (ECI) to the content that is derived from a person engaged in a U.S. trade or business. ECI income is treated similarly to a natural born U.S. citizen because the foreign taxpayer is taxed at graduated rates with a maximum rate of 35% for corporation and 39.6% for individuals. Income that arises from a trade or business is considered non-passive, typically meaning the individuals own a percentage in the trade or business.
Foreign taxpayers are either subject to FDAP income or ECI income. FDAP income is primarily composed of passive income subject to withholdings at 30%. ECI income is mainly comprised of non-passive income and is taxed at a graduated rate with deductions being taken into consideration.