International Tax Concepts: Dual-Status Taxpayers
A taxpayer’s status as a resident or nonresident is not always straightforward. A dual-status taxpayer, for example, may qualify as both a nonresident alien and a resident alien during the same tax year. Typically, this dual status occurs in the year that the taxpayer arrives in, or departs from, the United States. A dual-status taxpayer may be subject to one set of rules for part of the year and another set of rules for the other part of the year — and may qualify for certain elections, such as the first-year election discussed below.
Keep in mind, we are talking about tax status here. Dual status, as used here, does not imply citizenship. It simply refers to whether a person is a “resident” of the United States for tax purposes.
Who is a Dual-Status Taxpayer?
A dual-status taxpayer is defined as a person who changes their tax status from (i) a nonresident to a resident or (ii) a resident to a nonresident during the current year.
How is a Dual-Status Taxpayer Taxed?
A U.S. tax resident is, as a general rule, subject to tax on all income from all sources. Thus, dual-status taxpayers are subject to tax on their worldwide income from all sources for the period of the year that they are a U.S. resident. Income that is received by a U.S. resident may be subject to U.S. taxation even if it was earned while they were a nonresident alien.
A dual-status taxpayer is taxed on income from U.S. sources and on certain foreign-source income treated as effectively connected with a U.S. trade or business during the period of the year that they qualify as a nonresident alien.
Note that certain restrictions may apply to tax returns for dual-status taxpayers, and the failure to comply with those restrictions and the applicable rules may increase a taxpayer’s exposure to audit and, of course, penalties. Taxpayers may also consider applicable elections, such as the first-year election.
The First-Year Election
A nonresident who qualifies as a U.S. resident under the substantial presence test may elect to be treated as a dual-status resident for the prior tax year, if certain tests are met, by filing a proper election statement making the first-year election.
More specifically, if a taxpayer does not meet either the green card test or the substantial presence test for the two prior years and did not elect to be treated as a resident, but they meet the substantial presence test for the current year, they may elect to be treated as a U.S. resident for part of the prior year. To qualify for this election, the taxpayer must meet the following criteria:
- The taxpayer must have been present in the United States for at least 31 consecutive days in the prior year, and
- The taxpayer must have been present in the United States for at least 75% of the total number of days that began with the first day of the 31-day period and ended with the last day of the prior year. For purposes of this 75% requirement, the taxpayer is generally allowed to treat up to 5 days of absence from the United States as days of presence in the United States.
Note, however, that certain days may be excepted.
Most tax treaties contain an article that defines tax residency for treaty purposes. An applicable tax treaty’s residency article may change the default residency rules and may necessitate consulting with a tax attorney with international tax experience.
Dual-Status Individuals Married to a U.S. Resident
A dual-status individual who is married to a U.S. citizen or to a resident may elect to file a joint income tax return. The election applies for the entire year if all of the following apply:
- The taxpayer is a nonresident alien at the beginning of the year.
- The taxpayer is a resident alien or U.S. citizen at the end of the year.
- The taxpayer is married to a U.S. citizen or resident alien at the end of the year.
- The taxpayer’s spouse joins in the election.
Taxpayers making the foregoing election are subject to the following rules:
- The taxpayer and their spouse are treated as U.S. residents for the entire year for income tax purposes.
- The taxpayer and their spouse are taxed on worldwide income.
- The taxpayer and their spouse must file a joint return for the year of the choice.
- Neither the taxpayer nor their spouse may make the election for any subsequent tax year — even if they are separated, divorced, or remarried.
Taxpayers making this election must file a compliant statement.
Failed to Report Offshore Accounts?
Largely because of the complexity and confusing nature of the applicable tax regimes, dual-status taxpayers often run afoul of important IRS reporting rules, particularly those requiring that they report non-U.S. accounts and assets. Among the more common reporting violations are failures to file an FBAR, Form 8938, Form 5471, Form 3520, and others. Indeed, the potential penalties and exposure for failing to file such forms can be very significant. We have helped many taxpayers with such violations remove penalty exposure and comply with future filing obligations. It is, perhaps, one of the most rewarding areas of practicing tax law. Taxpayers with offshore account reporting violations should contact a qualified tax attorney.