1040-NR: Important Tax Tips for Nonresident Aliens

1040-NR: Important Tax Tips for Nonresident Aliens

1040-NR for Nonresident Aliens (NRA)

1040NR:  Most US persons who file a US tax return each year will file an IRS Form 1040. Alternatively, the Form 1040-NR is filed by nonresident aliens to report US-sourced income — FDAP and ECI. The distinction between the 1040 vs. 1040-NR is that a US person such as a US citizen, Lawful Permanent Resident, or Foreign National subject to US tax because they meet Substantial Presence files a Form 1040 and reports their worldwide income. Conversely, a nonresident alien who does not fall into one of these categories generally files a Form 1040-NR in order to report their US-sourced income only.*

*Foreign residents (who meet substantial presence but qualify for the closer connection exception) file 1040-NR and Form 8840.

Despite the fact that the 1040-NR form is used to report US-sourced income only, leave it to the Internal Revenue Service to make the form unnecessarily complicated.

Let’s take a quick review of five (5) important tax tips for nonresident aliens filing Form 1040-NR:

Are you a Nonresident Alien or Resident Alien (1040-NR vs 1040)?

US citizens and lawful permanent residents are always considered US persons unless the lawful permanent resident claims a treaty-tie breaker rule position. In order to avoid US tax on worldwide income, it is crucial for foreign national nonresident aliens to not meet the Substantial Presence Test (SPT). Also, it is important to note that SPT test is not only based on the current-year residence in the United States. Rather, the test is comprised of a three-year staggered rule  (1:1, 3:1, and 6:1 ratio) to determine whether a person qualifies as a US resident under SPT.

Even if a person does meet substantial presence, they may still be able to avoid reporting their worldwide income if they can show a closer connection to a foreign country(s) and file a Form 1040-NR along with IRS Form 8840.

FDAP vs ECI & 1040-NR Filing

It is important to determine which type and category of US income the nonresident alien is reporting. FDAP refers to Fixed, Determinable, Annual and Periodic income — which is primarily passive income. Generally, there is a mandatory 30% withholding on the income in order to ensure the nonresident alien pays tax to the United States.

It is important to note that withholding is not the same as tax. Some tax treaties provide for a reduced tax rate on certain income, and a taxpayer may be able to rely on the treaty in order to reduce or eliminate tax liabilities to the US government.

If the income is ECI (Effectively Connected Income), then the nonresident alien can generally claim deductions associated with that income, although there may be some limitations on those deductions that do not apply to non-US persons — depending on the type of deductions/expenses.

One common type of Effectively Connected Income is when a foreign nonresident alien elects to treat rental property income from a US property as a trade or business instead of the default category of FDAP.

Treaty Rules to Reduce Income Tax

The United States has entered into more than 50 bilateral tax treaties with foreign countries. Based on the language in some of these tax treaties, a person may be able to reduce their tax liability based on the reduced tax rate(s) as contained in the treaty.

Limited Foreign Asset and Account Reporting

When a US person files a Form 1040 and has foreign assets, accounts, investments, and/or income, the taxpayer is required to include all of this information on the tax return on various international information reporting forms.

Depending on the type of assets, along with the value of the investments, the taxpayer may have to file one or several international information reporting forms, such as Forms 3520, 3520-A, 5471, and 8938 as well as FBAR each year.

If a person is a nonresident alien, then generally they are not required to disclose this information — although dual-status tax filers may have to include the asset reporting for information regarding the portion of the year that the taxpayer is considered a US person (but this usually does not include FBAR filing).

Dual-Status Tax Return

Dual-Status returns are not common. They typically occur in either the first-year that a person becomes a US person and in the final year they are a US person — and requires the taxpayer to make an election to be treated as a dual-status taxpayer.

The benefit of the dual-status election is that the taxpayer only pays tax on their worldwide income (as opposed to US-sourced income only) for the portion of the year that they are considered a US person — and not for the portion of the year that they are considered a nonresident alien.

Due Diligence Before Filing

Even if a person is a nonresident alien, if they have US-sourced income then they may still have to file a US Tax Return, IRS Form 1040-NR. The US tax rules and reporting are different when it comes to nonresident aliens. There are various exceptions, elections, and treaty positions that a taxpayer may be able to claim in order to reduce or eliminate their US tax liability.

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