Preparing Returns for Foreign Students and Scholars as a

© 2004 Peter James Lingane. All rights reserved. May be reproduced in its entirety for educational use within the TCE/VITA programs.

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Preparing Returns for Foreign Students and Scholars by Peter James Lingane, EA

Presented to VITA Volunteers, UC School of Law, Davis February 7, 2004

Updated February 13, 2004

Introduction. Some of you have volunteered to prepare tax returns for foreign students and scholars because you have language skills or a cultural sensitivity that will ease the process. Others may see this as a way to save visitors to our country the cost of tax preparation. Others still may feel that they have technical knowledge that a randomly selected preparer may lack.

These are generous reasons. But do not allow your generosity to obscure the first important rule for volunteer tax preparers: First, do no harm1.

The volunteer programs do not retain records of those assisted and there is no way to compensate customers for mistakes. Thus, if you find that a customer has an income tax liability of more than a few dollars, ask yourself whether they might be better off with a preparer who will be there to correct a mistake or whose liability insurance will pay for a mistake that cannot be corrected. Incidentally. the average tax preparation fee at H&R Block, a large, national tax preparation firm, is about $1202.

The second important rule for volunteer preparers is to identify all of the issues that might be relevant to the customer’s tax situation, even those issues about which you have not been trained. This involves a comprehensive interview3. There is no incentive to be quick and every incentive to be careful.

The need for a comprehensive interview means that the training of VITA and Tax-Aide volunteers should include information which is “outside scope.” The purpose of this extra information is not to encourage volunteers to prepare complex returns but to allow volunteers to know when the return is complex.

If you come across a complex or unfamiliar situation, remember rule one!

Relatively early in the interview, you will want to determine whether the customer is a resident of the United States and a resident of California for income tax purposes. This question must be resolved early on because residents file their taxes under one set of rules while nonresidents and part-year residents follow other rules and use different forms.

1 Commonly referenced to Hippocrates, Epidemics, Bk. I, Sect. XI. Declare the past, diagnose the present, foretell the future; practice these acts. As to diseases, make a habit of two things—to help, or at least to do no harm. 2 2003 Annual Report. 3 For suggestions about how you might conduct this interview, and questions that you might ask, see www.lingane.com/taxaide/interview.pdf.


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At the risk of oversimplifying, you are generally a resident where you live. The specific rules are different for federal and California purposes.

You are generally a resident for federal income tax purposes if you are in the United States for 183 days measured over a three year period. You can be a U.S. resident for income tax purposes even if you are an undocumented alien with no legal right to live or work in the United States. Americans travel widely for business and pleasure and foreigners come to the United States just as frequently for similar reasons. The federal tax residency rules have specific exceptions for those who commute frequently to the United States, for airline personnel who overfly the United States, for diplomats stationed in the United States and for students and scholars temporarily in the United States.

Residents of the United States pay federal income tax on worldwide income, exactly as citizens are taxed. In contrast, nonresidents only report income earned in the United States or that originates in the United States.

Federal tax law denies nonresidents many provisions that those who live here take for granted. A nonresident cannot file a joint return with their spouse. Nonresidents, other than those from India, cannot claim exemptions for their dependents. A nonresident is generally denied the standard deduction. A nonresident cannot claim the Earned Income Credit and is generally denied the Child Care and Child Tax Credits.

For these reasons, low and moderate income taxpayers generally pay less federal tax if they are U.S. residents.

Example. Consider a student with a $7,000 taxable scholarship in 2003. There is a federal income tax liability if the student is a nonresident for income tax purposes but no tax liability if the student is a resident.

Nonresident Resident Scholarship $ 7,000 $ 7,000 Standard deduction denied <4,750> Personal exemption <3,050> <3,050> Taxable income 3,950 None Tax from Tax Table $ 398 none

Taxation of worldwide income is a big deal for someone with a high income, especially if this income is lightly taxed in the country of origin. Students generally don’t have high incomes and taxation of worldwide income is an empty threat.

This brings us to the third important rule for volunteer preparers. The customer may be better off if there is a legitimate reason to file as a U.S. resident.


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Additional Information. The Internet has made it a breeze to get information. You can download copies of the following references.

Federal. www.irs.gov.

Form 1040NR, Instructions

Form 1040NR-EZ, Instructions

Pub 519, U.S. Tax Guide for Aliens

Pub 515, Withholding of Tax on Nonresident Aliens and Foreign Corporations

Pub 901, U.S. Tax Treaties. The treaties themselves are posted on the Internet. Go to www.irs.gov and search the IRS site for "treaty."

Form W-7, Instructions

California. www.ftb.ca.gov.

Form 540NR, Instructions

Pub 1031, Guidelines for Determining Residency Status

Pub 1051A, Guidelines for Married Filing Separate Returns

Pub 1100, Taxation of Nonresidents and Individuals Who Change Residency

Elections Make Quick Work of Nonresident Returns, Peter James Lingane, EA Journal, January 2003. www.lingane.com/tax/taxaide.

Forms and publications are also available at the IRS and FTB offices in downtown Oakland near the 12th Street BART station or you can call 800-829-FORM (IRS) or 800-338-0505 (FTB) and ask that a copy be mailed to you.

The IRS has a special number for federal international issues at (215) 516-2000. The call is not toll free and the quality is uneven but the wait is short. A new twist this year: the system will hang up on you unless you push the buttons to say that you are calling from overseas.

http://www.irs.gov/

http://www.irs.gov/

http://www.ftb.ca.gov/

http://www.lingane.com/tax/taxaide


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Federal Taxation of Nonresidents (Lesson 5, Pub 678FS)

The United States taxes citizens and residents on their worldwide income. We tax nonresidents on U.S. -sourced income but we do not tax nonresidents on foreign-sourced income. So, you have to be able to distinguish U.S.-sourced income from foreign-sourced income. U.S.-sourced income goes on the tax return of a nonresident alien, foreign-sourced income does not.

Sourcing can be complex. Publication 519 lays out general sourcing principles and the rules for common types are income. In applying these rules, it may be necessary to under stand the meaning of “payer’s residence” or “tax home.”

Source is determined by Dividends Where payer is incorporated Interest Payer’s residence Rents Where property is located Salaries, wages, and other compensation for personal services

Where services are performed

Self-employment income Multifaceted. Services, sale of inventory, interest and royalty income are sourced separately.

Sale of real property Where the property is located Sale of personal property other than inventory (that is, stocks and bonds)

Tax home of the seller

Scholarships and fellowships Residence of grantor Social Security benefits Residence of payer

The Form 1040NR has five pages. The first two pages are similar to Form 1040 and are used to assess tax on U.S.-sourced income which is “effectively connected with a U.S. trade or business.” Income which is not effectively connected with a U.S. trade or business is reported on page 4. The distinction between effectively connected and not effectively connected income is analogous to the distinction between business and investment income or between active and passive income.

Not effectively connected income is commonly “fixed or determinable, annual or periodic” income. These categories may be identical, but I’m not positive.

The distinction is important because the taxpayer is only allowed deductions against effectively connected income. The distinction is also important because net business income is taxed at the graduated rates that apply to U.S. residents while gross investment income is taxed at flat rates.


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Examples Dividends and interest are effectively connected income if earned in the context of business operations. Non business investment income is not effectively connected and is reported on page four of the tax return. Rents are generally not effectively connected income. However, a nonresident can elect to have rents treated as effectively connected income. This election is important because, without it, rental expenses do not offset rental income. Wages, scholarships and fellowships are effectively connected income. The sale of U.S. real estate used in a business is effectively connected. The sale of a U.S. personal residence is not effectively connected. The sale of a foreign real estate is foreign-sourced and is NOT reported on the tax return. Income from the exercise of nonqualified options which were granted while working in the United States are probably effectively connected income even if exercised after departing the United States. By the same logic, I would have expected Social Security and pension income to be effectively connected income. This is not correct. Social security and pension income are generally reported on page four. The sale of stocks and bonds is “effectively connected” income if the sale occurs in the context of a business operation. More commonly, the sale is from the nonresident’s personal investment portfolio and is NOT effectively connected and is NOT reported on Schedule D or on page one of the tax return. Before considering whether the sale of stocks and bonds is effectively connected, we really need to decide whether the sale is U.S.-sourced. As noted in the table above, the sale is U.S.-sourced if the nonresident’s tax home is in the United States and foreign-sourced if the nonresident’s tax home is outside the United States.

2002 Publication 5194 defines “tax home” as the

general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home. Your tax home is the place where you permanently or indefinitely work as an employee or a self-employed individual. If you do not have a regular or main place of business because of the nature of your work, then your tax home is the place where you regularly live. If you do not fit either of these categories, you are considered an itinerant and your tax home is wherever you work.

The tax home of a student or scholar is likely to be in the United States and therefore the sale of stocks and bonds is likely to be U.S.-sourced.

Example 6 (p.2-4). Olga does not know which form to file. She has no wages but she sold $50,000 of stock on-line. She made only $70 after expenses. Assuming Olga is a

4 The IRS has not yet updated this publication for 2003.


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nonresident alien and that her tax home is in the United States, Olga should report the sale at the bottom of page four, Form 1040NR. Her gain is taxed at 30% unless a lower rate is set by treaty. Capital losses are denied and cannot be carried forward5. The text (p. 2-4) says that the sale is reported on Form 1040NR, Schedule D. This is an error. Schedule D, and the preferential tax rates accorded long term capital gains, is restricted to gains which are effectively connected to a U.S. trade or business. Your first obligation as a volunteer is to do no harm. Refer situations in which a nonresident has incurred a significant gain from the sale of securities unless you are positive as to the location of the taxpayer’s tax home.

Page three of Form 1040NR summarizes the itemized deductions which are directly related to the effectively connected income.

• A nonresident can claim a deduction for state income tax assessed on wages earned in the United States because the state tax is an “expense” of doing business in the United States.

• For similar reasons, unreimbursed job expenses are deductible, subject to 2% of AGI.

• A nonresident cannot claim a deduction for medical expenses or for mortgage interest or real estate tax on a personal residence because medical expenses and home ownership are not “expenses” of doing business.

• Contributions to U.S. charities and casualty or theft losses are deductible against effectively connected income because the tax code says they are.

• Education expenses are generally not allowed as itemized deductions. Nonresidents are denied all education credits and education adjustments except the adjustment for interest on student loans.

NO DEDUCTIONS ARE ALLOWED AGAINST NOT EFFECTIVELY CONNECTED INCOME

In principle, not effectively connected income is taxed at a flat 30% rate. The reality is that the rates are set in bilateral tax treaties with the result that a variety of rates are applied to different types of not effectively connected income. These special rates are summarized in Table 2 of Publications 515 and 901.

Two situations deserve special comment.

• Interest received by a business is effectively connected income. This income is taxable.

However, nonresidents can exclude not effectively connected interest income if it is from deposits with persons in the banking business or with saving

5 They can, however, be used to offset capital gains in the current year. Reg. §1.871-7(d)(4)(iii).


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banks and credit unions chartered under state or federal law or if it is from certain deposits with insurance companies.

Query: Is interest paid by a brokerage firm to a nonresident on idle cash excludable? I interpret U.S. brokerage firms as being in the banking business.

Nonresidents can also exclude “portfolio interest.” This is interest paid by a special type of securities which cannot be owned by citizens or residents.

Some tax treaties exclude all interest from U.S. tax.

Interest paid on municipal bonds is not taxed by the federal government but the interest on private activity municipal bonds is subject to AMT.

Even though interest is not taxed, it is reported in paragraph L on page 5 of the nonresident tax return. See the comprehensive example in chapter 6 of Publication 5196.

• Gains on the sale of capital assets by nonresidents, most commonly stocks and bonds, are excluded if the nonresident is present in the United States less than 183 days in the year of sale. The excluded gains are reported in paragraph L on page 5 of the tax return.

Students and scholars will generally not qualify for this provision except, perhaps, when they enter or leave the United States.

The fifth and final page of the Form 1040NR reports the information needed to determine residency status and special tax treatments under U.S. law or treaty. Many of the questions are self explanatory.

Questions D, E and H are used to confirm the claimed nonresidency status.

Question K. Lines 56, 59 and 61 refer to estimated tax payments and tax paid with a request for an extension or when leaving the United States. If no such payments were made, this question can be left blank.

Question L is where excluded U.S. bank interest is reported, and excluded gains of the sale of capital assets.

Question M is where the taxpayer claims a reduced rate of tax based on the provision of a bilateral treaty. Note that the treaty article must be cited.

Question P relates to U.S. citizens and long term green card holders residents who give up their citizenship or residency. If the facts suggest that the change was intended to “evade” U.S. tax, the taxpayer continues to be subject to U.S. tax law for ten years after the change.

6 The 2002 VITA text made this same point in Example 1 on p. 5-3. However, the discussion changed in 2003 to say that tax-exempt interest income is not reported. Whether this is a policy change or only the opinion of the author of the student text is unknown. The significance is whether Form 1040NR-EZ can be used in these circumstances. The instructions to Forms 1040NR and 1040NR-EZ are silent. Excludable interest is not reported on Form 1042S.


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Comprehensive Problem 1 (p. C-2).

Michelle Deventer, a permanent resident of Belgium, came to the U.S. on an F-1 visa on August 1, 2001. She has remained in this country since then and is a full-time student at the local university. Michelle, born 4-15-1978, is single. She began working on the university campus on January 3, 2003. She filed Form 8233 with the payroll department on January 15, 2003. Using the following information, complete Michelle’s tax return.

Form 1042-S Gross Income, $2,000 Income Code 19, Compensation during study or training (text, p. 3-9ff) Exemption Code 04, exempt by treaty (see Form 1042-S) FIT Withheld none

Form W-2 Wages $3,200 FIT Withheld $788 Kansas Income Tax Withheld $79 Social Security and Medicare Withheld none

The solution is on p. C-15.

Criticisms of the solution in the text. No address No citizenship or nationality No permanent foreign address No occupation Treaty benefit income for 2002 is not consistent with problem statement

The following information was apparently developed during the interview Citizenship Return filed in 2002 – there is a filing requirement due to type of visa. Taxpayer is not subject to tax on treaty benefit income.


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BELGIUM TAX TREATY ARTICLE 21 Students and Trainees

(1)(a) An individual who is a resident of one of the Contracting States at the

time he becomes temporarily present in the other Contracting State and

who is temporarily present in that other Contracting State for the primary

purpose of:

(i) Studying at a university or other recognized educational institution in

that other Contracting State, or

(ii) Securing training required to qualify him to practice a profession or

professional specialty, or

(iii) Studying or doing research as a recipient of a grant, allowance, or

award from a governmental, religious, charitable, scientific, literary,

or educational organization,

shall be exempt from tax by that other Contracting State with respect to

amounts described in subparagraph (b) for a period not exceeding 5

taxable years from the date of his arrival in that other Contracting State.

(b) The amounts referred to in subparagraph (a) are:

(i) Gifts from abroad for the purpose of his maintenance, education,

study, research, or training;

(ii) The grant, allowance, or award; and

(iii) Income from personal services performed in that other Contracting

State in an amount not in excess of 2,000 United States dollars or its

equivalent in Belgian francs for any taxable year.


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Determining U.S. Residency (Lesson 1, Pub 678FS)

There are four ways to become a resident for federal income tax purposes.

1. Become a U.S. citizen

2. Be granted lawful permanent residency or “green card” by the immigration authorities.

3. Elect to file a joint return with your spouse who is a resident or citizen.

4. Have a “substantial presence” in the Untied States.

The presumption of residency because of a substantial presence is refutable if you are in the United States for less than 183 days in the current year, if you maintain your tax home in a foreign country and if you can prove a closer connection to that foreign country. See Publication 519 for details.

You have a substantial presence in the United States if you are physically present in the United States

• For at least 31 days in the current year and

• For at least 183 days during the current and prior two years.

The 183-day rule involves a mathematical formula which discounts days in the prior year by one third and days in the second previous year by one sixth.

Do not round intermediate calculations when using this formula.


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Example. Johann was in the United States for 91 days in 2001, 152 days in 2002 and 117 days in 2003. Applying the formula, 117 + 152 / 3 + 91 / 6 = 117 + 50.67 + 15.17 = 182.83 days

Johann has NOT been in the United States for 183 days during the past three years. Johann is a nonresident alien during 2003.

Example. In 2002, Johann’s flight from San Francisco to Frankfort was scheduled for a 9 p.m. departure. Through no fault of his, the flight was delayed to 1 am. This delay increases Johann’s days of presence to 153 days. Applying the formula, 117 + 153 / 3 + 91 / 6 = 117 + 50.67 + 15.17 = 183.17 days

Johann has been in the United States for 183 days during the past three years. Johann is PROBABLY a U.S. resident for tax purposes during 2003.

Example. Johann arrived in New York City harbor shortly after midnight on a cruise ship from Bermuda. The day of arrival would be his second or third day of presence in the United States because U.S. territorial waters are part of the United States. If Johann had arrived at JFK airport near New York City shortly after midnight on a flight from Frankfort, the day of arrival would be his first day of presence in the United States because U.S. airspace does not count as part of the United States.


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Publication 519 discusses the nuances and special situations that can be important when applying the substantial presence test. Treaty provisions may overrule the test.

If a volunteer encounters one of these special situations, they need to ask themselves whether they have the training and experience to make the right decision. “First, do no harm.” A special circumstance of particular importance to teachers and students is the rule that an individual temporarily present in the United States on an “F”, “J”, “M” or “Q” visa is generally exempt from the substantial presence test so long as they substantially comply with the terms of their visa.

Will a student who accepts unauthorized employment in a fast food restaurant be deported? Not likely. But a student who accepts unauthorized employment is not substantially complying with their visa for income tax purposes and is treated as a resident for federal income tax purposes7.

There should be no withholding of Social Security and Medicare tax on the wages of a student or scholar working the INS authorization. See Lesson 8 in the text for more on this topic. While not foolproof, the preparer should ask additional questions if Social Security and Medicare taxes have been withheld.

There are limitations on how long the exemption can be claimed. In general, someone who is in the United States to study is exempt from the substantial presence test for a total of five calendar years or parts thereof during his or her lifetime. Any part of a calendar year in which the individual is in the United States to study or to teach counts as one year.

Example. Julianna came to the U.S. on an F-1 visa in October 2000. She had never been in the U.S. before. As a student, she is exempt from counting her days of presence during part or all of 5 years. Juliana will probably not be exempt if she remains in the U.S. beyond December 31, 2004. The reason I am equivocating is that the IRS is willing to extend the five year period if the student makes a good case. See Form 8843 and Publication 519 for the sorts of the situations in which the five year period might be extended.

7 Reg. §301.7701(b)-3. "An individual ... will be deemed to comply substantially with the visa requirements relevant to residence for tax purposes if the individual has not engaged in activities that are prohibited by the Immigration and Nationality Act and the regulations thereunder and could result in the loss of F, J or M visa status. An individual will not be deemed to comply substantially with the visa requirements relevant to residence for tax purposes merely by showing that the individual's visa has not been revoked. An independent determination of substantial compliance may be made by the Internal Revenue Service. ... For example, if an individual with an F visa (student visa) is found to have accepted unauthorized employment or to have maintained a course of study that is not considered by the Internal Revenue Service to be full-time, the individual will not be considered to comply substantially with the individual's visa requirements regardless of whether the individual's visa has been revoked."


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If Julianna is not exempt and remains in the U.S. beyond July 1, 2005 (the 182nd day), she is a probably resident for tax purposes as of the beginning of 2005. The text quotes the wrong date when working this example, p. 1-7.

An individual who is temporarily present in the United states on a “J” or “Q” visa to teach or to perform research is exempt from the substantial presence test for a maximum of two calendar years or parts thereof. It does not matter whether they were teaching or studying during these two years. See Form 8843 for exactly how this test is applied.

Example. Neeni entered the United States to teach on a temporary J-1 via in October 2002. She had studied in the United States from 1992 though 1995 and she had taught in the United States during 1998 and 1999. Her 2002 Form 8843 shows the following.

Type of U.S. visa (J or Q) held during: 1996 1997 1998 J-1 1999 J-1 2000 2001

Because Neeni was present in the United States as a teacher, trainee, or student for parts of 2 of the 6 prior calendar years (1996 - 2001), she is probably not entitled to exclude days of presence during 2002 as a teacher or trainee. The text uses an incorrect 6-year look back period for this example, p. 1-7.

The text is not a primary resource. Use Publication 519, the instructions to Form 1040NR and the tax forms as your

references when preparing nonresident tax returns.

The purpose of the visit, to study or to teach, determines whether the two or five year rule applies. The visa is not material.

Example. Mike is a graduate student. He arrived in June 1999 on a J-1 visa. All days are exempt during 2003 because the five year rule applies to students.

Family members of an “exempt” visa holder are also exempt.

Example. Mike’s wife entered the United States with her husband in June 1999. She has a J-2 visa and is allowed to work in the United States. She is exempt from the substantial presence test during 1999 - 2003 because her husband is a student.

The residency starting date is generally the first day of presence in the United States in the year that residency is established. As discussed in Publication 519, it is possible to neglect a few days of de minimis presence for purposes of the residency starting date.

Example. Neeni entered the U.S. October 3, 2002 on a J-1 visa but she is not exempt because she taught in the United States during two of the previous six years. She satisfies the substantial presence test as of the 153rd day of 2003. Her residency starting date is January 1, 2003.


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If Neeni elects the first year choice, discussed below, her residency starts October, 3, 2002.

Example. Wei Wu of the People’s Republic of China entered the United States as a graduate student on an F-1 visa in mid-1998. He remains continuously in the United States. He is exempt from the substantial presence test for five years and satisfies the test in mid 2003. His residency starting date is January 1, 2003.

The residency termination date is usually the last day of the year. However, the residency termination can be measured from the day after the last day of presence in the United States. See Publication 519 for details.

Example. If Wei Wu departs the United States on July 1, 2003 (the 182nd day), he is a nonresident for tax purposes during all of 2003. If his flight is delayed until July 2 by a terrorism threat, he is a resident from January 1 through December 31. Depending on the circumstances, Wei Wu may be entitled to terminate his U.S. residency July 2, 2003.

When one becomes a resident by both the substantial presence test and the green card test, the residence starting date is the earlier of the first day of presence or the green card date.

Example. Zachary entered the United States in March 2003 on an exempt visa. He is advised by the immigration authorities that his application for permanent residency was approved on July 13, 2003 and that he should receive his “green card” by mid August. Zachary does not satisfy the substantial presence test because of his exempt status. His residency starting date is July 13, 2003. If Zachary had entered the United States using a visa which did not confer exempt status, he would have become a resident for tax purposes with a March 2003 starting date because the residency date under the substantial presence test is earlier than the green card date. In either event, Zachary is a dual-status alien for tax year 2003. He is taxed as a nonresident for the first part of the year and by special rules during the rest of the year. In tax jargon, Zachary is a “dual-status alien” and his tax return is a “dual-status return.”

Dual-status returns should be referred to an experienced preparer. The year in which a taxpayer gives up their residency can also be a dual-status year. However, it should be possible to avoid a dual-status return by arranging for residency to terminate as of the end of the calendar year. Seek professional assistance in such situations because delaying residency termination to the end of the year could mean double taxation of foreign income earned after leaving the United States.


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Residency Elections. It is not uncommon for someone to live and work in the United States while their spouse and family live outside the United States. The spouse working in the United States is generally a resident for income tax purposes while the spouse outside the United States is generally a nonresident.

Husband and wife can elect to file a joint return as residents reporting the worldwide income of both spouses. This is an attractive option when the nonresident spouse has little or no income.

Example. A U.S. resident has $15,000 in worldwide income. His spouse lives in Ethiopia and has little income. The husband could file Separately from his spouse and pay some federal income tax. Alternatively, husband and wife could elect to file jointly. They would pay no federal income tax if they choose to file Jointly because of the second personal exemption and larger standard deduction.

Consult Publication 519 on the procedure for making this election. The nonresident spouse must obtain an ITIN (Form W-7).

Married couples should consider the election to file a joint return as an alternative to filing two dual status returns.

Example. A couple and their daughter immigrate to the U.S. in March and are issued Green Cards shortly thereafter. The couple and their daughter are nonresidents at the beginning of the year and residents at the end of the year. The parents earned $3,000 before coming to the U.S. and $14,000 after coming to the U.S. Normally, husband and wife would file Separate dual-status returns. However, husband and wife can elect to file a joint return as full-year residents and report the worldwide income of both spouses. The election decreases the number and complexity of their tax returns. In this particular situation, the election makes this couple eligible for the Earned Income Tax Credit and increases their refund by a couple of thousand dollars.

Still another election is the “first-year choice.” This allows someone arriving in the United States in the latter part of the year to be taxed as a resident even though they have not lived here long enough8.

Example. The mother of a U.S. citizen enters the U.S. in October on a visitor's visa but does not leave when her visa expires. The mother has no income and her child is her sole support.

8 You must jump though a number of hoops to make the first year election. These are discussed in Pub. 519. In addition, you cannot elect the first year choice until they have been in the U.S. long enough to satisfy the 183-day residency requirement. Since it is mathematically impossible to satisfy the residency requirement prior to the April filing deadline, the return should be prepared on the basis of the first year choice; the tax liability should be paid by the April filing deadline; the time to file should be extended; and the taxpayer should file the return after July 1.


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The mother does not ordinarily qualify as a dependent in the year of entry because she is not here long enough to become a resident by the end of the year. However, the mother will qualify as a dependent as of the date of entry if she elects the first year choice.


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California Residency and Related Issues

Anyone living in California, even relatively briefly, is generally considered a resident for California income tax purposes. The primary exception is military personnel from outside California. It is possible to convince the California authorities that you are a nonresident, even though you are here a lot, but it is an uphill slog.

Practically speaking, the foreign student or scholar living in California files a California Form 540 resident return reporting worldwide income. This is the situation whether or not

• They file their federal return as a U.S. resident or as a nonresident

• The employment is authorized by the immigration authorities

• The income is excluded from the federal return by stature or treaty

• The income originates in California.

Someone new to California, or who recently left California, is a part-year California resident. A California resident or part-year resident must file a California income tax return if worldwide income exceeds about $12,000 per person or to claim a refund of California tax withheld. The tax liability of a part-year resident is based on the ratio of their California taxable income to worldwide taxable income. See California Form 540NR.

The California filing status must generally be the same as that used on the federal return. This means that a U.S. nonresident alien, or the spouse of a nonresident alien, cannot file their California return as Head of Household or Married Filing Jointly. A further implication is that U.S. nonresidents are not eligible for the California Credit for Child and Dependent Care Expenses.

Community Property Rules

If you are living in California but intend to return to somewhere else, California’s community property rules probably do not apply. If the somewhere else is a community property jurisdiction like France or Mexico, the community property rules of that jurisdiction probably apply.

If you or your spouse are a nonresident of the United States, federal law says that community property rules are largely disregarded when preparing your federal income tax return. California community property rules would apply to the preparation of the California tax return if your or your spouse intend to remain in California.


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Who Must File (Lesson 2, Pub 678-FS)

Residents. Generally speaking, a resident must file a federal income tax return if their taxable income exceeds the personal exemption and standard deduction amounts. See Publication 17, Chapter 1.

Dual-Status Aliens must file a federal income tax return if they must file during the period of residency or the period of nonresidency.

If a return must be filed, the nature of the return depends on the residency as of the end of the year. If the taxpayer is a resident as of the end of the year, they file a short year Form 1040 reporting income and deductions during the period of residency and they attach a statement reporting income and deductions during the period of nonresidency.

If the taxpayer is a nonresident as of the end of the year, they file a short year Form 1040NR reporting income and deductions during the period of nonresidency and they attach a statement reporting income and deductions during the period of residency.

Chapter 6, Publication 519 illustrates the preparation of a dual-status return.

The tax liability of a dual status alien is not necessarily the tax during the period of residency plus the tax during the period of nonresidency. Effectively connected income such as wages is added to similar income during the residency period before the tax is determined. This nuance is important when the wage or other effectively connected income is high enough to span more than one tax bracket.

Nonresidents must file a return if they

• Are engaged in a trade or business in the United States whether or not that business is profitable.

• Have rental income and wish to offset this income with expenses.

• Have income which is not effectively connected with a trade or business in the United States if insufficient tax was withheld.

• Wish to claim a refund of tax withheld

Nonresident students and scholars must generally file a return because they are classified as engaged in a trade or business in the United States. Students, scholars and immediate family members must file a Form 8843 with the return to claim the exemption from the substantial presence test.

If a student, scholar or immediate family member has no income subject to withholding, they can file Form 8843 alone.

See Publication 519 for the definition of immediate family.


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Example. Pedro is studying in the United States on a F-1 visa. He has $213 in wages from authorized employment. Pedro has no federal income tax liability but he must still file a tax return (and Form 8843) because his wages are subject to income tax withholding. Pedro will receive a refund of any federal tax withheld. Warning. The penalty for not filing an income tax return is 25% of the tax liability. Thus there will be no monetary penalty if Pedro does not file a return. However, not filing a return might raise flags with the immigration authorities if Pedro were to subsequently apply for permanent residency.

There is no monetary penalty for failing to file Form 8843 by the due date of the nonresident tax return, including extensions. However, failure to file a timely Form 8843 allows the IRS to revoke exempt status and reclassify the student or scholar as a resident for income tax purposes9.

One cannot reclassify oneself as a resident by deliberately not filing Form 8843. The regulation cited in footnote 8 allows the IRS to disregard the failure to file Form 8843 when it is in the government’s interest to do so.

The following example from Pub. 678FS raises a number of issues warranting discussion.

Example 4 (p. 2-4). Peter is a married student from Canada and the sole support of his wife who has no income. He earned $11,000 from an assistantship. We will assume that his assistantship is authorized employment under the terms of his exempt visa.

• Peter and his wife are nonresident aliens. Peter must file a federal income tax return because he has income which is subject to income tax withholding. He must also file Form 8843.

9Reg. §301.7701(b)-8. (d) Penalty for failure to file statement.

(1) General rule. If an individual is required to file a statement pursuant to paragraph (a)(1), (a)(2)(ii), (a)(2)(iii) or (a)(3) of this section and fails to file such statement on or before the date prescribed by paragraph (c) of this section, the individual will not be eligible for the closer connection exception described in §301.7701(b)-2 and will be required to include all days of presence in the United States (calculated without the benefit of §§ 301.7701(b)-3(b)(5), 301.7701 (b)-3(c), and 301.7701(b)-4(c)(1)) for purposes of the substantial presence test and for determining the individual's residency starting and termination dates. If an individual is considered to be a resident because of this paragraph and the individual is also a resident of a country with which the United States has an income tax convention pursuant to that convention, the individual shall be treated in the manner provided in §301.7701(b)-7(a) (relating to the treatment of individuals who are dual residents). (2) Exception. The penalty described in paragraph (d)(1) of this section shall not apply if the individual can show by clear and convincing evidence that he or she took reasonable actions to become aware of the filing requirements and significant affirmative steps to comply with those requirements.

(e) Filing requirement disregarded. Notwithstanding paragraph (d) of this section, the Secretary or his or her delegate may in their sole discretion, when it is in the best interest of the government to do so and based on all of the facts and circumstances, disregard the individual's failure to file timely the statement described in paragraph (a) of this section in determining the individual's days of presence in the United States.


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Peter’s wife would have to file a federal return if she had income subject to withholding. She do not have income and so no tax return is required. Even though Peter and his wife live in a community property state, the community property rules are disregarded for federal income tax purposes whenever one spouse is a nonresident alien. Peter’s wife must file Form 884310. No California returns are required because Peter’s and his wife’s combined worldwide income is below the California filing threshold ($24,692/couple in 2003).

• Residents may claim the person exemption of their spouse when filing Separately if the spouse has no income and is not the dependent of another taxpayer. The spouse’s exemption can be claimed even if the spouse is not a resident of the United States, Canada or Mexico. (Pub 17, chapter 3.) Nonresidents from Canada and Mexico may claim their spouse’s personal exemption when filing Separately under the same conditions as residents; that is, so long as the spouse has no income and is not the dependent of another U.S. taxpayer. Thus Peter will show two personal exemptions on the Form 1040NR. His wife must obtain a Social Security number or ITIN (Form W-7). Nonresidents from Japan, South Korea and India can claim the personal exemption of their spouse under more limited circumstances . (Pub 678-FS, Lesson 4.) Nonresidents from other countries cannot claim their spouse’s personal exemption.

• Article XV of the U.S.-Canada tax treaty11 exempts certain wages earned by Canadian residents temporarily in the United States from U.S. tax. Peter’s wages do not qualify for the exemption because they exceed $10,000 and because,

10 The text says (p. 6-1) that a “Form 8843 must be filed for every family member who is in the U.S. on an F-2 or J-2 visa.” This statement does not appear in the instructions to Form 8843 or Publication 519. 11 ARTICLE XV Dependent Personal Services 1. Subject to the provisions of Articles XVIII (Pensions and Annuities) and XIX (Government Service),

salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State.

2. Notwithstanding the provisions of paragraph 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in a calendar year in the other Contracting State shall be taxable only in the first-mentioned State if: (a) Such remuneration does not exceed ten thousand dollars ($10,000) in the currency of that other State; or (b) The recipient is present in the other Contracting State for a period or periods not exceeding in the aggregate 183 days in that year and the remuneration is not borne by an employer who is a resident of that other State or by a permanent establishment or a fixed base which the employer has in that other State.

3. Notwithstanding the provisions of paragraphs 1 and 2, remuneration derived by a resident of a Contracting State in respect of an employment regularly exercised in more than one State on a ship, aircraft, motor vehicle or train operated by a resident of that Contracting State shall be taxable only in that State.


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presumably, Peter was in the United States more than 183 days in the year in question.

The Filing Deadline is generally June 15th for a nonresident return. However, a nonresident who earns wage income must file by April 15th.

Citizens and residents who are out of the country on the April 15 deadline, are granted an automatic extension to June 15 with no paperwork. The automatic extension to June 15 does NOT apply to nonresidents.

Residents and nonresidents can apply for an automatic extension to August 15 to file their returns. Any outstanding tax liability must be paid by the normal due date, however. A further extension to October 15 to file is available for reasonable cause.


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Treaty Overview (Lesson 3, Pub 678-FS)

Treaty benefits are tied to the county in which the individual resided immediately before entering the United States.

Example. Suigita is a citizen of India. She was a resident of Canada at the time she received her undergraduate degree. She has now come to the United States to pursue a graduate degree. Suigita is governed by the U.S. treaty with Canada, not the treaty with India, because she was a Canadian resident immediately before entering the United States.

Most treaties lower the rate of tax on not effectively connected income. These preferential rates are assembled in Publication 901.

Treaty benefits are elective. You don’t have to do what the treaty says you may.

Example. A scholar from Mexico is teaching in the U.S. on a J-1 visa. The teaching assignment stretches to three years and the scholar becomes a U.S. resident by virtue of the substantial presence test. The U.S. tax treaty with Mexico treaty says that an individual who is a resident of both the U.S. and Mexico is considered a resident of the country in which he has a permanent home12. Thus, if the scholar clams the treaty benefit, he is likely a resident of Mexico, and files Form 1040NR. Alternatively, if the scholar does not claim the benefit, he is a resident of the United States and files Form 1040.

Many treaties provide a limited exemption for wages (income code 17) earned by someone working in the United States for a limited period, typically no more than half a year. This provision would be applicable to a student or scholar who is in the U.S. for a limited period.

12 ARTICLE 4 Residence 1. For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, place of incorporation, or any other criterion of a similar nature. However, this term does not include any person who is liable to tax in that State in respect only of income from sources in that State. 2. Where by reason of the provisions of paragraph 1, an individual is a resident of both Contracting States, then his residence shall be determined as follows: a) He shall be deemed to be a resident of the State in which he has a permanent home available to him;

if he has a permanent home available to him in both Contracting States, he shall be deemed to be a resident of the State with which his personal and economic relations are closer (center of vital interests);

b) If the State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either State, he shall be deemed to be a resident of the State in which he has an habitual abode; c) if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident of the State of which he is a national; d) in any other case, the competent authorities of the Contracting States shall settle the question by mutual agreement.


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Many treaties exclude income earned by students and scholars who are in the U.S. for, typically, as long as five years, if the income is related to their studies (income code 18) or teaching (income code 19). Students and scholars sometimes erroneously claim treaty benefits for wage and Schedule C income (income codes 16 and 17) but, according to the text, only the treaty with Canada allows a general exclusion for wage income with no limit of time.

Example. The student, your customer, says that Article 7 of the U.S. tax treaty with XYZ allows a $10,000 exemption for dependent personal services (income code 17) and she provides you a Form 1042S from her employer as “proof.” You doubt that this is correct. You, as a VITA/TCE volunteer, have three choices.

• Tactfully disengage and encourage the student to find another preparer.

• Obtain a copy of the XYZ treaty, read article 7 and proceed appropriately.

• Compete the tax return as the student directs, citing article 7 of the XYZ treaty as the basis for the exclusion. Presumably, the IRS will deny the exclusion if the treaty does not allow the exclusion.

In principle, the student or scholar is supposed to alert the withholding agent of favorable treaty treatment by filing a Form 8233 and the withholding agent is supposed to issue a Form 1042S rather than a W-2. The Form 1042S identifies the amount and type of income and the reason that the income is exempt from tax.

If the amount earned exceeds the amount which is exempt from tax, the withholding agent is supposed to issue a Form W-2 for the taxable portion.

The nonresident tax return is designed so that improper paperwork does not affect the taxable income.

Example 10 (p. 5-12). Christiane, from Germany, worked part of the year at the local university in California. She gave the university a Form 8233 and they properly applied her treaty benefit. In August, she moved to Illinois and began the fall semester at the local university. She also gave this university a Form 8233. The Illinois university was not aware that Christiane had already exempted part of her income in California. The result of these paperwork snafus is that too much income was reported on the Forms 1042S. This error is automatically fixed on her tax return. Her Form 1040NR tax return looks as follows:

Line 8, W-2 income 380 + 1,685 2,065 Line 12, 1042S income 5,000 + 5,000 10,000 Line 22, income exempt by treaty 5,000 <5,000>Total Effectively Connected Income 7,065


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Scholarships and Fellowships. The first issue is to whether the scholarship is U.S. or foreign-sourced because the United States does not tax foreign-sourced scholarships and fellowships received by a nonresident alien.

Scholarships, fellowship grants, grants, prizes, and awards are sourced to the residence of the payer regardless of who actually disburses the funds. Payments for research or study in the United States by the U.S. government, by a U.S. resident, or by a domestic corporation are U.S.-sourced. Payments from a foreign government or corporation are foreign-sourced even though the funds are disbursed through a U.S. agent.

U.S.-sourced scholarships fall into one of three categories

1. Qualified Scholarships. Section 117 of the Internal Revenue Code law says that money for tuition, fees, books, and/or required supplies is not taxed if the money was spent for the intended purposes, if there is no requirement to perform services and if the student is a degree candidate.

This rule applies to scholarships received by residents and nonresidents alike and applies to both U.S. or foreign-sourced scholarships.

2. Room and Board. Money from U.S. sources for room and board is generally taxable, even if paid with no requirement to perform services.

Some countries have treaty provisions which exempt U.S.-sourced funds used for room and board. See Table 2 of the text or, better yet, Table 2 of Publication 515. These scholarships should be identified by Code 15 on Form 1042-S.

Contrary to the text, there is generally no time limitation on Code 15 treaty benefits. See Table 2 in Publication 515 or 901. That said, a student is only eligible for exempt status for a maximum of five years. So, the practical limit on Code 15 benefits is five years.

3. Taxable as Wages. Money received (or a waiver of charges) on condition that the recipient perform services such as teaching or research is taxable as wages. This income should be identified by Code 18 (compensation for teaching and research) or 19 (compensation during study and training).

Lesson 3, Example 2. Aseye is from Ghana. She is a student on an F-1 visa. She received a tuition waiver but she was not required to work. She also received a $250 scholarship from a local group to help pay for her books. Aseye pays her room and board with monies from her home country. The tuition waiver and scholarship are nontaxable qualified scholarship income and are not reported. The monies from aboard are not reported on her U.S. return because the income is not U.S.- sourced.

Lesson 3, Example 3. Birgit is from Sweden. She is a student on an F-1 visa and she receives a tuition waiver in exchange for her services as a graduate assistant.


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Her tuition waiver is taxable income to the extent that it reflects the value of her services. It is NOT exempt Code 18 income because there is no Code 18 provision in the tax treaty with Sweden (Text Table 2, p. 3-27).

Lesson 3, Example 4. Reinhard, from Germany, is a student with an F-1 visa. He receives a tuition waiver but he is not required to perform any services. The tuition waiver is a nontaxable qualified scholarship. Reinhard has another scholarship that covers his room and board. It would normally be taxable but Article 20(3) of the U.S. German income tax treaty says this scholarship is exempt Code 15 income13. See also Table 2 in the text, p. 3-21. The scholarship is reportable but nontaxable.

13 ARTICLE 20. Visiting Professors and Teachers; Students and Trainees 1. Remuneration that a professor or teacher who is a resident of a Contracting State and who is present

in the other Contracting State for a period not exceeding two years for the purpose of carrying out advanced study or research or for teaching at an accredited university, college, school, or other educational institution, or a public research institution or other institution engaged in research for the public benefit, receives for such work shall be taxable only in the first-mentioned State. This Article shall not apply to income from research if such research is undertaken not in the public interest but primarily for the private benefit of a specific person or persons. The benefits provided in this paragraph shall not be granted to an individual who, during the immediately preceding period, enjoyed the benefits of paragraph 2, 3, or 4.

2. Payments other than compensation for personal services that a student or business apprentice (including Volontäre and Praktikanten in the Federal Republic of Germany) who is or was immediately before visiting a Contracting State a resident of the other Contracting State and who is present in the first-mentioned State for the purpose of his full-time education or training receives for the purpose of his maintenance, education, or training shall not be taxed in that State, provided that such payment arise from sources, or are remitted from, outside that State.

3. Payment other than compensation for personal services that a person who is or was immediately before visiting a Contracting State a resident of the other Contracting State receives as a grant, allowance, or award from a non-profit religious, charitable, scientific, literary, or educational private organization or a comparable public institution shall not be taxed in the first-mentioned State.

4. A student or business apprentice within the meaning of paragraph 2, or a recipient of a grant, allowance, or award within the meaning of paragraph 3, who is present in a Contracting State for a period not exceeding four years shall not be taxed in that State on any income from dependent personal services that is not in excess of $5,000 (five thousand United States dollars) or its equivalent in Deutsche mark per taxable year, provided that such services are performed for the purpose of supplementing funds available otherwise for maintenance, education, or training.

5. A resident of one of the Contracting States who is an employee of an enterprise of such State or of an organization or institution described in paragraph 3, and who is temporarily present in the other Contracting State for a period not exceeding one year solely to acquire technical, professional, or business experience from any person other than such enterprise, organization, or institution, shall be exempt from tax by that other State on compensation remitted from outside that other State for services wherever performed paid by such enterprise, organization, or institution if such compensation does not exceed $10,000 (ten thousand United States dollars) or its equivalent in Deutsche mark.


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Compensation for Teaching and Research

Treaties generally exempt the wages of someone temporarily in the U.S. to teach or do research from U.S. income taxes for a period of two years. Table 2 of Publications 515 and 901, and the table on p. 3-8 of the text, list the countries with Code 18 treaty benefits.

The exemption does not apply to the earnings of a spouse or dependents.

The time limit is measured from the day of arrival in the U.S. See, for example, article 22(1) of the India treaty cited in footnote 14.

This seems to mean that the exemption interval could span parts of three calendar years even though the teacher would be generally exempt for a maximum of parts of only two calendar years. The German, Indian, Dutch, Thai, and British treaties say that prior benefits can be forfeited if the teacher stays beyond the prescribed time limit14. This could require amended returns and tax and interest for prior years.

Because treaty benefits are optional and taxpayers can choose to not claim benefits to which they are entitled, an individual who expects to stay more than the time limit might be better off not claiming the treaty benefit in the first place.

Illustrations

• Deepak was most recently a resident of India and he is teaching in the U.S. on a J-1 visa. He has an 18 month contract and expects to return to India when it ends. He should claim the Code 18 benefit afforded by Article 22(1) of the U.S.-India treaty15 when filing his return.

• In the second year, Deepak renews his contract for an additional year. This extends the contract beyond the two year limit and his earnings from the

14For example, the U.S. German treaty includes the following protocol. 18. With reference to paragraphs 1, 4, and 5 of Article 20 (Visiting Professors and Teachers; Students and Trainees). If a resident of a Contracting State remains in the other Contracting State for a period of time exceeding that prescribed, that other State may tax the individual under its national law for the entire period of the visit, unless in a particular case the competent authorities of the Contracting States agree otherwise. 15 ARTICLE 22. Payments Received by Professors, Teachers and Research Scholars 1. An individual who visits a Contracting State for a period not exceeding two years for the purpose of

teaching or engaging in research at a university, college or other recognized educational institution in that State, and who was immediately before that visit a resident of the other Contracting State, shall be exempted from tax by the first-mentioned Contracting State on any remuneration for such teaching or research for a period not exceeding two years from the date he first visits that State for such purpose.

2. This Article shall apply to income from research only if such research is undertaken by the individual in the public interest and not primarily for the benefit of some other private person or persons.


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university are taxable from the beginning of his employment16. Deepak must file amended returns for all tax years in which he claimed the treaty benefit.

• Assume that Deepak had been hired on a 4-year contract. Since he expects to stay beyond the maximum years of presence allowed by the treaty between the U.S. and India, he should not claim the treaty benefit. Wait a minute. He is “exempt” for only two years. I was not aware that treaty benefits extended to resident aliens.?!

• Assume that Deepak had been hired on a 4-year contract but that Deepak returns to India after only one year. He is entitled to the treaty benefit, even though his original contract exceeded the time limit on the benefit.

Code 19. Compensation During Study or Training. Several treaties allow students to earn a few thousand dollars tax-free. See p. 3-10 in the text, or Table 2 in Publications 515 or 901, for the treaty countries and amounts.

Exercise , p.3-13. What Code 19 treaty benefit is available for students from the following countries?

Time in U.S. Wages Exempt Portion Germany 2 years $ 5,400 5,000 China 6 6,200 5,000 Ghana 3 4,700 No treaty provision Nigeria 1 2,100 No treaty provision Poland 4 7,600 2,000 Israel 6 5,800 None, time expired Russia 2 7,300 No treaty provision

Exercise 2, p. 3-14. How much of these Code 19 (teachers) wages is exempt from U.S. taxation?

Time in U.S. Wages Exempt Portion India 1 year $34,000 Unlimited China 1 34,000 Unlimited China 3 34,000 Unlimited South Africa 1 34,000 No treaty provision Sweden 2 34,000 No treaty provision

16So says the text. I have not been able to identify the specific article in the India treaty.


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Exercise 4, p. 3-15. The following students received scholarships for tuition and for room and board in the amounts indicated during 2003. There was no requirement to provide services. All the students first entered the U.S. in 2000. How much is reportable and how much is exempt? Hint: the tuition is a qualified scholarship.

Tuition Room & Board Reportable Exempt China $5,000 $4,600 $4,600 Unlimited Poland 3,800 6,700 6,700 Unlimited India 3,150 4,900 4,900 None

Australia 4,950 5,000 5,000 None Pakistan 3,700 7,300 7,300 None Russia 4,600 5,900 5,900 Unlimited Guyana 4,400 2,950 2,950 None

Form 8833 and Reporting Treaty Benefits Claimed If you claim treaty benefits that override or modify any provision of the Internal Revenue Code, and by claiming these benefits your tax is, or might be, reduced, you may need to attach Form 8833 to your U.S. tax return.

Form 8833 is required if you claim the following treaty benefits.

• A reduction or modification in the taxation of gain or loss from the disposition of a U.S. real property interest based on a treaty.

• A credit for a specific foreign tax for which foreign tax credit would not be allowed by the Internal Revenue Code.

• You determine your country of residence under a treaty and you receive payments or income of totaling more than $100,000

You do not have to file Form 8833 in the following situations.

• You claim a reduced rate of withholding tax under a treaty on interest, dividends, rent, royalties, or other fixed or determinable annual or periodic income ordinarily subject to the 30% rate.

However, you must cite the treaty article authorizing this reduced rate at the appropriate location on your nonresident income tax return.

• You claim a treaty reduces or modifies the taxation of income from personal services, pensions, annuities, social security and other public pensions, or income of artists, athletes, students, trainees, or teachers. This includes taxable scholarship and fellowship grants.

Again, you must cite the treaty article authorizing this reduced rate at the appropriate location on your nonresident income tax return.


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• You claim a reduction or modification of taxation of income under an International Social Security Agreement or a Diplomatic or Consular Agreement.

• You are a partner in a partnership or a beneficiary of an estate or trust and the partnership, estate, or trust reports the required information on its return.

• The payments or items of income that are otherwise required to be disclosed total no more than $10,000.

If you are required to report the treaty benefits but do not, you may be subject to a penalty of $1,000 for each failure. For additional information, see section 301.6114–1(c) of the Income Tax Regulations.


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Family Issues (Lesson 4, Pub 678-FS)

Much of this lesson has been addressed previously so we will only make a quick review.

Everyone needs a Social Security number or an ITIN.

Married nonresidents cannot file jointly with their spouses (unless the spouse is a resident) and they cannot file as head of household.

U.S. law denies nonresident aliens the personal exemption for their spouse and the dependency exemption for their children. However, the tax treaties with a few countries say that the United States cannot discriminate against their residents in this manner. The treaties may also add extra conditions.

For example, the treaty with India says that the U.S. cannot discriminate against students from India in allowing exemptions and the standard deduction17. This means that nonresident students from India can claim the personal exemption for their spouse if they satisfy the conditions that apply to residents filing Separately. That is, the spouse can have no U.S.-sourced “gross income” and cannot be claimed as a dependent on another U.S. tax return.

A reminder. Gross income does not include tax-exempt or excludable income. Gross income is the net proceeds from the sale of securities, not the net gain, and the gross revenue from a business not the net income.

This treaty provision also means that nonresident students from India can claim the exemption for their dependents if they meet the six conditions that apply to U.S. citizens and residents.

• The dependent must be a U.S. citizen or resident, or a resident of Canada or Mexico, at some time during the calendar year.

If the dependent is admitted to the United States on “F–2,” “J–2,” or “M–2” visas, he or she will generally be nonresident while in the United States and generally ineligible for the dependency exemption.

The blanket prohibition in the text (p. 4-3) against any dependent with one of these visas is too broad.

• The dependent must live with the taxpayer all year or must be their child or other near relative on the approved list.

17 ARTICLE 21, Payments Received by Students and Apprentices. 2. In respect of grants, scholarships and remuneration from employment not covered by paragraph 1, a student or business apprentice described in paragraph 1 shall, in addition, be entitled during such education or training to the same exemptions, reliefs or reductions in respect of taxes available to residents of the State which he is visiting.


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• The dependent cannot have gross income of more than the exemption amount, currently $3,050, if the dependent is age 19 or older. The age limit is extended to 24 years if your child is a full time student.

• If the dependent is married, their income must be low enough that neither they nor their spouse is required to file a federal income tax return.

• The taxpayer must provide more than half of your dependent’s support.

• The dependent must have a Social Security number or ITIN.

The treaties with Canada and Mexico provide a broader exemption: any nonresident from these countries is entitled to the personal exemption for a spouse and the dependency exemptions for their children on the same basis as U.S. citizens and residents.

The treaties with South Korea and Japan allow any nonresident from these countries the personal and dependency exemptions on the same basis as U.S. citizens and residents if two additional conditions are met.

• The spouse or dependent must live with the taxpayer

• The exemption amount must be pro rated if the taxpayer has both U.S.-sourced and foreign sourced income. The proration is based on the ratio of the taxpayer’s U.S.-sourced gross income which is effectively connected with a U.S. trade or business to the taxpayer’s entire income from all sources during the tax year.

Example. Mr. Sato who is a resident of Japan, lives temporarily in the United States with his spouse and two of their children. During the tax year he receives $9,000 of U.S. wages and $1,000 of U.s.-sourced dividend income. He also receives $3,000 from outside the United States that is not effectively connected with his U.S. trade or business. Thus, his total income for the year is $12,000. Mr. Sato meets all of the usual requirements for claiming exemptions for his spouse and two children. The exemption amount is $3,050 per person for 2003. Mr. Sato’s total exemption amount for his spouse and two children is pro rated as follows:

( $9,000 / $12,000 ) times 3 times $3,050 = $6,863

Nonresidents are NOT eligible for the earned income credit. In principle, nonresidents are eligible for child and dependent care credit and for the child tax credit. However, one must be able to claim the dependency exemption for the child in order to claim these credits and this requirement effectively precludes most nonresidents from qualifying for these credits.)

The earned income tax credit is of great benefit to low income taxpayers. Consideration should be given to filing these taxpayers as residents so that they can claim the credit, assuming there is a reasonable basis for doing so.


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Exercise 2 (p. 4-5). Devesh is from India and he is studying in the U.S. on an F-1 visa. His wife and two children are with him in the U.S. on F-2 visas. His third child was born in the U.S. and is a U.S. citizen. Devesh earned $7,850 from authorized on-campus work and he provided all the support for his family. His wife had no income.

• What is Devesh’s filing status? Other married nonresident alien (MFS).

• Can he claim the personal exemption for his wife? Yes; the tax treaty with India allows this exemption to nonresident Indian students on the same basis as U.S. residents. Enter her information on line 7c of Form 1040NR.

• Can he claim the dependency exemption for any of his children? The tax treaty with India allows the dependency exemption to nonresident Indian students on the same basis as U.S. residents. Devesh can take a deduction for his third child because this child meets the usual residency tests. Devesh cannot take a deduction for his other children because they are not residents of the U.S., Canada or Mexico.

• Are any special forms needed to claim these treaty benefits? No. Form 8833 is not required.

• Would Devesh get a larger refund if there were a way for him to file as a resident? Yes, because he would be eligible for the earned income tax credit.


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Comprehensive Problems

Comprehensive Problem 2 (p. C-6). Sue, from Malaysia is single and 26 years old. She first entered the U.S. on an F-1 visa on August 1, 1997 and she has been a full-time student since then. She began working in the campus bookstore in 1999. In 2003, her W-2 shows that she earned $5,200. Her Social Security card is not valid for employment. Is Sue a resident or nonresident for income tax purposes? If the answer is not clear from these facts, what would you ask Sue during the interview? Sue has been in the United States for parts of seven years. Without a special dispensation from the IRS, Sue is a resident under the substantial presence test.

Sue’s work in the bookstore is apparently unauthorized employment, meaning that Sue has not been in substantial compliance with the terms of her visa since 1999. This means that Sue was likely not entitled to exempt status in 1999 and following years and should have been filing resident income tax returns since 1999.

Comprehensive Problem 3 (p. C-6) Kiwal entered the U.S. from Malaysia on August 1, 1999 on an F-1 visa. He is a full time student at the local university and has not left the country since he arrived here. He is single and 27 years old. Kiwal started to work in the cafeteria in 2000. He tells you that he has never filed a tax return because he did not know how. His W-2 shows no deductions for Social Security and Medicare taxes. Complete his federal and California returns for 2003 and advise whether Kiwai should file for any prior years. It appears that the work in the cafeteria is authorized employment and that Kiwai is in substantial compliance with his visa. He is therefore exempt from the substantial presence test for five years, 1999 – 2003, and should file as a nonresident alien.

His gross wages is $4,100, his only deductions are $40 in state income tax and the $3,050 personal exemption, his taxable income is $1,010 and his federal tax liability is approximately a hundred dollars. Kiwai is entitled to a refund of about three hundred dollars

His California return shows $4,100 in wages and AGI. After subtracting the $3,070 California standard deduction, Kiwai’s California taxable income is $1,030and his tax liability after his personal exemption credit is zero. Kiwai is entitled to a refund of all tax withheld.

Federal returns should be filed for 2000, 2001 and 2002. There will be no late filing penalty because these will be refund returns. There is no reason to file a


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federal return for 1999 because there is no tax due and the statue on refund claims has expired.

Kiwai should file Forms 8843 for 1999 through 2003. The IRS is entitled to disregard this form for the late years which would effectively deny Kiwai exempt status during 1999 through 2002. His is unlikely, however, because residency status would entitle Kiwai to a larger refund.

California returns should be filed for 1999 through 2002 because the California statue on refund returns has not expired for any of these years.

Comprehensive Problem 4 (p. C-9). Lee Cheng is a single student from the Peoples Republic of China. He entered the U.S. on January 2, 2002 on an F-1 visa. Even though he started to work at the campus security office in 2002, he has remained a full time student. When he started his job, he did not know about Form 8233 and consequently his 2002 return showed a large refund. In June 2003, he gave the payroll office a Form 8233, claiming the China treaty benefit so he would not have as much federal withholding this year. His W-2 for the current year shows $3,000 in wages and $475 in federal income tax withheld. There is no withholding for FICA taxes or for state tax. His 1042S for the current year show $3,500 in Code 19 income and 01 Exemption Code. Complete his 2003 federal and California income tax returns.

No California return is required because Lee’s worldwide income is below the California filing requirement and no state tax was withheld.

The tax treaty with the People’s Republic of China allows $5,000 of Code 19 income to be excluded from Lee’s tax return. Since his total income is $6,500 dollars, this suggests Lee’s total effectively connected income is $1,500. After subtracting the personal exemption amount, taxable income is zero and Lee is entitled to a full refund of his federal withholding. Lee also files Form 8843.

I don’t understand the 01 Exemption Code (effectively connected income) but whether the code is right or wrong does not affect the preparation of the return or the tax liability. Lee cites Article 20(c) of the treaty with the People’s Republic of China as the basis for the excluded amount.

I would not prepare the return as shown in the text (p. C-19). My concern is that the document matching program will be looking for $3,000 on the wages line because that is the number on the W-2. I would write “see statement” to the left of the wages entry.

The statement would be as follows.


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W-2 wages 3,000 Form 1042S wages 3,500 Excluded by treaty <5,000> Transferred to line 3 1,500

Comprehensive Problem 5 (p. C-13). Henry from Belgium is single and 26 years old. He entered the U.S. on August 1, 1997 on an F-1 visa. In May of 1999, Henry graduated and returned to Belgium. On June 1, 2003 he reentered the U.S. on a J-1 visa to teach at the local university for two years. What income tax return does Henry file for 2003? Begin by completing Form 8843. You will discover in Part II that Henry is not eligible for exempt status as a teacher because he was present in the United States as a teacher, trainee or student for parts of 1997, 1998 and 1999. Henry satisfies the substantial presence test late in 2003 and his residency beginning date is backdated to his first day of presence or June 1.

The text (p. C-14) says that Henry is a resident for income tax purposes. This is imprecise. Henry is a nonresident for the period prior to June 1 and a resident during the balance of the year. This makes Henry a dual-status alien and a complex tax return. Refer.

Comprehensive Problem 6 (p. C-13). Sinju Khadori is a married student from India. Her husband had a small amount of gross income. She obtained BCIS permission to work off-campus and her employer withheld Social Security and Medicare taxes.

Is she entitled to a refund of these taxes? You bet! Authorized employment by F-1 visa holders is not subject to FICA withholding.

Should she talk to her employer about this? Yes. If the employer is unable to help her, She should file Form 843 and supporting documentation to claim a refund.

CLASS EVALUATION VITA Training: Taxation of Nonresident Students and Scholars

UC Davis February 7, 2004

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Documents

Preparing Returns for Foreign Students and Scholars as a