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Substantial Presence Test | US International Tax Lawyer & Attorney

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The substantial presence test is one of the most important legal tests in the Internal Revenue Code (IRC), because it determines whether a person is a US tax resident solely by virtue of his physical presence in the United States.  Additionally, this Test is essential to the determination of whether a person is a “US Person” for FBAR and Form 8938 purposes. In this article, I will explain the substantial presence test and highlight its main exceptions.

Substantial Presence Test: The Main Rule

In reality, there are two substantial presence tests; if either test is met, a person is considered to be a US tax resident unless an exception applies.

The first substantial presence test is met if a person is physically present in the United States for at least 183 days during the calendar year. 26 USC §7701(b)(3).  

The second substantial presence test (the so-called “lookback test”) is satisfied if two conditions are met: (1) the person is present in the United States for at least 31 days during the calendar year; and (2) the sum of the days on which this person was present in the United States during the current and the two preceding calendar years (multiplied by the fractions found in §7701(b)(3)(A)(ii)) equals to or exceeds 183 days. 26 USC 7701(b)(3)(A).  

Let’s discuss how exactly the lookback test works.  The way to determine to determine whether the 183-day test is met is to add: (a) all days present in the United States during the current calendar year (i.e. the year for which you are trying to determine whether the Substantial Presence Test is met) + (b) one-third of the days spent in the United States in the year immediately preceding the current year + (c) one-sixth of the days spent in the United States in the second year preceding the current calendar year. See 26 USC §7701(b)(3).

Substantial Presence Test: Presence

As one can easily see, a critical issue in the substantial presence test is to determine during which days a person is considered to be “present in the United States”. Pursuant to 26 USC §7701(b)(7)(A), a person is considered to be present in the United States if he is physically present in the United States at any time, however short, during the day, including the days of arrival and departure.

There are limited exceptions under 26 USC §§7701(b)(7)(B) and 7701(b)(7)(C) for: commuters from Canada and Mexico, foreign vessel crew members and persons who travel between two foreign countries with a less than a 24-hour layover in the United States.

Substantial Presence Test: Exempt Persons

In addition to the exceptions above, the Internal Revenue Code contains a large number of categories of persons exempt from the Substantial Presence Test. 26 USC §§7701(b). In other words, the days that these “exempt persons” spend in the United States do not count toward the Substantial Presence Test. Here is a most common list of exempt persons:

Foreign government-related individuals and their immediate family (26 USC §7701(b)(5)(B))

Teachers and trainees and their immediate family (26 USC §7701(b)(5)(C))

Foreign students on F-, J-, M- or Q-visas (26 USC §7701(b)(5)(D))

Professional athletes temporarily in the US for charitable sporting events (26 USC §7701(b)(5)(A)(iv))

Individuals unable to leave the US due to medical conditions (26 USC §7701(b)(3)(D)(ii))

A couple of notes on these categories. First, for the “professional athletes who are temporarily present in the United States to compete in a charitable sporting event” category, the sports event must meet the following requirements for the exemption to apply: (1) it must be organized primarily to benefit §503(c)(3) tax-exempt organization; (2) the net proceeds from the event must be contributed to the benefitted tax-exempt organization; and (3) the event must be carried out substantially by volunteers.

Second, concerning the last category “foreign aliens who are unable to leave the United States because of a medical condition”, Rev. Proc. 2020-20 expanded this medical condition exception to include “COVID-19 Medical Condition Travel Exception” for eligible individuals unable to leave United States during “COVID-19 Emergency Period”. The term COVID-19 Emergency Period is a single period of up to 60 consecutive calendar days selected by an individual starting on or after February 1, 2020 and on or before April 1, 2020 during which the individual is physically present in the United States on each day. An Eligible Individual may claim the COVID-19 Medical Condition Travel Exception in addition to, or instead of, claiming other exceptions from the substantial presence test for which the individual is eligible.

Substantial Presence Test: “Closer Connection” Exception

In addition to exceptions and exemptions listed above, there is one more highly important exception to the Substantial Presence Test called the “Closer Connection” Exception. Under 26 USC §§7701(b)(3)(C), a person is exempt from the application of the Substantial Presence Test if the following four conditions are met:

1) the person is present less than 183 days in the United States during the current year;

2) the person can establish that, during the current year, he had a tax home in a foreign country (obviously, “tax home” is a term of art that has its special significance for the purposes of the “closer connection” exception;

3) the person has a “closer connection” to that foreign country than to the United States; and

4) the person has not applied for a lawful permanent residency status in the United States.

I have addressed the Closer Connection Exception in detail here.

Substantial Presence Test:  Tax Treaty Exception

Tax treaties provide another exception. IRC §7701(b)(6) and Treas. Reg. §301.7701(b)-7 provide that an individual who meets the substantial presence test but is a resident of a treaty country under a tie-breaker provision of an income tax treaty may elect to be treated as a nonresident alien for US tax purposes. This election is made on Form 8833, Treaty-Based Return Position Disclosure.

It’s important to note that while this treaty election can significantly affect an individual’s US tax obligations, it does not negate the fact that the individual met the substantial presence test. This distinction is crucial for certain reporting requirements, such as FBAR and Form 8938.

Substantial Presence Test: Closer Connection Exception and Treaty Election vs. FBAR

One of the most common pitfalls of US international tax compliance relates to a situation where the substantial presence test is met but either a closer connection exception is claimed or an election is made to be taxed as a resident of another country.  In such a situation, even many practitioners incorrectly conclude that the taxpayer is not required to file FBAR.  This is not the case; even where a tax treaty foreign tax residency election or a closer connection exception claim is made, the taxpayer may still need to file an FBAR. 76 Fed. Reg. 10,234, 10,238; IRM 4.26.16.2.1.2(6) (11-06-15).

I will discuss this FBAR exception to the closer connection and tax treaty exceptions in another article.

Contact Sherayzen Law Office for Professional Help With US International Tax Law

Understanding the nuances of the US international tax law, including the Substantial Presence Test with its numerous exceptions and its implications for both tax residency and FBAR reporting, is essential for individuals who spend significant time in the United States. Given the complexity of these rules and their potential US tax impact, you need qualified professional help to properly navigate these complex rules.

This is why you need to contact Sherayzen Law Office.  Our international tax team is highly knowledgeable and experienced in this area of law. We have helped hundreds of US taxpayers to determine their US tax residency status, and we can help you!  

Contact us today to schedule your confidential consultation!

IRS Corporate Jet Audits Campaign | MN IRS Audit Tax Lawyer

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On February 21, 2024, the IRS announced that it will begin dozens of audits of business aircraft usage as part of a new tax enforcement campaign. In this short article, I will discuss these new IRS corporate jet audits in more detail.

IRS Corporate Jet Audits: Focus on Personal Use of High-Net Individuals

The IRS announced that it will be auditing the usage of corporate aircraft for personal purposes.  The chief revenue agency of the United States was blunt in identifying who it is targeting — high-net individuals. The audits will focus on aircraft usage by large corporations, large partnerships and high-income taxpayers and whether, for tax purposes, the use of jets is being properly allocated between business and personal reasons.

Officers, executives, other employees, shareholders and partners often use business aircraft for both business and personal reasons. In general, the Internal Revenue Code allows a business deduction for expenses of maintaining an asset, such as a corporate jet, as long as the company uses the asset for a business purpose. However, the company must allocate use of a company aircraft between business use and personal use. This is a complex area of tax law, and record-keeping can be challenging.

Hence, for someone such as an executive using the company jet for personal travel, the amount of personal usage impacts eligibility for certain business deductions. Use of the company jet for personal travel typically results in income inclusion by the individual using the jet for personal travel and could also impact the business’ eligibility to deduct costs related to the personal travel.

The number of audits related to aircraft usage could increase in the future following initial results and as the IRS continues hiring additional examiners.

IRS Corporate Jet Audits: Funding and Strategies

The IRS was quick to identify  the Inflation Reduction Act as the source of funding of this new IRS campaign. The IRS will be using advanced analytics and resources from the Inflation Reduction Act to more closely examine this area. At the same time, the agency complained that, in the past, it did not have the resources to properly audit this area due to low resources.

“During tax season, millions of people are doing the right thing by filing and paying their taxes, and they should have confidence that everyone is also following the law,” said IRS Commissioner Danny Werfel. “Personal use of corporate jets and other aircraft by executives and others have tax implications, and it’s a complex area where IRS work has been stretched thin. With expanded resources, IRS work in this area will take off. These aircraft audits will help ensure high-income groups aren’t flying under the radar with their tax responsibilities.”

The examination of corporate jet usage is part of the IRS Large Business and International division’s “campaign” program. Campaigns apply different compliance streams to help address areas with a high risk of non-compliance. These efforts include issue-focused examinations, taxpayer outreach and education, tax form changes and focusing on particular issues that present a high risk of noncompliance.

IRS Corporate Jet Audits: Implications for Broader IRS Tax Enforcement

The IRS corporate jet audits are just part of a larger effort of the IRS to step up tax enforcement worldwide. Prior to the Inflation Reduction Act, more than a decade of budget cuts prevented the IRS from keeping pace with the increasingly complicated set of tools that the wealthiest taxpayers use to avoid taxes. The IRS is now taking swift and aggressive action to close this gap with the focus on high-net-worth individuals.

“The IRS continues to increase scrutiny on high-income taxpayers as we work to reverse the historic low audit rates and limited focus that the wealthiest individuals and organizations faced in the years that predated the Inflation Reduction Act,” Werfel said. “We are adding staff and technology to ensure that the taxpayers with the highest income, including partnerships, large corporations and millionaires and billionaires, pay what is legally owed under federal law. The IRS will have more announcements to make in this important area.”

Of course, one of the most important areas of the increased IRS tax enforcement is US international tax compliance. This involves compliance with foreign income reporting, FBARs and various other information returns (Forms 3520, 3520-A, 5471, 8865, 8938, et cetera).

Contact Sherayzen Law Office for IRS Audits of Your US International Tax Compliance

If the IRS is auditing your US international tax compliance, including foreign income and foreign asset reporting, contact Sherayzen Law Office for professional help as soon as possible. We have helped taxpayers around the world with the IRS international tax audits. We can help you!

Contact Us Today to Schedule Your Confidential Consultation!

US Income Tax Obligations of Green Card Holders: General Overview

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There is a common misconception among Green Card Holders (a common name for US permanent residents) that their US income tax obligations are limited in nature in comparison to US citizens. In this article, I seek to dispel this erroneous myth and provide some general outlines of the US income tax obligations of Green Card Holders.

US Income Tax Obligations of Green Card Holders: Worldwide Income Reporting

I receive a lot of phone calls from Green Card holders who believe that their US income tax reporting obligations are limited only to US-source income (sourcing of income, by the way, is also a very complex subject and I often see egregious mistakes committed even by experienced accountants).

This is not correct. In fact, US permanent residents and US citizens are both considered to be “tax residents of the United States.” US tax residents are required to report their worldwide income on US tax returns and pay US income taxes on foreign-source income (and, obviously, US-source income).

Thus, if you have a Green Card and you have foreign assets (such as foreign bank and financial accounts, foreign businesses, foreign trusts, et cetera), you must report the income from such foreign assets on your US tax returns.

Be careful! You must remember that all foreign income must be reported in US dollars and according to US tax laws. Leaving aside the issue of currency conversion (which is a topic for another article), the reporting of foreign income under US tax laws may be extremely challenging because foreign tax laws may treat this income in a different manner. Let me emphasize this point – the treatment of income under foreign local tax rules may not actually be the same as the treatment of the same income under US tax rules.

For example, Assurance Vie accounts in France may be completely tax-exempt if certain conditions are met. However, the annual income from these accounts must be reported on US tax returns.

Moreover, to make matters worse, these accounts may contain PFIC (Passive Foreign Investment Company) investments which are treated in a very complex and generally unfavorable manner under US tax laws. The calculation of US tax liability in this case may be extremely complex (especially since the French banks are not required to keep the kind of information that is necessary to properly calculation PFIC tax and interest).

US Income Tax Obligations of Green Card Holders: Reporting of Foreign Bank and Financial Accounts

As US tax residents, the Green Card holders are also required to disclose their ownership of certain foreign bank and financial accounts to the IRS. Many US permanent residents are shocked to learn about these requirements and the draconian penalties associated with failure to file the required information reports.

The top two bank and financial account reporting requirements are FinCEN Form 114 (known as “FBAR” – the Report of Foreign Bank and Financial Accounts) and Form 8938 (which was born out of FATCA). Other forms, such as Form 8621, may apply.

It is beyond the scope of this article to discuss these requirements in detail. However, it is impossible to overstate their importance, especially the FBAR, due to potentially astronomical non-compliance penalties (including criminal penalties). You can find more information about these requirements at sherayzenlaw.com.

US Income Tax Obligations of Green Card Holders: Reporting of Foreign Business Ownership

Many US permanent residents are surprised to find out that they may be required to provide detailed reports about their foreign businesses – corporations, partnerships and disregarded entities. Indeed, Green Card holders may be subject to burdensome and expensive US reporting requirements on Forms 5471, 8865, 926, 8938, et cetera. These forms may require Green Card holders to provide foreign financial statements translated under US accounting standards, including US GAAP (Generally Accepted Accounting Practices).

Again, you can find more information about these requirement at sherayzenlaw.com.

US Income Tax Obligations of Green Card Holders: Reporting of Foreign Trusts

Another complex trap for Green Card Holders is reporting of an ownership or a beneficiary interest in a foreign trust (generally, on Form 3520). This complicated topic is beyond the scope of this article, but you can find more information about these requirements at sherayzenlaw.com.

US Income Tax Obligations of Green Card Holders: Other Reporting Requirements

There are numerous other US income tax obligations of Green Card Holders that may apply. Moreover, US has multiple income tax treaties with various countries which may modify your particular tax situation. In order to fully determine your US tax obligations as a Green Card holder, it is best to consult with an experienced international tax attorney.

Contact Sherayzen Law Office for Help With Your US Income Tax Obligations

Sherayzen Law Office is a specialized international tax law firm which is highly experienced in helping US Permanent Residents with their US income tax obligations and reporting requirements. One of the unique features of our firm is that our tax team provides both legal and accounting services to our clients throughout the world.

Contact Us Now To Secure Professional Help and Avoid (or Rectify) Costly Mistakes!