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!
