Taxation of Foreign Persons in the US: A Comprehensive Guide

As one of the world’s largest consumer markets, the United States remains a popular destination for foreign investment, thanks to a strong economy and free trade agreements with several foreign countries. Business structure, residency status, income sources and types, and tax treaties are some of the variables affecting foreign founders’ tax obligations. One of the fundamental tax considerations for non-US citizens is the founder’s residency status. Individuals are classified as “resident aliens” or “nonresident aliens” by the Internal Revenue Service (IRS) for tax purposes and are taxed differently. Understanding the differences between these two statuses is critical because they have significant implications for your tax obligations. 

Taxation of Foreign Persons in the US: Key Takeaways 

• Non-resident aliens are non-citizens of the United States who either fail the substantial presence test or do not have a permanent resident card or “green card.”
• To become an investor in the United States, neither citizenship nor residency are required.
• Ownership of an S-Corporation is restricted to US persons.
• The residency status of a foreign investor determines their tax liabilities and filing requirements.
• Foreign persons are only taxed on income earned in the US.

Who is considered a “foreign person” for tax purposes in the US?

The IRS defines a foreign person as “any nonresident alien, foreign corporation, foreign partnership, foreign trust, foreign state, and any other non-U.S. person.” A foreign corporation or partnership’s U.S. branch is typically regarded as a foreign person.  It also includes a foreign branch of a US financial institution if the foreign branch is a qualified intermediary.

• Nonresident alien: A nonresident alien is a person who is not a citizen of the United States or who does not meet the requirements to be classified as a resident alien under any of the two (2) tests: the substantial presence test (SPT) or the green card test, for the purposes of US tax law. 
• Foreign Corporation: A foreign corporation is a legal entity not formed or organized in the United States or under US law in any of its states or the District of Columbia.
• Foreign Partnership: A “foreign partnership” is any partnership not formed or established under US federal law or the laws of any US state.

How is an alien’s tax residency status determined?

The Green Card and Substantial Presence tests are used to determine an alien’s residency status. A non-US citizen is classified as a nonresident alien unless he meets the Green Card or Substantial Presence Test (SPT). 

Green Card Test: You are considered a resident alien if the immigration laws have granted you the privilege to reside permanently in the United States as an immigrant. This status is usually awarded to those approved by U.S. Citizenship and Immigration Services (USCIS) for a Permanent Resident Card, Form I-551, popularly referred to as a “green card.” If you pass the green card test at any point during the calendar year but fail the SPT for that year, your residency starting date is the first day you are present in the United States as a lawful permanent resident. This status remains in effect until the holder voluntarily renounces it or the United States government revokes it.

Substantial Presence Test: The SPT considers the number of days a foreign individual has been physically present in the United States during a specific period. For an alien to pass the substantial presence test, they have to be physically present in the United States for at least 31 days in the current year and a minimum of 183 days in the three years that comprise the current year and the two immediately preceding years, counting:

• All the days you were physically present in the US during the current year, 
• 1/3 of the days you were present in the first year prior to the current year and
• 1/6 of the days you were present in the second year before the current year

The residence test considers a day of residence in the United States to be a full day for the current calendar year. A day of residence only counts as one-third of a day of residence in the previous year and one-sixth of a day in the year before. This implies that the final total must be at least 183 after dividing the total number of days of residence over the previous two years by three or six. You may also visit our blog to learn more about how US tax residency is determined. 

No-Lapse Rule

“No lapse” residence rules are set out in IRC Code Section 7701(b)(2)(B)(iii) and Treasury Regulation Section 301.7701(b)-4(e). If a foreign national leaves the US within a year and returns at any point in the following year, residency is deemed to have never ended between the two residency periods, even if the person has a stronger bond with a foreign nation than the US during that time. 

What is the significance of aliens’ residency status for US tax purposes?

The residency status of aliens is critical in determining their tax obligations and benefits. The income that must be reported to the IRS and subjected to US tax, deductions and credits that could be claimed, and reporting requirements depend on a non-US citizen’s residency status. The U.S. tax system distinguishes U.S. residents from non-residents for tax purposes as they are taxed differently. To comply with tax laws and reduce tax liabilities, foreign persons must have a firm grasp on the significance of their residency status in US taxation.

Can a foreign person own a business in the US?

In most cases, starting a business in the United States does not necessitate either citizenship or permanent residency. However, you will need a “work visa” to manage your business or perform your duties in the US as an officer.

How can a foreign person invest in the US?

A foreign person can buy stocks of US companies, take control of an existing company, or form a new business entity in the United States. Foreign corporations can also operate in the US through a branch office or subsidiary.

What types of business structures can a foreign person establish in the US? 

Nonresident aliens may form, own, or be members of a US partnership, corporation, or limited liability company (LLC) but cannot own an S-corporation. Only US citizens and resident aliens can own S-corporations. On the other hand, foreign corporations can establish representative offices, branches, or wholly owned subsidiaries in the US.  

What are some of the factors that a foreign person should consider when forming a business entity in the United States?

Some factors to consider when starting a US business include:  

1. Short- and long-term goals of the investor
2. Type of business structure (LLC, partnership, or corporation)
3. State of registration
4. Applicable federal, state, and local taxes
5. Availability of financial resources
6. Cost of formation
7. Tax implications in the U.S. and home country

How does one establish a business entity in the US? 

Generally speaking, the process and procedure for nonresident aliens or foreign entities to establish a business in the United States is roughly the same for US citizens and resident aliens. The process would differ depending on the type of business structure being established and the state of registration. Legal requirements for forming a business vary by state and by entity type. Here are the basic steps:

1. Choose a legal structure
2. Select a state in which to register your business
3. Register the company (including in other states where you’ll have offices, employees, or sales activities)
4. Obtain an EIN from the IRS
5. Obtain the necessary permits and licenses
6. Open a bank account

How are foreign persons taxed in the US?

Foreign persons are only taxed on income earned from sources within the United States. They are taxed differently, with rates varying according to the type of income earned in the United States. Tax treaties between the United States and their home countries also come into play.

Taxation of Nonresident Aliens 

Nonresident aliens are subject to two rates: one for effectively connected income (ECI) and another for fixed or determinable, annual or periodic (FDAP) income that is not effectively connected income. 

• FDAP income not effectively connected with a trade or business in the United States is taxed at a flat rate of 30% of the gross amount unless a tax treaty specifies a lower rate.  Non-residents are not eligible to claim standard deductions and tax credits usually available to citizens and resident aliens.
• The ECI (after allowable deductions) and personal service income earned in the U.S., such as wages or self-employment income, are taxed at the same graduated or progressive rates that apply to US persons.  

Shown below are the federal individual income tax brackets for 2023 that non-resident aliens must follow.

Taxation of Dual Citizens 

You are subject to different tax laws for the parts of the year you are a nonresident alien and the parts of the year you are a US resident. The date of receipt determines whether foreign income is taxable.

• Any income, including foreign income, you received during the year as a resident alien is taxed, even if you earned it as a non-resident alien or became one after receiving it but before the year ended.
• During your nonresident alien status, you are taxed on US-source income connected to a US business or trade. Income from sources outside the US that is not effectively connected with a trade or business in the US is not taxable if received while you are a nonresident alien, even if the income was earned while you were a resident alien or if you became a resident alien or US citizen after receiving the income and before the end of the year.

The tax rates for dual citizens are as follows:

• Your resident alien income and nonresident alien income that is effectively connected to a trade or business in the US are added (less allowable deductions) and taxed at the progressive rates applicable to US citizens and resident aliens.
• Gross income not connected to a trade or business in the United States is taxed at a flat 30% or lower treaty rate while you are a nonresident.

Taxation of Foreign Corporations

Foreign corporations are only taxed on US-sourced income, and the tax rate depends on the income type.​​

• Effectively Connected Income (ECI): When it engages in business in the United States through a branch, subsidiary, or investment, the net ECI is subject to a federal income tax rate of 21%.
• Fixed or determinable annual or periodical (FDAP):  FDAP income such as dividends, interests, and royalties derived from U.S. sources but not technically ECI is taxed under Section 881 on a gross basis at 30% or a reduced rate provided in a tax treaty between the US and home country.
• Branch Profit Tax (BPT): Foreign corporations are subject to a 30% BPT (or a lower rate under an applicable treaty) on after-tax branch profits for the year that are effectively connected with a US business to the extent of the amount not reinvested in that US trade or business. This is in addition to the federal tax on income that is effectively connected to the conduct of a trade or business in the US. 

Taxation of Foreign Partnerships

Foreign partnerships are not subject to federal tax on the entity level. Instead, the partnership’s income, gains, losses, deductions, and other credits pass through directly to the partners, who must report their share of the partnership’s tax items in their tax returns and pay any tax due.

What are the filing requirements for nonresident aliens and their respective deadlines?

You are required to file a federal tax return and, in most cases, a state tax return if you had any source of income in the United States during the prior tax year. You may be required to file additional forms depending on your specific circumstances and financial transactions. Here are some of the forms you may be required to file. 

1. Form 1040-NR, U.S. Nonresident Alien Income Tax Return: As a nonresident alien, you must file Form 1040-NR to report all US-source income in the following cases:

• If you are engaged in trade or business in the US 
• If you are not engaged in a U.S. trade or business but have other U.S. source income on which withholding tax did not fully satisfy the tax due
• If you are claiming a refund of over withheld or overpaid

2. Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return: Submit this form to request an automatic filing deadline extension.
3. Form 8233, Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual: Submit this form to your employer every year to claim exemption from withholding on compensation for personal services according to a tax treaty or the personal exemption amount. The form must be mailed or faxed to the IRS within five days after the employer approves and signs it.
4. Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b): Attach Form 8833 to your tax return (Form 1040-NR). If you are not required to file a tax return, you must file it at the IRS Service Center, where you would typically file a return to make the treaty-based return position disclosure under Section 6114 (see Regulations Section 301.6114-1(a)(1)(ii)) or under Regulations Section 301.7701(b)-7.
5. W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals): If you are the beneficial owner of an income subject to withholding, or if the withholding agent or payer requests it, give them this form. You can also use it to indicate whether you are requesting a reduced withholding rate or an exemption from it.

If the deadline falls on a weekend or legal holiday, the due date is moved until the next business day.

What are the filing requirements for dual citizens?

Use Form 1040-NR to report US-sourced income for the nonresident period and Form 1040 to report worldwide income for the resident period. 

• Resident at End of Year

When a dual-status alien becomes a resident of the United States during the tax year, and at the end of the tax year, they have to file Form 1040 with Form 1040-NR attached. Ensure that “Dual-Status Return” is written across the top of each return. 

Deadline for Filing: 

• April 15 of the year following the end of your tax year if you are a calendar year-filer 
• By the 15th day of the fourth month following the end of your tax year if filing other than the calendar year: 
• Nonresident at the End of Tax Year

If a dual-status alien leaves the United States during the tax year and does not return by the end of the tax year, they must file Form 1040-NR along with Form 1040. Write “Dual-Status Return” across the top of the returns.

Deadline for Filing: 

• If you file on a calendar year, you must file by April 15 of the year following the end of your tax year if you receive withholding-eligible wages. 
• If filing on a basis other than the calendar year, file by the 15th of the fourth month after the end of the tax year. 
• If you did not receive withholding wages and are filing on a calendar year, you must file by June 15th of the following year. 
• If you are filing on a basis other than the calendar year, file by the 15th day of the sixth month following the end of your tax year.

Other returns that may be required include the following: 

• A dual-resident taxpayer who wishes to claim treaty benefits must file his return using Form 1040-NR and attach Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).
• Form 5472 (visit Cleer’s blog to learn more about reportable transactions). 
• The forms listed under nonresident alien’s filing requirements may also apply.

What are the filing requirements for foreign corporations?

• If a foreign company does business or trade in the US or has income from sources in the US, it must file a return using Form 1120-F (U.S. Income Tax Return of Foreign Corporation). This is the case even if the company has no ECI or US-source income during the tax year or if its income is not subject to income tax because of a tax convention or provision of the law. 
• If it is not engaged in trade or business in the US, it is not required to file a return if its income tax liability is fully satisfied by withholding tax at source. However, this rule does not apply if it claims a refund or is subject to accumulated earnings tax.      

Below is a list of some forms a foreign corporation may be required to file.

Need help navigating U.S. taxation for foreign founders?

Navigating the complexities of the U.S. multi-tiered tax system can be challenging and nerve-wracking for new business founders. Don’t worry! Cleer Tax can help you structure your business, maintain accurate bookkeeping, file your tax returns, and optimize your tax deductions while ensuring compliance with US tax laws. We have a team of tax professionals adept at preparing US tax returns for foreign persons. 

Cleer provides Corporate Income Tax Packages encompassing federal and state income tax filings for a hassle-free experience. Our comprehensive new company setup package offers tax consultation, bookkeeping, and a chart of accounts set up to help you do it right from the start. We also offer all-inclusive bookkeeping packages, which include your monthly statements plus your federal and state tax returns.

If you need any help reducing your tax liability, schedule a consultation, or feel free to contact us.