In this blog, we explore three somewhat obscure rules designed to thwart those who try to alternate between tax residencies in order to avoid U.S. taxation.
Alternating Residency Status – An Example
Let’s take the following scenario to illustrate the issue at hand:
Charlie has moved to the U.S., and for a number of years has had the status of a U.S. tax resident by virtue of his days of presence in the U.S. (i.e., under the substantial presence test).
While in the U.S., Charlie has grown a successful business, and now a buyer has made an offer to buy the business.
Charlie makes a plan – leave the U.S. and move to the UAE temporarily, sell the business while resident in the UAE, pay no U.S. tax on the sale (and avoid tax altogether), and then move back to the U.S. after the dust has settled.
To thwart such planning, the U.S. has three “gotcha” rules, each of which come into play depending on the time spent outside the U.S., and depending on the direction of the move (to the U.S. or away from the U.S.).
Gotcha #1 – The Anti-Toggle Rule
Section 7701(b)(10) of the Internal Revenue Code has a special rule which provides that the taxation rules of Section 877 (which otherwise are applicable to individuals who expatriate before June 17, 2008) are applied to an alien: (i) who was at any time a resident alien for three consecutive years; (ii) who then became a nonresident alien (“NRA”); and (iii) who again becomes a resident alien before completing three years of nonresident alien status.
In that situation, the individual is subject to U.S. tax on U.S.-source income (as specially defined under Section 877(d)) during the intervening period when the individual was a nonresident alien. This rule applies equally to aliens who are resident aliens in either period under the green card test or under the substantial presence test.
In Charlie’s case, if he was a U.S. tax resident for three or more years, then left to the UAE and sold his business, then the sale would be subject to U.S. taxation (despite being an NRA at the time of the sale) if he moves back to the U.S. within three years of his initial move away from the U.S.
Gotcha #2 – The No-Lapse Rule (previous-year resident)
Treasury Regulation 301.7701(b)-4 contains rules for residency time periods, including residency beginning and end dates. Section (e)(1) of the regulation contains a no-lapse rule, which states that an individual cannot have the status of an NRA for part of the year (i.e., the first part of the year) if the individual was a U.S. tax resident during the previous year.
To quote the regulation – “An alien individual who was a United States resident during any part of the preceding calendar year and who is a United States resident for any part of the current year will be considered to be taxable as a resident at the beginning of the current year.”
In Charlie’s case, if he were to try a more aggressive approach, and move to the UAE (and sell his business), but then return to the U.S. the same year, he could not claim to be a part-year resident under the no-lapse rule. This rule is somewhat broader than the anti-toggle rule, since it renders Charlie a U.S. tax resident for the entire year, rather than an NRA subject to certain U.S.-source income.
Gotcha #3 – The No-Lapse Rule (subsequent-year resident)
Similar to the previous gotcha rule, this rule under Treas. Reg. 301.7701(b)-4(e)(2) states that an individual cannot have the status of an NRA for part of the year (i.e., the second part of the year) if the individual becomes a U.S. tax resident during the subsequent year. So, while normally, an individual can claim part-year tax residency if he has a so-called “closer connection” to a foreign country during the second part of the yar, such claim is disallowed if the individual is a U.S. tax resident at any point during the subsequent year.
To quote the regulation – “An alien individual who is a United States resident for any part of the current year and who is also a United States resident for any part of the following year (regardless of whether the individual has a closer connection to a foreign country than the United States during the current year) will be taxable as a resident through the end of the current year.”
Given the potential pitfalls associated with moving to and from the United States, especially when tax motivation underlies the move, it’s best to consult with a U.S. tax expert to ensure that your plans make the most sense from a tax perspective.
