America’s "Substantial Presence" Test – Most Have Heard of It, Few Understand It

Imagine strutting defiantly through U.S. airports thinking you are tax immune only to find out you might be caught in an IRS tax web. Many foreign nationals proudly tell me: “Since I have no income from U.S. sources and have not spent more than 182 days in the U.S. this year, I am tax immune.” When I explain to them that’s not how the substantial presence test works, they shrivel.

To be clear, if you spend less than 31 days per calendar year in the U.S., you won’t be considered a U.S. person for U.S. tax purposes. Conversely, if you spend 183 days or more per calendar year in the U.S., you will be considered a U.S. person. But what happens if you spend more than 30 days but less than 183 days in the U.S. that calendar year?

Enter, the substantial presence test.

So what is the substantial presence test?

It’s a tool the U.S. government utilizes to give itself the power to tax a foreign national even if they spent less than 183 days in the U.S. (This test only applies to foreign nationals who are not permanent residents of the U.S. If you are a "Green Card" holder, you are automatically considered a U.S. person.)

And how does the substantial presence test work?

The substantial presence test is really Part 2 of a two-part analysis. Before it can be applied, you must apply Part 1.

Part 1:

1.     Are you a U.S. citizen, Green Card holder, or other Lawful Permanent U.S. Resident? If yes, stop here. You are automatically a "U.S. person" for tax purposes by virtue of your citizenship and/or residency.

2.     For all other (non-immigrating) foreign nationals:  

a.     Were you physically in the U.S. for less than 31 days in the year in question?

i.     If yes, stop here. You are NOT considered to be a U.S. person for tax purposes for that year.

b.     Were you physically in the U.S. for 183 days or more in the year in question?

i.     If yes, stop here. You ARE considered to be a U.S. person for income tax purposes for that year.

c.     If you were in the U.S. for more than 30 days but less than 183 days in the year in question, then apply Part 2 – the substantial presence test.

Part 2:

The substantial presence test looks at the last three years to determine whether a foreign national with less than 183 days in the U.S. in the year in question should be treated as a U.S. person anyway.

The test begins by counting days spent in the U.S. for each of the last three years beginning with the year being examined. The day of arrival and departure count as two full days, even if you were present in the U.S. for less than five minutes on a particular day. After counting the days present in the U.S. for the calendar year in question (Year 1), the year before that (Year 2), and the year before that (Year 3), multiply your Year 1 days by 1, Year 2 days by 1/3, and Year 3 days by 1/6. If the three totals add up to 183 days or more, then you have substantial presence in the U.S. in the year in question (even if you spent less than 183 days in the country).  

So I have substantial presence in the U.S., what’s the big deal?

You will be characterized as a U.S. person for tax purposes, which means you will be taxed on your worldwide income (even if you’re not a U.S. citizen or green card holder, and even if you have no income from U.S. sources). In addition to having to file tax returns and pay tax, you will be required to report foreign holdings and financial accounts (like the FBAR and FATCA) or face astronomical penalties for not complying.

Can I fix this?

Perhaps. I will discuss exceptions and other possible solutions in a future post.