U.S. Tax Residency: Key Differences In The Income & Transfer Tax Rules

Forbes

20-05-2025

U.S. tax residency rules
The application of U.S. tax laws often turns on the meaning of 'residency.' Although U.S. citizens and residents are subject to federal income taxes on their worldwide income, non-residents who are not U.S. citizens ('Foreign Persons') are generally not unless the income has a nexus to the U.S. Under the U.S. income tax regime, individuals may establish residency through their physical presence in the U.S.
U.S. estate and gift tax laws—referred to as 'transfer taxes'—also apply to U.S. citizens and residents. Significantly, however, the U.S. transfer tax regime defines the term 'residency' different than its U.S. income tax counterpart. Here, individuals establish residency through a test focused on that person's domicile, regardless of physical presence.
Foreign Persons are subject to U.S. income taxes on: (1) income that is effectively connected with a U.S. trade or business, or (2) U.S. source income that is fixed, determinable, annual or periodic. By comparison, U.S. residents are subject to federal income taxes on their worldwide income.
Section 7701 of the Code defines the term 'resident' for U.S. income tax purposes. In addition to lawful permanent residents of the U.S. (i.e., 'green-card holders'), residents include individuals who meet the 'substantial presence test.' The substantial presence test focuses on the number of days the person is physically present in the U.S., placing more significance on the days in the current year as opposed to prior years. Specifically, individuals satisfy the substantial presence test if they are physically present in the U.S. at least: (1) 31 days in the testing year, and (2) 183 days total in a three-year lookback period which includes the testing year. For these purposes, individuals count the number of days they were physically present in the U.S. in the testing year, 1/3 of the days in the immediately preceding year, and 1/6 of the days in the year prior to the preceding year.
Example
Jon arrives in the U.S. in 2022. He is physically present in the U.S. the following number of days for 2022-2024: 240 days in 2022; 150 days in 2023; and 90 days in 2024. To determine whether Jon meets the substantial presence test for his 2024 tax year, Jon would make the following computation:
2022: 240 / 6 = 40 days
2023: 150 / 3 = 50 days
2024: 90 / 1 = 90 days
Total = 180 days
Because Jon was not physically present in the U.S. 183 days or more in the three-year window, he would not meet the substantial presence test. Note that Jon would satisfy the substantial presence test if he had been in the U.S. an additional three days or more in 2024.
In addition to being subject to U.S. income tax on their worldwide income, U.S. residents are often subject to numerous foreign information return requirements including the FBAR, Form 8938, Form 3520, Form 3520-A, and Form 5471. Individuals who learned of their U.S. residency and missed foreign information returns may be able to regain compliance and pay reduced penalties under an IRS compliance program such as the IRS Streamlined Filing Compliance Procedures.
Federal tax laws also impose a U.S. transfer tax upon death (referred to as an estate tax) and in making certain inter vivos gifts (referred to as a gift tax). Similar to the U.S. income tax rules above, these transfer taxes apply to U.S. citizens and residents. However, the definition of residency under the U.S. transfer tax regime differs significantly from this term's usage under the U.S. income tax laws.
For U.S. transfer tax purposes, an individual is a resident—and therefore subject to tax—if the individual had domicile in the U.S. upon death or making the gift. See Treas. Reg. sec. 20.0-1(b)(1); Treas. Reg. sec. 25.2501-1(b). Thus, unlike the mechanical substantial presence test which utilizes physical presence as the proper marker, the transfer taxes focus on whether the person resided in the U.S. with an intent to remain there indefinitely. The domicile test requires an analysis of all relevant facts and circumstances, including where the individual worked, where the individual's family resided, etc.
U.S. residents subject to U.S. transfer taxes may voluntarily change their domicile through relocating overseas and establishing an intent to remain in that foreign country indefinitely. But U.S. transfer taxes may continue to apply if the person maintains property in the U.S. (e.g., real property). In these circumstances, the individual, who is no longer a U.S. resident, may be subject to transfer taxes on a much reduced exemption of $60,000 (compared to the roughly $14 million exemption that applies for U.S. citizens and residents for 2025). Careful tax planning can often be key in reducing these taxes.
Taxpayers who have non-U.S. citizen spouses also must be aware of a reduced marital deduction. Generally, U.S. transfer tax laws allow spouses who are U.S. citizens to receive an unlimited amount of wealth through gifts. Under section 2323(i) of the Code, spouses who are not U.S. citizens may receive an inflation-indexed exclusion of $100,000 (currently $190,000 in 2025) without gift tax consequences. Again, careful tax planning may significantly reduce the transfer taxes in these circumstances.
The U.S. income tax or transfer tax applies to individuals who establish residency in the U.S. For these purposes, the U.S. income tax rules focus on an individual's physical presence in the U.S. whereas the U.S. transfer tax regime centers on domicile. Because the tests differ, taxpayers and tax professionals alike should exercise caution in separating the two tests to determine a taxpayer's tax residency status under the different tax regimes.