The Final Section 1411 Regulations and ‘Special’ Resident Aliens

Celebration, FL

One of the basic principles of the 3.8% “net investment income tax” (NIIT) under §14111 is that the tax does not apply to individuals who are classified as “nonresident aliens” for U.S. income tax purposes, as defined in §7701(b).2 What was not clarified in the statute, however, was how aliens are treated where they are resident aliens for only part of the year, or where their resident or nonresident alien status may be affected by various elections in the Code or by the provisions of an income tax treaty. Fortunately, the final regulations3 answer all of these questions, and in a manner that seems to be entirely consistent with the statute.

If an alien is classified as a resident alien under §7701(b) for the entire year, the individual is potentially subject to the NIIT. If the resident alien is single, the relevant NIIT “threshold” for “modified adjusted gross income” (MAGI) – above which the individual’s “net investment income” is generally subject to the NIIT – is $200,000. If the resident alien is married to another resident alien, the threshold is $125,000 for each spouse if they file separate returns, but $250,000 if they file a joint return.4 Whether two individuals are permitted to file a joint return under the general rules and, if not, whether they may “elect” to file a joint return (as discussed below) depends on their particular facts.

Although the NIIT rules are fairly easy to apply to a full-year resident alien, the rules – and the potential tax planning opportunities – are more complex if the resident alien falls within a number of categories which this author loosely refers to as “special” categories. The principal such categories are the following:

• An individual who is a resident alien for only part of the year, either based on the individual’s actual facts or on the basis of an election that is available under the Code.
• An individual who is a resident alien under the Code for part or all of the year, but who is re-classified as a nonresident alien under the “tie-breaker” provisions of an income tax treaty for either part or all of the year.
• A married individual who is a nonresident alien at the close of the taxable year, but whose spouse is a citizen or resident alien, and where the couple elects under §6013(g) to be classified as resident aliens5 for the entire taxable year, and for subsequent taxable years.
• A married individual who is a resident alien at the close of the taxable year, but whose spouse is a citizen or resident alien, and where the couple elects under §6013(h) to be classified as resident aliens for the entire taxable year.

These categories are discussed separately below.

Part-Year Resident Aliens

An alien may be classified as a resident alien for only part of the year, and as a nonresident alien for the balance of the year. The final regulations refer to these aliens as “dual status aliens.”6 In most cases this situation occurs where an alien moves to the United States during the year and becomes classified as a resident alien around the same time as the move, or when an alien who has been living in the United States for several years as a resident alien moves out of the United States and becomes classified as a nonresident alien around the time of the move (or some time thereafter). The individual’s classification as a part-year resident alien during the first year may be on the basis of actual facts, or on the basis of an election that might be made under §7701(b)(4) by a full-year nonresident alien to be classified as a resident alien for part or all of the year based on the special rules in the Code.

Other less common situations can arise where an individual is classified as a dual status alien. For example, a nonresident alien may acquire a U.S. permanent residence visa (“green card”) during the year and become classified as a resident alien thereafter for that reason, or an alien may surrender his/her green card (often if living outside the United States) and become classified as a nonresident alien after that. In some cases an individual may even be classified as a “triple status” alien – nonresident at the start of the year, resident alien during a period of at least 183 days during the same year, and nonresident alien once again at the end of the year.

In all of these situations the final regulations confirm that the alien is potentially subject to NIIT, but only during the resident alien portion of the year.7 In calculating whether NIIT is imposed, the regulations contain a “pro-taxpayer” rule which provides that the applicable threshold is applied without pro-rating. Thus, if the alien is single, the $200,000 threshold would be applied to the alien’s MAGI during the resident alien portion of the year (even if that period lasted for only a few weeks or months), and if married filing separate, the $125,000 threshold would be applied to the same period. (The alien’s nonresident alien status for part of the year would prevent the alien, if married, from filing a joint return with a $250,000 threshold.)

Although it would be unusual for the individual’s potential NIIT exposure to discourage an alien from making a §7701(b)(4) resident alien election or from planning his/her foreign business trips so as to become classified as a resident alien, the potential NIIT effect of any such election or planning should nevertheless always be considered.

Treaty Tie-Breaker Nonresident Aliens

The §7701(b) regulations confirm that where a resident alien is classified as a resident of a tax treaty country under the “tie-breaker” provisions of the relevant treaty, the individual is reclassified as a nonresident alien in determining the individual’s own U.S. tax liability. Because §1411 provides that NIIT is not imposed on an individual who is classified as a nonresident alien under §7701(b), the NIIT regulations provide that a treaty tie-breaker alien – referred to in the regulations as a “dual resident individual” – will be classified as a nonresident alien for NIIT purposes, and thus exempt from NIIT.8 It should be noted, however, that if the alien is classified as a treaty tie-breaker alien for only part of the year, the alien is potentially exposed to NIIT for the balance of the year during which he/she is classified as a resident alien – but without pro-rating the applicable $200,000 or $125,000 threshold.

Elective §6013(g) Aliens

If at the close of the year an individual is a nonresident alien who is married to a citizen or resident alien, the couple may elect under §6013(g) to file a joint return for the year. (It does not matter whether the spouse, if an alien, was a resident or nonresident alien at the start of the year.) The effect is to classify the electing nonresident alien spouse as a resident alien for the entire year, and if the other spouse has not been a resident alien for the entire year, the election classifies him/her as a resident alien for the entire year as well. One advantage of a §6013(g) election is that the spouses are treated as resident aliens until the end of the last year in which either of them is an actual resident alien. Thus, in the year that the couple moves out of the United States, their resident alien status continues to the end of that year, thus allowing them to file a joint return for that year as well. At the same time, if filing a joint return for such last year might result in higher U.S. tax than filing as actual nonresident aliens following their move out of the United States, the couple may elect to terminate the §6013(g) election for such year.

Section 6013(g) provides clearly that the election is only effective for purposes of chapter 1 of the Code (Normal Taxes and Surtaxes) and chapter 24 (Collection of Income Tax at Source on Wages). The NIIT regulations thus recognize that a §6013(g) election is not effective for NIIT purposes,9 but they provide that a couple may elect for their §6013(g) election to be effective for NIIT purposes as well.10 Because of this flexibility in the NIIT regulations, a couple that contemplates making a §6013(g) election should always examine their facts carefully to determine whether there could be advantages to making a parallel §6013(g) election for NIIT purposes.

For example, the MAGI (for NIIT purposes) of the electing resident alien spouse may be $150,000, which is $25,000 more than the NIIT threshold for a married filing separate couple. If that spouse has significant net investment income and if the electing nonresident alien spouse has little or no net investment income or other income, making a §6013(g) election for NIIT purposes would increase the couple’s NIIT threshold to $250,000, and would thus avoid the imposition of NIIT on the resident alien spouse. By the same token, if the electing nonresident alien spouse has substantial investment income as well as other U.S.-source employment income, making a parallel §6013(g) election for NIIT purposes might actually increase the couple’s NIIT. Thus, before deciding whether to make the §6013(g) election for income tax purposes, and additionally for NIIT purposes, a calculation should be made of each spouse’s potential income tax and NIIT with and without either election.

The NIIT regulations provide that if a couple makes a parallel §6013(g) election for NIIT purposes, the election will be effective for as long as the regular §6013(g) election (i.e., for income tax purposes) remains in effect. In most cases, this means that the NIIT election would remain in effect through the end of the couple’s last year of actual resident alien status, and thus would continue to the end of the taxable year in which they move out of the United States (assuming that in the year following the move out of the United States both are nonresident aliens for the entire year). However, if it appeared that there could be adverse NIIT consequences of remaining resident aliens to the end of the taxable year of the move abroad, the couple could exercise their right to terminate the election under §6013(g)(4) with respect to such year (in which case they would usually be “dual status aliens” for such year, and NIIT would potentially apply only to the “actual” resident alien portion of the year). However, based on the rule in the regulations that a §6013(g) election for NIIT purposes remains in effect for as long as the parallel income tax election does, presumably the couple could not revoke the NIIT election for the year of their move out of the United States but not simultaneously revoke the income tax election.

Elective §6013(h) Aliens

A much more limited election is available to a couple where one spouse is a nonresident alien at the start of the year but a resident alien at year-end, and where the other spouse is a citizen or resident alien at year-end. (Again, it does not matter whether the spouse, if an alien, was a resident or nonresident alien at the start of the year.) Under §6013(h), the couple may make an election to be classified as resident aliens for the entire year (assuming that the other spouse is an alien and not a citizen). This election is valid only for that particular taxable year, and has no effect for subsequent years (unlike a §6013(g) election).

Because a §6013(h) election is only effective for purposes of chapters 1 and 24, the NIIT regulations provide that a §6013(h) election that is made solely for income tax purposes will not be effective for NIIT purposes, but that a parallel §6013(h) election may be made for NIIT purposes, if the couple wishes to do so.11 In deciding whether to make such a parallel election, the considerations should be the same as those described above for §6013(g) purposes. Thus, before deciding whether to make the §6013(h) election for income tax purposes, and additionally for NIIT purposes, a calculation should be made of each spouse’s potential income tax and NIIT with and without either election.

This commentary also appears in the December 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Klasing and Francis, 6080 T.M., Section 911 and Other International Tax Rules Relating to U.S. Citizens and Residents, and in Tax Practice Series, see ¶3310, Computation of Tax — Individuals.