Who Is Subject to U.S. Taxes? (International Tax)

Worldwide vs. territorial tax systems

The U.S. generally operates on a worldwide tax system for its citizens and resident individuals. This means income from both U.S. and foreign sources generally falls within the U.S. income tax system, subject to applicable exclusions, credits, treaties, and other rules.

This is in comparison to a territorial tax system, which generally focuses on income sourced within that country and excludes certain foreign-source income. The specific rules vary by country, and foreign earnings are not necessarily taxed in only one other jurisdiction.

Businesses require a separate look. The U.S. corporate international tax system includes exceptions and special rules, so the worldwide-versus-territorial distinction is not the same for every taxpayer.

Who is subject to U.S. taxes? Individuals

Similar to the concept of nexus, meaning enough of a connection to a state for tax obligations to arise, international tax jurisdiction considers the relationship between the taxpayer and the country.

Under IRC Section 1, Treasury Regulation Section 1.1-1, and the residency rules in Section 7701(b), U.S. citizens and resident aliens generally are subject to federal income tax on their worldwide income. This generally remains true when a U.S. citizen lives abroad.

One way to understand the policy is that citizens and residents have continuing personal and legal relationships with the U.S. These relationships can include access to U.S. resources and protections, even while living overseas. However, the tax obligation comes from the law and the taxpayer’s status, rather than whether they actually use a particular benefit.

These are personal relationships to the U.S., in comparison to the economic relationships discussed below.

What is a U.S. person?

A U.S. person is defined under IRC Section 7701(a)(30). The definition includes U.S. citizens and resident individuals, domestic corporations, domestic partnerships, estates other than foreign estates, and trusts that meet the applicable U.S. court-supervision and control tests.

For individuals who are not U.S. citizens, tax residency generally depends on the green card test or substantial presence test, subject to elections, exceptions, and applicable treaty rules. Tax residency is not the same as immigration status.

The substantial presence test generally requires at least 31 days of U.S. presence during the current year and a weighted total of at least 183 days over three years. The calculation includes all qualifying days in the current year, one-third of the days in the preceding year, and one-sixth of the days in the year before that. Certain days may be excluded, and exceptions or treaty relief may apply.

Who is subject to U.S. taxes? Businesses

IRC Section 11 and Treasury Regulation Section 1.11-1 generally govern the federal income tax imposed on corporations. A domestic C corporation generally is a separate taxpayer, subject to the applicable corporate and international tax rules.

However, not every business organized in the U.S. pays income tax in the same way. Partnerships and S corporations generally pass income through to their owners. An LLC may be treated as a partnership, corporation, or disregarded entity, depending on its ownership and tax elections.

This distinction matters: where a business is organized helps determine its status, but its federal tax classification determines how its income is reported and who generally pays the income tax.

Economic relationships with the U.S.

A person does not need to be a U.S. citizen or resident to have U.S. tax obligations. IRC Section 871 addresses nonresident alien individuals, while Sections 881 and 882 address foreign corporations.

A foreign person may be subject to U.S. tax on certain U.S.-source income or income effectively connected with a U.S. trade or business. For example, a foreign individual living overseas may have U.S. tax obligations from rental property in the U.S. or from business activities conducted here.

Simply owning U.S. property does not automatically create a federal income-tax return requirement. Receiving rental income, selling the property, or conducting a U.S. business may create tax, withholding, or filing obligations. Some income may be fully taxed through withholding without requiring a separate income-tax return, depending on the facts and applicable rules.

Note: Having a U.S. customer does not automatically make service income U.S.-source. For services, the general sourcing rule looks at where the work is physically performed, rather than simply where the customer is located or where payment is received.

Double taxation

Double taxation can occur when one country taxes income because of the taxpayer’s citizenship or residence, while another taxes the same income because of its source or connection to that country.

For example, a U.S. citizen living in the U.S. who owns a rental property or operates a business earning income in Japan may have Japanese tax and filing obligations under the applicable local rules. The income generally must also be reported on the taxpayer’s U.S. return.

Foreign tax credits and applicable treaty provisions may help reduce double taxation, subject to eligibility requirements and limitations. The result depends on the type of income, the taxes paid, the taxpayer’s status, and the rules of both countries.

The foreign earned income exclusion may also help eligible individuals who live and work abroad. However, it generally applies to qualifying income from services performed abroad, rather than ordinary passive rental income. A foreign rental property does not qualify for that exclusion simply because it is located overseas.

Note: You cannot claim a foreign tax credit for foreign taxes attributable to income excluded under the foreign earned income exclusion. These provisions need to be coordinated, rather than automatically applied together to the same income.

In summary

U.S. citizens and resident individuals generally are taxed on worldwide income. Foreign persons may also be subject to U.S. tax through their income or business connections to the country. Determining your status, the source of the income, and the applicable relief provisions is the starting point.

For more information on international tax, including the impact of the Tax Cuts and Jobs Act and subsequent changes, please schedule a call with our office for a consult.