Leave the USA, cash in, and come back? Here's a gotcha for you

Welcome to The Friday Edition. I’m Phil Hodgen, purveyor of biweekly international tax goodies. This week I’m going to tell you about a nasty little “gotcha” rule hidden deep in the bowels of the Internal Revenue Code.

But first . . .

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Leave, cash in your gains, and return

We see people toggle from U.S. resident to nonresident and back to resident status. They do this so they can harvest large income items or capital gains as a nonresident of the USA, thereby avoiding U.S. income tax.

Example. You moved to the United States several ago years on an E-2 visa and started a business. You filed U.S. resident income tax returns for all four years because you satisfied the substantial presence test–you are a resident because you were physically present in the United States for a sufficient number of days each year.

A buyer made an offer to buy your business. The number was too big to refuse. The expected tax bill was too big a number to stomach. You hatched an Idea.

You left the United States in 2024 and move to Dubai.

In 2025, you were a nonresident for U.S. income tax purposes. You sold your U.S. business. Result: zero capital gain tax in the United States (capital gain is not subject to U.S. tax for nonresidents except in two niche situations). Zero tax in Dubai (no income tax there).

In 2026, you plan to return to the United States on an EB-5 visa and become a resident again.

Result: Clever plan thwarted. You must pay U.S. capital gain tax at resident tax rates on the sale of your business in 2025, while you were a nonresident of the U.S. for income tax purposes.

What IRC §7701(b)(10) says

Just so you have it handy, here is the offending Code section, IRC §7701(b)(10):

IRC §7701(b)(10) Coordination With Section 877. If—

IRC §7701(b)(10)(A) — an alien individual was treated as a resident of the United States during any period which includes at least 3 consecutive calendar years (hereinafter referred to as the “initial residency period”), and

IRC §7701(b)(10)(B) — such individual ceases to be treated as a resident of the United States but subsequently becomes a resident of the United States before the close of the 3rd calendar year beginning after the close of the initial residency period,

such individual shall be taxable for the period after the close of the initial residency period and before the day on which he subsequently became a resident of the United States in the manner provided in section 877(b). The preceding sentence shall apply only if the tax imposed pursuant to section 877(b) exceeds the tax which, without regard to this paragraph, is imposed pursuant to section 871. ## 0.4 Who this affects

IRC §7701(b)(10) applies only to non-U.S. citizens (“aliens” in tax law lingo) who follow a specific pattern:

Become U.S. tax residents;
Leave the U.S. and become U.S. tax nonresidents; and then
Become U.S. tax residents again within a specified timeframe.

How to analyze your exposure to this risk

Here is a seven-step procedure to determine whether you have a tax problem under IRC §7701(b)(10).

Step 1: You are an alien

You must be a non-U.S. citizen (an “alien” in tax terminology).

Step 2: You are a resident alien

You are a “resident alien” for U.S. tax purposes, meaning you satisfied either:

The substantial presence test (IRC §7701(b)(1)(A)(ii)); or
The green card test (IRC §7701(b)(1)(A)(i)).

Step 3: You were a resident alien in three consecutive calendar years

You must have been a resident alien for at least one day during each of three consecutive calendar years (the “initial residency period”). IRC §7701(b)(10)(A) says (emphasis added):

IRC §7701(b)(10)(A) — an alien individual was treated as a resident of the United States during any period which includes at least 3 consecutive calendar years (hereinafter referred to as the “initial residency period”), . . .

This is subtle. You can satisfy this requirement in 367 days:

Example: You received lawful permanent resident status on December 31, 2022. This satisfied the green card test, so you were treated as a resident for one day in 2022. You continued to hold green card status for all of 2023. On January 2, 2024, you filed Form I-407 to abandon your green card, so you satisfied the green card test for 1 day in 2024.

You were treated as a resident of the United States in three consecutive calendar years (2022, 2023, and 2024). Therefore you met the threshold requirement for the application of IRC §7701(b)(10). You have an “initial residency period.”

Step 4: Identify your residency termination date

We need to know when your initial residency period ended.

Determine the last day you were considered a resident alien during your initial residency period, using the residency termination rules in IRC §7701(b)(2)(B) and the accompanying regulations.

Step 5: Calculate the safety buffer period end date

After your initial residency period ends, you must remain a nonresident for a definite amount of time to be safe from the U.S. income tax as mandated by IRC §7701(b)(10). Let’s arbitrarily call this the safety buffer period.

The Code uses stilted language, but read it slowly and it’s easy to understand what it means. IRC §7701(b)(10)(B) says (emphasis added):

IRC §7701(b)(10)(B) — such individual ceases to be treated as a resident of the United States but subsequently becomes a resident of the United States before the close of the 3rd calendar year beginning after the close of the initial residency period,

Look at your residency termination date. In my example, it is January 2, 2024. Now look for the first calendar year that begins after January 2, 2024. Duh, it’s 2025.

So the second calendar year beginning after the close of the initial residency period is 2026, and the third is 2027.

Calendar years always end on December 31, so in my example, the close of the third calendar year beginning after the close of the initial residency period is December 31, 2027.

Step 6: Determine your residency recommencement date

At some point you return to the United States and recommence your status as a resident alien for income tax purposes. You either spend too many days in the United States (substantial presence test) or you get a green card (lawful permanent resident), so you’re a resident alien.

The rules for determining your residency commencement date can be found in IRC §7701(b)(2)(A) and the companion regulations.

Write down that date.

Step 7: Compare safety buffer period end date to residency recommencement date

If you became a resident alien again (Step 6) before the closing date of the three full calendar years after your initial residency period ended (Step 5), then IRC §877(b) applies to you during your entire nonresident period.

IRC §7701(b)(10), flush left text says (emphasis added):

such individual shall be taxable for the period after the close of the initial residency period and before the day on which he subsequently became a resident of the United States in the manner provided in section 877(b). The preceding sentence shall apply only if the tax imposed pursuant to section 877(b) exceeds the tax which, without regard to this paragraph, is imposed pursuant to section 871.

If you became a resident alien again (Step 6) after the closing date of the three full calendar years after your initial residency period ended, then you are safe. IRC §877(b) does not apply to you.

Example. Continuing the prior example, your initial residency period ended on January 1, 2024. The closing date of the third full calendar year that started after your initial residency period ended is December 31, 2027.

If you commenced being a resident alien for U.S. income tax purposes on December 15, 2027, the flush left language above says you are taxable in the manner provided in IRC §877(b).

On the other hand, if you commenced being a resident alien for U.S. income tax purposes on January 15, 2028, the flush left language of IRC §7701(b)(10) does not apply to you, and you will be treated as a nonresident alien for all purposes during the time period from January 2, 2024 (when you left the USA) until January 15, 2028 (when you started a new residency period).

Tax consequences if IRC §877(b) applies

If IRC §877(b) applies to you (because you returned to the USA too soon and became a resident for income tax purposes again) here’s what it means for your tax bill.

Normal income types subject to U.S. tax

Nonresidents are normally subjected to U.S. income tax on two categories of U.S. source income:

Effectively Connected Income: Business profits, U.S. wages, connected rental/royalty income; and
Fixed, Determinable, Annual, or Periodical Income: U.S.-source interest, dividends, rents, royalties, certain capital gains.

See, IRC §§871, 872(a), 877(b)(1).

These continue to be taxed to you while you’re a nonresident. The only difference is the tax rate that is applied to those income items. See below, under Higher tax rates.

Additional income types subject to U.S. tax

If you fall afoul of the IRC §7701(b)(10) rule, there are additional types of income that will be treated as U.S. source income, even though they are really foreign-source income. You will pay tax on them. See IRC §§877(b)(1), 877(d). Normally, nonresidents would not be subject to U.S. tax on these items, so this is where you feel the pain.

U.S. property gains: Gains from selling property (except stocks/bonds) located in the U.S. IRC §877(d)(1)(A).
U.S. securities gains: Gains from selling U.S. corporate stock or debt obligations of U.S. persons/government entities. IRC §877(d)(1)(B).
Controlled foreign corporation (CFC) Income: Income or gain from stock of a foreign corporation if it was a CFC where you owned > 50% while you were a U.S. resident. (Note: this rule is manky and nearly incoherent in the context of IRC §7701(b)(10), because it was written with expatriation in mind). IRC §877(d)(1)(C).

By far the most important of these is the sale of stock of U.S. corporations. It could be publicly traded stock (cash in those NVDIA gains) or it could be the stock of a privately-held start-up company, as in my example above. Ordinarily, nonresidents do not expect capital gain tax on sale of such stock, but with IRC §7701(b)(10), capital gain tax is imposed.

Higher tax rates

IRC §7701(b)(10) imposes the IRC §877(b) tax only if it is higher than the default U.S. tax rates applicable to a nonresident alien. The flush left language of IRC §7701(b)(10) says, in relevant part:

The preceding sentence shall apply only if the tax imposed pursuant to section 877(b) exceeds the tax which, without regard to this paragraph, is imposed pursuant to section 871.

Thus, you calculate the income tax under IRC §§1, 55 (regular income tax and alternative minimum income tax) and also calculate the income tax under IRC §871. Pay the higher of the two.

Deductions

You may only claim deductions that are “connected with” the income included in your tax base under IRC §877(b)(2).

Planning considerations

How can you bail out of the U.S. income tax system, cash in your chips tax-free, then return to the USA to live?

If you never have three consecutive calendar years in which you held U.S. resident alien status (the “initial residency period”), you are safe from the application of IRC §7701(b)(10).
If you need three consecutive full calendar years of nonresident status, look to use the closer connection rules or claim treaty nonresident status under an applicable income tax treaty.
Or (and this is bombproof and cannot be recommended more highly) do not accidentally or intentionally become a “resident alien” for U.S. income tax purposes for three full calendar years. Don’t get a green card, and don’t run afoul of the substantial presence test. Keep it simple. Fun exists outside the USA. Go find it.