Should Non-U.S. Persons and Businesses File “Protective” U.S. Tax Returns?

By: Tyler B. Korn, Esq.

Non-U.S. persons engaging in a U.S. trade or business are often surprised to learn that a timely filed U.S. return is required in order for them to obtain the benefit of otherwise tax deductible items. Businesses and individuals that are simply unaware of their U.S. filing obligations, and that do not file a “protective return” on the belief that they are not engaged in a U.S. trade or business, stand to lose their deductions if they are ultimately determined by the IRS to have been so engaged. Failure to file a protective return can therefore lead to the worst of all possible outcomes – the application of U.S. tax liability on gross income (i.e., without reduction by deductions or credits).

“Failure to file a protective return can…lead to the worst of all possible outcomes – the application of U.S. tax liability on gross income.”

The filing of a “protective return,” which is simply a tax return showing no U.S. tax liability, protects the right of a foreign person or business to claim deductions and credits. Under Section 882(c)(2) of the Internal Revenue Code, deductions and credits are allowed only if a true and accurate income tax return is filed as prescribed by law, and the return includes all the information that the IRS considers necessary for calculating the deductions and credits.

In general, U.S. trade or business will be found to exist only if there are regular, continuous, and considerable business activities within the Unites States, whether undertaken directly or through an agent. But once a foreign person or business is found to have U.S. trade or business, all sales, services, or manufacturing income from U.S. sources is considered to be “effectively connected” to the income of that trade or business. The result is that other income of the foreign person or business, which would not otherwise be taxable in the U.S., can become subject to U.S. taxation.

For these reasons, any nonresident alien individuals or foreign businesses conducting even limited activities in the U.S. should seriously consider filing a protective return. This includes the following: (i) those who have previously derived income from U.S. sources but who have not filed returns; (ii) those taking the position that they are not engaged in a U.S. trade or business; (iii) those taking the position that they have no U.S. tax liability under the provisions of an applicable tax treaty; (iv) those undertaking activities in the U.S. through agents or independent contractors; (v) partners of U.S. partnerships; (vi) sellers of property where title passes in the U.S.; and (vii) those who have received income from U.S. sources but who have not received an information return from the payor reporting the income to the IRS.

If a return was filed for the immediately preceding tax year, or if the current tax year is the first year for which a return is required, a nonresident alien’s current year return must be filed within 16 months of the due date for that return. If a return should have been, but was not, filed for the preceding year, the current year’s return must be filed no later than the earlier of: (a) 16 months after the due date of the current year’s return or (b) the date IRS mails a notice to the nonresident alien advising him that the current year return has not been filed. Foreign corporations are subject to similar rules, but the 16-month period for filing the return is extended to 18 months.

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