Tax Compliance: IRS May Be Able to Improve Compliance for Nonresident Aliens and Updating Requirements Could Reduce Their Compliance Burden
Published: 2010-04-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Every year, the U.S. receives millions of legal visits by foreign individuals. Nonresident aliens--who are neither U.S. citizens nor residents--may be required to file a federal tax return if they earn U.S.- source income, and their noncompliance can contribute to the tax gap. As with U.S. citizens and residents, the Internal Revenue Service (IRS) is responsible for ensuring that nonresident aliens fulfill their tax obligations. GAO was asked to (1) identify what data are available on nonresident alien tax filing and compliance, (2) provide information on guidance IRS provides to nonresident aliens and third parties on tax requirements and any challenges associated with filing, and (3) assess actions IRS takes to enforce nonresident alien tax compliance. To meet its objectives, GAO examined IRS and other federal agency documentation, reviewed tax filing and other data, and interviewed IRS officials and other third parties.
section_title: What GAO Found
paragraphs: For tax year 2007, nonresident alien individuals filed about 634,000 Forms 1040NR, the U.S. Nonresident Alien Income Tax Return. IRS has not developed estimates for the extent of nonresident alien tax noncompliance because it often lacks information to distinguish between nonresident aliens and other filers, and examinations can be costly and difficult since many nonresident aliens would depart the country before IRS could examine their returns. IRS's outreach and education efforts have focused on presenting information on nonresident tax issues to a variety of audiences and making information available on its Web site and in its publications. Nevertheless, some nonresidents, their employers, and paid preparers may not be aware of nonresident alien tax rules, according to representatives of groups that work with employers and nonresidents to assist them in fulfilling their tax obligations. Other filing challenges exist. For example, individuals filing Forms 1040NR cannot file electronically. Also, nonresidents in the U.S. for less than 90 days who earn over $3,000 in compensation for services paid for by a foreign employer will likely have to file Form 1040NR, even if they owe no tax. The $3,000 exemption threshold, enacted by Congress in 1936 to lessen the tax compliance burden on nonresident aliens and never adjusted for inflation or other purposes, likely results in a greater proportion of nonresident aliens having a filing requirement today than in 1936. IRS has expanded its nonresident alien enforcement efforts over the past decade. However, IRS does not have a program to automatically identify nonresident aliens who improperly file Form 1040 instead of Form 1040NR, which can result in lost tax revenue when these taxpayers take unallowed deductions. IRS may be able to use taxpayer information to identify this type of noncompliance systematically. Finally, some nonresidents must file a certificate of compliance, referred to as a sailing permit, before departing the U.S. to ensure that tax obligations have been satisfied. The requirement is difficult to enforce and few nonresidents fulfill it, potentially leading to broader noncompliance if individuals assume the lack of enforcement extends to other tax rules.
section_title: What GAO Recommends
paragraphs: GAO suggests that Congress consider raising the exemption threshold for income paid by a foreign employer and eliminating the certificate of compliance, or sailing permit, requirement. GAO also recommends that IRS determine if creating an automated program to identify improper filing of Form 1040 by nonresident aliens would be a cost-effective means of improving compliance. In commenting on a draft of this report, IRS agreed with our recommendation.

section_title: Letter
paragraphs: Every year, the U.S. receives millions of legal visits by foreign individuals,  some of whom have U.S.-source income or are engaged in a U.S. trade or  business. Individuals who are neither U.S. citizens nor residents are  known as nonresident aliens for tax purposes and may be required to file  federal tax returns to report their U.S.-source income. Nonresident aliens’  failure to comply with their tax requirements can contribute to the tax  gap—the difference between taxes paid on time and what should have  been paid. The Internal Revenue Service (IRS) last estimated a gross tax  gap of $345 billion for tax year 2001. IRS estimated that it would eventually  collect, through various enforcement efforts, about $55 billion of the gross  tax gap, leaving a net tax gap of $290 billion. As it is for U.S. citizens and  residents, IRS is responsible for helping nonresident aliens to understand  their tax obligations and ensuring compliance with such obligations.
In response to your request, this report provides information on  nonresident alien tax obligations and compliance. Specifically, this report  (1) identifies what data are available on nonresident alien tax filing and  compliance, (2) provides information on guidance IRS provides to  nonresident aliens and associated third parties on tax and filing  requirements and any burdens and challenges associated with filing, and  (3) assesses actions IRS takes to enforce nonresident alien tax  compliance.
To provide data on nonresident alien tax filing and compliance, we  obtained and reviewed IRS data from nonresident alien income tax returns  (Form 1040NR) filed for tax years 2003 to 2007, the 5 most recent years for  which data were available. We compared the Form 1040NR data to  published data on other individual taxpayers from IRS’s Statistics of  Income program. We also interviewed IRS research and compliance  officials. To provide information on guidance IRS provides to nonresident  aliens and associated third parties on tax and filing requirements and  associated burdens and challenges, we reviewed IRS tax forms, guidance,  and outreach materials. We also interviewed IRS officials responsible for  conducting outreach efforts and representatives from groups that work  with employers and nonresidents to assist them in fulfilling their tax  obligations, such as paid tax return preparers, accounting and law firms,  and university business officers. To assess actions that IRS takes to  enforce nonresident alien tax compliance, we used IRS’s goal in its 2009- 2013 strategic plan of increasing resource allocation to priority areas as  criteria. We reviewed data from IRS’s enforcement programs, reviewed  related documentation, and interviewed IRS enforcement officials to  determine whether resources were increased for nonresident alien  compliance efforts and what results IRS had achieved.
We conducted this performance audit from July 2009 through April 2010 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives. For more information on our scope and  methodology, see appendix I.
subsections: section_title: Background
paragraphs: For federal tax purposes, non-U.S. citizens are categorized as either  resident or nonresident aliens and are subject to different tax and filing  requirements. Generally, a nonresident alien is an individual who (1) does  not possess a permanent resident card, known as a green card, or (2) has  not established a substantial presence in the U.S., which is generally  determined by the number of days an individual spends in the U.S. over a  3-year period, though other considerations apply. Resident aliens are  generally subject to the same federal tax requirements as U.S. citizens,  which include paying U.S. taxes on worldwide income and filing an  individual tax return (Form 1040). On the other hand, nonresident aliens  generally pay U.S. taxes only on income derived from U.S. sources and  may be required to report income on the nonresident alien individual tax  return (Form 1040NR). Nonresident aliens cannot take some credits and  deductions available to residents and citizens. However, nonresidents may  qualify for reduced tax rates or exemptions as a result of tax treaties  between the U.S. and their countries of residence.
Generally, the tax rate nonresident aliens are to pay varies by both the  types of income earned and the individuals’ countries of residence.  Nonresident aliens earning income effectively connected to a U.S. trade or  business, such as employee wages, are generally taxed at the same  graduated rates as U.S. citizens and residents, though some tax treaties  offer certain exemptions on this type of income. The U.S.’s tax treaty with  China, for example, exempts from taxation certain income earned from  the performance of personal services if the nonresident alien is in the  country for no more than 183 days. Income not effectively connected to  U.S. trade or business, such as certain types of investment income, is  generally taxed at 30 percent. However, nonresidents with income such as  interest payments on deposits with a U.S. bank, or who are covered by a  tax treaty may qualify for income exemptions or lower tax treaty rates. For  example, residents of Mexico earning dividends from U.S. companies may  qualify for a 10 percent or lower tax rate on this income instead of the flat            30 percent rate.
Nonresidents with income effectively connected to a U.S. trade or  business are generally required to file Form 1040NR even if they owe no  taxes because of a tax treaty or deductions. Conversely, nonresident aliens  not engaged in a U.S. trade or business and whose tax liability was  satisfied by the withholding of tax at the source do not have to file. A  filing exemption also holds for nonresidents meeting certain other criteria,  such as the following.
Nonresidents whose only U.S.-source income is wages in an amount  less than the personal exemption amount—$3,650 for tax year 2009— do not have to file if they have no other need to file, such as to claim  tax treaty benefits or a refund.  Income of $3,000 or less paid by foreign employers for personal  services performed in the U.S. is not considered to be from U.S.  sources for nonresidents in the country for 90 days or less. An  individual with only this type of U.S.-source income would not need to  file a return. This $3,000 threshold has not changed since its inception  in 1936 and would equate to over $46,000 in 2009 dollars if adjusted for  inflation.
Table 1 lists examples of nonresident aliens earning U.S.-source income  and the potential tax treatment in each scenario.
As with U.S. citizens and residents, nonresidents must have a taxpayer  identification number in order to file a tax return. Foreign individuals  authorized to work in the U.S., such as individuals traveling on a  nonimmigrant temporary worker visa, must apply for a Social Security  number (SSN). Individuals who do not qualify for a SSN but have a valid  filing requirement under the Internal Revenue Code may apply to IRS for  an individual tax identification number (ITIN). For example, certain short- term foreign business visitors earning wages from foreign employers while  in the U.S. and foreign investors would generally apply for an ITIN.
Tax law also requires that both resident and nonresident aliens obtain a  certificate of compliance, known as a sailing permit, to ensure that their  outstanding U.S. tax obligations have been satisfied prior to departing the  country. First enacted in 1921, the requirement stipulates that most aliens  permitted to work in the U.S. must visit an IRS office 2 weeks to 30 days  prior to departing the country, provide documentation to support any  claims of taxable income and prior tax payments made, and complete  either a Form 1040-C (U.S. Departing Alien Income Tax Return) or Form  2063 (U.S. Departing Alien Income Tax Statement). An alien is to file Form  1040-C to report all income received or expected to be received during the  tax year and generally is to pay any outstanding U.S. tax liability at the  time the form is filed. Form 2063 is to be filed when the departing alien has  no taxable income for the tax year or when tax collection will not be  hindered by the alien’s departure from the country. Certain frequent  travelers between the U.S. and Mexico or Canada, alien students and  exchange visitors, and visitors for business admitted on a class B-1 or       B-1/B-2 visa with no taxable income and in the country for no more than  90 days are generally exempted from the sailing permit requirement.
Finally, entities making income payments to nonresidents are required to  withhold taxes at either graduated or fixed rates, depending on the type of  income earned, except when the payee can verify the individuals are  entitled to an exemption. For example, a nonresident alien earning wages  from a U.S. employer would generally be subject to graduated withholding  in a manner similar to that of U.S. citizens and residents. On the other  hand, a financial institution disbursing U.S.-source investment income to a  foreign-based individual would generally withhold at a fixed 30 percent  rate, unless the entity could verify that the nonresident was entitled to a  reduced treaty rate. In both of these examples, the employer and financial  institution are required to report income payments and withholding to IRS  on information returns, such as Form W-2 (Wage and Tax Statement) or  Form 1042-S (Foreign Person’s U.S.-source Income Subject to  Withholding). In certain circumstances with nonresident alien athletes and  entertainers, IRS enters into arrangements that set withholding rates for  income earned from specific events, often at less than the 30 percent  otherwise required. These arrangements, called Central Withholding  Agreements, specify the amount and timing of U.S. tax payments and take  into account expenses associated with the income earnings.
section_title: Several Hundred Thousand Individuals File Form 1040NR and It Would Be Difficult to Measure Nonresident Alien Tax Noncompliance
paragraphs: According to IRS data, nonresident alien individuals filed about 634,000  Forms 1040NR for tax year 2007, a small number compared to the            143 million Forms 1040 other individual taxpayers filed for that year.  These nonresident filers reported $12.8 billion in income, resulting in a  $2.5 billion tax liability. The number of Form 1040NR filers varied little  from 2003 to 2007, the latest years for which data were available. However,  total income and total tax liability reported increased during this period,  as shown in table 2. Total income and tax liability reported on Form  1040NR increased by 64 percent and 71 percent, respectively, compared to  increases in reported income (40 percent) and tax liability (48 percent)  reported on Form 1040 from tax year 2003 to tax year 2007. The $5 billion  increase in total income reported on Forms 1040NR for this period is  largely due to increases among higher earners, since the total income that  nonresidents with $100,000 or more in income reported on Form 1040NR  increased from $3.8 billion to $8.1 billion (111 percent).
Form 1040NR filing data do not represent the full population of  nonresident alien taxpayers, however. Certain foreign investors earning  U.S.-source investment income with sufficient taxes withheld at the  source, for example, are not required to file Form 1040NR. Also,  nonresidents married to U.S. citizens or residents can choose to be treated  as residents and jointly file Form 1040 with their spouses. Other  nonresident aliens may incorrectly file Form 1040, meaning their tax  return information is not reflected in the Form 1040NR data.
IRS data also allow for comparison of nonresident alien filing  characteristics to those of U.S. citizen and resident filers, as shown in  table 3.
As shown in table 3, 53 percent of Form 1040NR filers reported no tax  liability for tax year 2007, in contrast to an estimated 25 percent of Form  1040 filers. Some nonresidents qualify for tax treaty income exemptions  which may contribute to the higher proportion of Form 1040NR filers with  no tax liability. Requiring a nonresident with no tax liability to file a U.S.  return creates some burden on the taxpayer, yet there are reasons why it  may be beneficial. For example, for individuals filing exclusively to claim a  treaty exemption, IRS may use that information to review and potentially  dispute claims. Additionally, some nonresidents may not know if they have  a tax liability until they go through the process of preparing a tax return.
Also as shown in table 3, a smaller percentage of Forms 1040NR than  Forms 1040 reported a tax balance or refund due for tax year 2007. These  differences could be due to various factors, such as some nonresidents  having no tax liability as a result of tax treaties. Also, a greater proportion  of Forms 1040NR than Forms 1040 were prepared by a paid tax return  preparer, a disparity which may be due to several factors, such as the  complexity of nonresident tax law and that some employers with  employees traveling internationally may hire tax professionals to assist in  preparing employees’ returns.
Figure 1 below shows that a small proportion of filers accounted for the  majority of reported tax liability. For example, about 20,000 filers               (3 percent of all Form 1040NR filers) reported over $100,000 in total  income, yet this population contributed 76 percent ($1.9 billion of           $2.5 billion) of reported tax liability reported for tax year 2007.  Conversely, 72 percent of nonresidents reported $10,000 or less in income,  with these returns accounting for 1 percent of all reported tax liability   ($29 million out of $2.5 billion). One reason why most nonresidents  reported low income amounts might be that some are in the country for  only part of the tax year.
subsections: section_title: IRS Lacks Comprehensive Data on Nonresident Alien Tax Compliance and Obtaining Data Would Be Challenging
paragraphs: IRS has not developed estimates for three types of nonresident alien tax  noncompliance: (1) failing to file a tax return, known as nonfiling,            (2) underreporting income on filed returns, and (3) filing Form 1040  instead of Form 1040NR. IRS has developed an estimate of overall  individual taxpayer nonfiling by comparing general population information  from the U.S. Census Bureau’s Current Population Survey to individual  income tax filing data, and matching data taxpayers report on tax returns  to that which third parties report on information returns, such as wage and  tax statements from employers. However, according to IRS research  officials, it is not possible for IRS to parse out the nonresident portion of  its nonfiling estimate because the agency lacks the information necessary  to distinguish between nonresident alien and other nonfilers. Also, census  data exclude many short-term nonresident visitors.
IRS has excluded Form 1040NR returns from its studies of individual  taxpayer underreporting, which it uses to estimate the tax gap. Those  studies rely partially on face-to-face examinations with individual  taxpayers. Sampling Form 1040NR filers in these studies would have been  costly and difficult since many nonresident aliens would have departed the  country by the time IRS examined the returns, according to IRS research  officials. Given limited agency resources, IRS has focused its compliance  measurement efforts on types of taxpayers that may represent greater  compliance risks. Total lost tax revenues associated with nonresident  noncompliance, for example, may be modest when compared with  underreporting for other areas, such as individual income tax, employment  taxes, or entities such as S corporations.
Additionally, IRS has not estimated the extent to which nonresidents  improperly file Form 1040 instead of Form 1040NR. This is partly  because sampling and examining Form 1040 filers to identify nonresidentswould be time-consuming and costly, given the large number of Form 1040filers and the likelihood that nonresidents will have already departed country.
Generating a rough estimate of the number of nonresident aliens who may  have a filing requirement using data from other federal agencies would be  challenging. The Department of Homeland Security (DHS) reported  admitting 9.7 million visitors for purposes other than pleasure to the U.S.  in 2007, while the Department of State reported issuing 6.4 million  nonimmigrant visas in the same year. Yet neither figure serves as a reliable  proxy for the number of nonresident aliens entering the country for  employment or business purposes, much less incurring a filing obligation.  DHS’s data reflect the number of entries into the U.S. rather than the  number of individuals, thus overcounting individuals making multiple trips  to the U.S. State data reflect the number of visas issued, but some were  issued for strictly leisure purposes, some visa recipients never enter the  U.S., and others may enter the U.S. and stay for a period of time sufficient  to establish tax residency. Even with an estimate of the number of  nonresident aliens entering the U.S. each year, it would be difficult to  further determine the number incurring a tax liability. Some individuals  may not earn sufficient income to prompt a filing requirement and others  may be noncompliant with the filing requirement but not owe U.S. taxes  because of tax treaty benefits.
section_title: IRS Has Recently Expanded Nonresident Outreach and Education Efforts, but Nonresidents Still Face Challenges in Fulfilling Their Tax Obligations
paragraphs: IRS’s outreach efforts have focused on presenting information on  nonresident tax issues to a variety of audiences. In 2009, IRS began  conducting seminars and workshops for tax practitioners on nonresident  alien tax issues and Form 1040NR at its Nationwide Tax Forums. IRS also  conducted two phone forums in 2008 on federal tax withholding, for  nonresident alien athletes and entertainers, and Central Withholding  Agreements.
IRS has also presented annually to groups such as the American Payroll  Association and National Association of College and University Business  Officers and has presented periodically to the American Bar Association,  Tax Executives Institute, and local attorney and certified public  accountant groups. Regarding nonresident aliens, these presentations  covered a wide array of topics, including tax residency rules, income  sourcing rules, tax treaty issues, descriptions of which forms to file, and  guidance on withholding on payments to foreign individuals. Additionally,  IRS employees at foreign posts are available to provide guidance to  nonresidents, although these posts generally are staffed by few employees,  making outreach difficult.
IRS has held preliminary discussions with the Department of State and the  U.S. Citizenship and Immigration Service about having links to information  on IRS’s Web site on nonresident alien tax requirements included on  sections of those agencies’ Web sites that cover visa applications and  requirements. IRS and the Department of State have discussed  incorporating tax information within visa application materials. However,  according to an IRS official involved with this effort, State was not  inclined to produce this material because of the cost involved and because  the agency did not want to be perceived as providing guidance on tax  matters.
According to IRS compliance officials, IRS does not engage in outreach to  tax software providers on nonresident alien tax issues, primarily because  Form 1040NR currently cannot be filed electronically, as discussed later.  Software providers could conceivably insert a question in their Form 1040  preparation programs inquiring if the user is a citizen, resident, or  nonresident alien.
According to IRS officials, IRS is assessing the feasibility and cost- effectiveness of setting up a toll-free number that individuals can call from  outside of the U.S. to receive tax assistance. Currently IRS tax assistance  toll-free numbers cannot be called from outside of the U.S. IRS also  produces various publications containing information relevant to  nonresident aliens and includes information on nonresident alien tax  issues on its Web site.
subsections: section_title: Nonresident Aliens Face Challenges in Fulfilling Their Tax Obligations
paragraphs: According to representatives from groups that work with employers and  nonresidents to assist them in fulfilling their tax obligations, nonresident  aliens face challenges in fulfilling their tax filing obligations. For example  and despite IRS’s outreach and education efforts, some nonresidents and  their employers may not be aware of the nonresident alien tax rules.  Although nonresidents earning wages from U.S. employers would likely  know that they had taxes withheld from their wages, they may not know  they also have to file a tax return or which return to file. Likewise, foreign  individuals in the U.S. for short-term business trips may be unaware that  they have a filing requirement given that comparable requirements may  not exist in their countries of residence. For example, in Canada,  nonresidents generally do not have to file a tax return if they owe no  Canadian tax. Also, some paid tax return preparers may not be familiar  with nonresident alien tax rules. Representatives from groups we spoke  with thought that unlicensed preparers in particular might not be familiar  with the nonresident alien tax rules.
Likewise, aspects of nonresident alien taxation, such as tax residency  rules, determining whether income is effectively connected to a U.S. trade  or business or is U.S.- or foreign-source, and applying tax treaty  provisions, can be difficult for nonresidents to understand. For example, it  can be challenging to answer the basic question of whether or not a  foreign person is a nonresident or resident alien. Beyond the green card  and substantial presence tests, noncitizen taxpayers or their practitioners  need to consider various scenarios in making residency determinations.  For example, individuals who would otherwise be treated as residents can  file as nonresidents if they have a closer connection to a foreign country.  It is also possible to be both a nonresident alien and resident alien in the  same tax year and different rules apply for the part of the year an  individual is a nonresident alien and the part of the year the individual is a  resident alien. Although no single rule may be difficult to apply, that  numerous rules need to be considered can make the residency  determination a difficult and time consuming one, according to  representatives from groups that work with employers and nonresidents  to assist them in fulfilling their tax obligations.
The inability for nonresidents to file Form 1040NR electronically is  another challenge the groups we interviewed mentioned. Currently, IRS  does not allow for electronic filing of Form 1040NR because it contains  fields that cannot easily be transcribed into an electronic format. IRS  redesigned Form 1040NR for tax year 2009, in part to address this  problem. However, it does not plan to accommodate electronic filing of  the form until at least 2014.
Another set of challenges that groups we interviewed identified concerned  obtaining ITINs, as discussed below.
ITIN applicants need to submit large amounts of documentation to IRS,  some of which must be certified by going to a U.S. embassy, which can  be time-consuming.
Some applicants need to prove that they cannot obtain a SSN before  they can be assigned an ITIN and some nonresidents apply for a SSN  just to get the rejection letter so they can then apply for an ITIN.
Some nonresidents unable to obtain an ITIN prior to departing the  country may end up not filing a return, even if owed a refund. Whether  or not they persist in the process to obtain an ITIN may depend on  whether or not the individuals anticipate subsequent U.S. taxable  activities.
Finally, some groups noted it is a burden for nonresidents paid by foreign  employers who take short business trips to the U.S. to file the required  Form 1040NR. As previously discussed, personal service income of  $3,000 or less paid to a nonresident by a foreign employer is not  considered to be from U.S. sources for individuals in the U.S. 90 days or  less who have no other compensation for services within the U.S.  Congress established this threshold in 1936 to permit foreign residents to  visit the U.S. for business purposes without being subject to taxes on thecompensation they earn while in the U.S. In discussing this exemption, th Senate noted that the lack of a threshold had created ill will  disproportionate to the small amount of revenue raised by taxing fo residents making short bus iness trips to the U.S.
Because the $3,000 threshold has not increased since 1936, it is likely that  a greater proportion of nonresident aliens have a filing requirement today  than when the threshold was established. For example, in 1936, $3,000 was  559 percent of the U.S. per capita personal income amount of $537. In  2008, $3,000 represented 8 percent of the U.S. per capita personal income  amount of $39,751. Likewise, a nonresident would need to earn an annual  salary of $12,133 to exceed the $3,000 threshold during a 90-day period,  assuming the individual had no other U.S.-source income. A salary of  $12,133 in 1936 is equivalent to $187,938 in 2008 dollars. A nonresident  earning $187,938 in 2008 would need to be in the U.S. for only 5 days for  business purposes to trigger a filing requirement, if the individual earned  no other U.S.-source income. This increased reach of the filing  requirement is underscored by the advance of economic globalization and  increase in business travel since the threshold was established.
Some groups we spoke with suggested raising the $3,000 threshold to  reduce the burden of filing tax returns on nonresidents who make short  business trips to the U.S. and are paid by foreign employers. In evaluating  whether to increase the threshold, either by the level of inflation since  1936 or another amount, various issues warrant consideration. For  example, although the current filing requirement may be applicable to a  broader population of nonresident aliens than in 1936, many nonresidents  who are required to file may ultimately owe reduced or no taxes because  of the tax treaties the U.S. has adopted. According to DHS data, at least    78 percent of admissions to the U.S. in fiscal year 2007 were of individuals  residing in countries with which the U.S. has tax treaties. Also, raising the  exemption amount could negatively affect U.S. residents if they do not  receive reciprocal exemptions on income otherwise subject to tax in  countries with which the U.S. has tax treaties.
Raising the threshold amount could result in lost tax revenue. For  example, IRS calculated that Form 1040NR filers who had income from  personal services in an amount of $40,000 or less reported $222.1 million  in tax liability for tax year 2007. This amount represented about 9 percent  of the total tax liability reported on Form 1040NR for that year. If the  threshold had been set at $40,000 for tax year 2007, which is slightly less  than the value of $3,000 in 1936 dollars inflated to 2007 dollars, the     $222.1 million could have been exempt and not paid. However, it is not  likely that all of that amount would have been exempt because some of the  nonresidents with personal services income of $40,000 or less could have  been paid by a U.S. employer or could have been in the U.S. for more than  90 days, and therefore would not have been entitled to the exemption.  Also, some of that tax amount may be attributed to other types of income.
Although increasing the exemption threshold would likely result in  reduced tax revenue, it would also likely result in reduced burden and cost  savings for some nonresidents and IRS. Some taxpayers would no longer  bear the burden or cost of obtaining an ITIN and filing a return. IRS would  likely realize cost savings from having to process fewer ITIN applications  and Forms 1040NR.
section_title: IRS Has Increased Nonresident Alien Tax Enforcement but May Be Able to Identify Additional Noncompliant Taxpayers
paragraphs: IRS has expanded its enforcement efforts over the past decade. In 2001,  IRS had two examiners who covered nonresident alien compliance issues.  Currently, IRS’s Large and Mid-sized Business division’s International  Compliance Strategy and Policy group (LMSB International) has              261 examiners dedicated to international compliance issues, including  nonresident alien tax compliance. LMSB International plans to hire an  additional 202 examiners during fiscal year 2010.
LMSB International has generally conducted face-to-face examinations of  nonresident aliens through special projects that focus on particular types  of taxpayers. For example, LMSB International has examined individuals  employed by foreign embassies or consulates and international  organizations in the U.S. Although U.S.-source income paid to nonresident  employees of foreign governments and international organizations may be  exempt from federal income tax, the exemption depends on the tax treaty  or consular convention between the U.S. and the relevant foreign  governments or other U.S. tax laws. Also, employees of foreign  governments and international organizations are generally considered  nonresidents regardless of how long they are in the U.S. LMSB  International found that some individuals were claiming income  exemptions to which they were not entitled or filed Form 1040 instead of  Form 1040NR. For this project, IRS first contacted potentially  noncompliant individuals and allowed them to voluntarily correct any  noncompliance. IRS assessed $32.0 million in taxes for 4,540 taxpayers  who voluntarily settled with IRS from fiscal year 2007 through the end of  January 2010, for an average of $7,049 per settlement. IRS then examined  3,720 taxpayers who did not voluntarily settle with IRS, assessing          $21.8 million in taxes, for an average of $5,851 per examination. LMSB  International is continuing these examinations.
Building face-to-face examination cases for nonresidents is resource  intensive. For example, preparing for and conducting the examinations of  employees of foreign embassies and consulates and international  organizations took up nearly all of LMSB International’s resources that  were dedicated to nonresident alien enforcement. LMSB International  used State Department visa information to identify the nonresidents it  contacted and examined. However, it is difficult and time consuming for  IRS to use visa information to identify corresponding tax returns because  visas do not include SSNs or ITINs, which are the unique identifiers  included on tax returns that IRS uses to build examination cases.
LMSB International is planning on using examiners it expects to hire in  fiscal year 2010 to conduct additional enforcement actions against  nonresidents that would be less time consuming and complex than face-to- face examinations. For example, IRS may examine potentially  noncompliant nonresidents through correspondence, according to an  LMSB International official. Likewise, through its Automated  Underreporter program (AUR), IRS has begun to match information  taxpayers report on Forms 1040NR to information third parties report to  IRS to identify nonresident alien taxpayers who may have underreported  their income. IRS previously concluded, through a test, that matching  income items from Form 1040NR, such as wages, was not a prudent use of  resources. IRS found that many of the tax returns it studied claimed tax  treaty benefits, which can be time consuming to verify and can require  expertise to evaluate that IRS AUR staff generally did not possess.  However, given that LMSB International is planning to hire additional  staff, it may be able to examine nonresident alien taxpayers whom it  identifies as potentially noncompliant through AUR, according to the  official.
IRS has a broad program to identify taxpayers who failed to file a required  tax return, including those who should have filed Form 1040NR. The  program only identifies whether individuals may have failed to file a tax  return and cannot easily identify which form they should have filed (i.e.,  Form 1040 versus Form 1040NR). IRS may be able to identify during an  examination that a nonfiler should have filed Form 1040NR.
subsections: section_title: IRS May Be Able to Systematically Identify Nonresidents Who Improperly File Form 1040
paragraphs: IRS does not have a program to automatically identify taxpayers who may  have improperly filed Form 1040 instead of Form 1040NR. According to an  LMSB International official familiar with examinations of nonresidents,  IRS has found that some nonresidents improperly file Form 1040 instead  of Form 1040NR. The official told us that nonresidents filing the wrong tax  return presents a greater compliance risk than nonresidents failing to file a  tax return altogether because withholding is required for most  nonresidents earning U.S.-source income regardless of whether they file a  tax return. Also, other nonresidents who do not file and for whom taxes  are not withheld, such as those working for foreign employers, may not  have tax liabilities because of tax treaty benefits. On the other hand,  nonresidents who file Form 1040 instead of Form 1040NR may claim  credits or take deductions to which they are not entitled, which may lead  to reduced tax revenue.
IRS may be able to systematically identify nonresidents who improperly  file Form 1040 instead of 1040NR. As previously discussed, nonresidents  must obtain an ITIN to file a tax return if they do not meet the  requirements to obtain a SSN. IRS can identify Forms 1040 filed using  ITINs. IRS can also identify Forms 1040 filed jointly by married individuals  that included both an ITIN and a SSN, as nonresidents married to U.S.  citizens or residents can choose to be treated as residents and file Form  1040 jointly with their spouses. IRS may also be able to use information  from ITIN applications (Form W-7) to further refine the identification of  taxpayers who may have filed the wrong tax return because ITIN  applicants indicate if they are resident or nonresident aliens, or a spouse  or dependent of either, on that form.
LMSB International officials told us that IRS may be able to effectively use  such a filtering process in its enforcement efforts. As previously discussed,  LMSB International is planning on initiating additional enforcement  actions against nonresidents that would be less time consuming and  complex than the face-to-face examinations it has traditionally conducted.  The officials told us that if IRS were able to identify nonresidents who may  have improperly filed Form 1040 instead of Form 1040NR, IRS could  examine some of those individuals through correspondence, for example  those who took large deductions that would not be allowed when filing  Form 1040NR. Likewise, IRS could review Forms 1040 filed jointly by a  married couple where one filer used an ITIN to ensure that the return  included the couple’s worldwide income, and not just their U.S.-source  income, as is required by U.S. tax law. The officials told us that it would be  worthwhile to test the identification process to determine the size of the  potential examination inventory and the cost-effectiveness of working on  these examination cases.
section_title: IRS Has Expanded Enforcement for Reporting and Withholding on Payments to Foreign Individuals
paragraphs: In 2008, LMSB designated reporting and withholding on U.S. income paid  to foreign individuals as a high-priority issue. U.S. persons or entities  who make payments of certain types of U.S.-source income to  nonresidents generally must withhold tax at a rate of 30 percent on suc payments, unless there are applicable tax treaty provisions allowing for  reduced rate. Such payments are generally subject to reporting on For 1042 (Annual Withholding Tax Return for U.S. Source Income of For eign  Persons) and Form 1042-S (Foreign Person’s U.S. Source Income Subject  to Withholding). The person or entity making these payments—generally  referred to as a U.S. withholding agent—is responsible for the withholding  and reporting. IRS’s focus for this issue is on the compliance of U.S.  withholding agents with regard to these reporting and withholding  responsibilities.
The impetus behind designating U.S.-source income reporting and  withholding as a priority issue was two-fold, according to an LMSB  International official. First, in September 2008, the Permanent  Subcommittee on Investigations of the Senate Committee on Homeland  Security and Government Affairs issued a report on actions foreign  individuals take to avoid payment of taxes on U.S. stock dividends. The  report brought attention to the problem of withholding agents not  reporting and withholding proper amounts of tax. Second, IRS historically  had not taken actions to enforce compliance with the requirements for  reporting and withholding on payments to nonresidents.
The U.S.-source income reporting and withholding initiative is made up of  three components, according to LMSB International officials.
First, IRS is attempting to address intermediary (e.g., hedge funds’ and  other financial institutions’) marketing of aggressive tax positions, such  as through instruments like total return swaps, which may allow  taxpayers to avoid taxation on income that would otherwise be taxed  at 30 percent.
Second, IRS has begun to match filed Forms 1042-S to Forms 1040 or  1040NR to determine if taxpayers are underreporting income.
Third, IRS has initiated a number of compliance projects. LMSB  International has started a marketing campaign within IRS to increase  focus on withholding agent compliance by, for example, encouraging  examiners to look for taxpayers with foreign addresses when reviewing  businesses’ payroll information. LMSB International has also begun  testing whether it can identify entities that filed Forms 5471  (Information Return of U.S. Persons With Respect To Certain Foreign  Corporations) or 5472 (Information Return of a 25 Percent Foreign- Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S.  Trade or Business) but failed to report payments to nonresidents on  Form 1042-S. IRS found for a test group of 10 corporations, 9 failed to  report some payments. However, it was unclear if these payments were  exempt because of tax treaties and as such appropriate to exclude  from reporting. IRS is continuing this test.
IRS uses Central Withholding Agreements to minimize tax compliance risk  for athletes and entertainers, who often are high earners relative to other  nonresident aliens. As shown in table 4, the number of agreements and  amounts withheld has increased over the past 3 fiscal years, although the  average amounts withheld have fluctuated.
section_title: Few Nonresidents Obtain Sailing Permits and IRS Does Not Enforce the Sailing Permit Requirement
paragraphs: The number of sailing permits filed annually has decreased substantially  over past decades. As we reported in 1988, the number of Form 1040-C  sailing permits filed dropped from about 176,000 in calendar year 1960 to  1,245 in fiscal year 1986. According to an LMSB International official,  about 1,000 Forms 1040-C were filed for tax year 2006. Likewise, neither  IRS nor the U.S. Customs and Immigration Service have enforced the  sailing permit requirement for departing aliens for decades, according to  LMSB International officials. These officials told us that IRS cannot  realistically enforce the sailing permit requirement given the volume of  foreign individuals who depart the U.S. daily. Enforcing the requirement  would be particularly burdensome, as IRS would have to check all aliens  for sailing permits even though the requirement is only applicable to some.  For example, only a portion of foreign individuals enter the U.S. for  business purposes. According to DHS data, about 74 percent of visitor  admissions were for pleasure rather than for business or other purposes in  fiscal year 2007.
That few individuals file sailing permits and IRS does not enforce the filing  requirement may not represent a significant compliance risk. Tax  withholding is generally required on payments of U.S.-source income to  nonresident aliens. Such withholding reduces the chance that  nonresidents will depart the country without paying taxes owed.  Furthermore, although foreign employers may not withhold U.S. taxes on  U.S-source income payments made to nonresidents, those individuals may  not have substantial tax liabilities because of tax treaties. As previously  discussed, at least 78 percent of admissions to the U.S. in fiscal year 2007  were of individuals residing in countries with which the U.S. had a tax  treaty.
On the other hand, there may be a downside to having a requirement that  is not enforced. Nonresidents who recognize that IRS does not enforce the  sailing permit requirement may assume that IRS will not enforce other  requirements, which could lead to broader noncompliance.  Representatives from groups that work with employers and nonresidents  to assist them in fulfilling their tax obligations told us that they were  aware that IRS has not enforced the sailing permit requirement in decades.  Also, according to an LMSB International official, the existence of a  requirement could even negatively affect overall tax compliance in that  some foreign individuals who file the Form 1040-C version of the sailing  permit may not realize that they have to file a tax return after the year’s  end and pay any additional tax that was not paid in conjunction with filing  Form 1040-C. Finally, although few aliens file sailing permits, IRS incurs at  least some cost to process filed permits and maintain guidance concerning  the requirement.
section_title: Conclusions
paragraphs: Much has changed since Congress developed the tax rules for nonresident  aliens. The world economy is increasingly interconnected and the number  of aliens entering the U.S. for business purposes has increased  accordingly. Congress passed legislation in 1936 to lessen the tax  compliance burden for nonresidents paid by foreign employers in the U.S.  for short periods of time. However, inflation has eroded the effect of the  dollar threshold Congress established and nonresidents increasingly may  have to file tax returns if they are in the U.S. for business for only a few  days.
Another requirement that has been effectively eroded by the increase in  travel to the U.S and other tax laws is the requirement that aliens obtain  certificates of compliance, otherwise known as sailing permits. For  nonresidents working for U.S. employers, withholding has supplanted  sailing permits as the primary way to minimize compliance risk.  Nonresidents working for foreign employers may not have substantial tax  liabilities because of tax treaty benefits. Further, few nonresidents obtain  sailing permits. IRS does not enforce the requirement, and it likely could  not effectively enforce the requirement given the volume of foreign  individuals departing the country daily. A lack of enforcement may also  lead taxpayers to conclude that IRS does not enforce other filing  requirements. Taken together, these conditions call into question whether  the sailing permit requirement is still necessary to ensure compliance.
Despite an increased focus on nonresident alien tax enforcement, IRS may  be missing an opportunity to identify more potentially noncompliant  taxpayers because it does not systematically identify nonresidents filing  the incorrect type of tax return. If IRS were able to identify taxpayers who  should have filed Form 1040NR instead of Form 1040 by using information  reported on tax returns or ITIN applications, it may be able to cost- effectively address this form of noncompliance for some taxpayers.  Without further study, IRS cannot know if this type of enforcement action  would be cost-effective.
section_title: Matters for Congressional Consideration
paragraphs: Given the increasing extent of business travel to the U.S. and the eroding  effect of inflation, Congress should consider raising the amount of U.S.  income paid by a foreign employer that is exempt from tax for  nonresidents who meet the other conditions of the exemption. Also, given  the difficulty of enforcing the requirement for aliens to obtain certificates  of compliance—sailing permits—before departing the country and the  existence of withholding requirements and tax treaties, Congress should  consider eliminating the sailing permit requirement.
section_title: Recommendation for Executive Action
paragraphs: We recommend that the Commissioner of Internal Revenue determine if  creating an automated program to identify nonresident aliens who may  have improperly filed Form 1040 instead of Form 1040NR by using ITIN  information would be a cost-effective means to improve compliance.
section_title: Agency Comments and Our Evaluation
paragraphs: In a March 31, 2010, letter responding to a draft of this report, IRS’s  Deputy Commissioner for Services and Enforcement stated that IRS  agreed to study the feasibility of an automated system to identify  nonresident aliens who improperly file Form 1040 instead of Form  1040NR, including whether information from ITIN applications can be  effectively analyzed with such an automated system. The letter also stated  that IRS would continue to look for ways to improve nonresident alien tax  compliance through enforcement and outreach. For the full text of IRS’s  comments, see appendix II.
As we agreed with your office, unless you publicly announce the contents  of this report earlier, we plan no further distribution of it until 30 days  from the date of this report. At that time, we will send copies of the report  to the Commissioner of Internal Revenue and other interested parties. This  report will also be available at no charge on GAO’s Web site at  http://www.gao.gov. If you or your staff have any questions about this  report, please contact me at (202) 512-9110 or brostekm@gao.gov. Contact  points for our Offices of Congressional Relations and Public Affairs may  be found on the last page of this report. Key contributors to this report are  listed in appendix III.
section_title: Appendix I: Scope and Methodology
paragraphs: To provide data on nonresident alien tax filing, we obtained and reviewed  statistics from the Internal Revenue Service’s (IRS) compliance data  warehouse (CDW) on Form 1040NR, the U.S. Nonresident Alien Income  Tax Return, for tax year 2003 to tax year 2007, the last 5 years for which  complete filing data were available. To provide context on these statistics,  we reviewed published data on other individual taxpayers from IRS’s  Statistics of Income program, which draws from a widely used database  composed of a sample of unexamined income tax returns. We determined  that the estimates provided had sampling errors of less than 1 percent. We  then assessed these two data sources for reliability purposes. To do this,  we interviewed IRS research officials, conducted logic testing, and  compared certain CDW data elements received by IRS to publicly available  data on Form 1040NR filings. On the basis of our assessment, we  determined that both sources used were sufficiently reliable for the  purposes of our review. To identify the availability of compliance data, we  reviewed IRS documentation on the National Research Program and  interviewed IRS research and compliance officials. We also examined  documentation on tax treaties, visa issuance data from the Department of  State, and the number of annual admissions of foreign visitors from the  Department of Homeland Security (DHS), in order to provide context as to  the potential number of nonresident aliens with a filing requirement or  incurring a tax liability each year.
To provide information on guidance IRS provides to nonresident aliens  and associated third parties on tax and filing requirements and any  burdens and challenges associated with filing, we reviewed IRS tax forms,  guidance, and outreach materials. We also interviewed IRS officials  responsible for conducting outreach efforts and groups that work with  employers and nonresidents to assist them in fulfilling their tax  obligations. More specifically, we conducted group interviews with  members of the American Institute of Certified Public Accountants, the  National Association of Enrolled Agents, and the National Association of  College and University Business Officers, and spoke with staff from  accounting and law firms that have nonresident aliens or their employers  as clients.
To assess actions that IRS takes to enforce nonresident alien tax  compliance, we used IRS’s goal in its 2009-2013 strategic plan of increasing  resource allocation to priority areas as criteria. We reviewed data from  IRS’s enforcement programs and interviewed IRS enforcement officials to  determine whether resources were increased for nonresident alien  compliance efforts and what results IRS had achieved. Specifically, we  reviewed IRS data on examinations and Central Withholding Agreements  and various IRS tax forms, and interviewed IRS officials to discuss  potential opportunities to expand enforcement efforts. We then assessed  these IRS sources for reliability by reviewing IRS documentation and  interviewing agency officials and determined that these sources were  sufficiently reliable for the purposes of our review.
We conducted this performance audit from July 2009 through April 2010 in  accordance with generally accepted government auditing standards. Those  standards require that we plan and perform the audit to obtain sufficient,  appropriate evidence to provide a reasonable basis for our findings and  conclusions based on our audit objectives. We believe that the evidence  obtained provides a reasonable basis for our findings and conclusions  based on our audit objectives.
section_title: Appendix II: Comments from the Internal Revenue Service
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact named above, Joanna Stamatiades, Assistant  Director; Jeff Arkin; Amy Bowser; Karen O’Conor; Amy Radovich; Cynthia  Saunders; and John Zombro made key contributions to this report.