Thank you @nakov and @rodrigo.pedra , I tried all of those steps. My updated configs are:
phpunit.xml
<php>
<env name="APP_ENV" value="testing"/>
<env name="DB_DATABASE" value=":memory:"/>
<env name="CACHE_DRIVER" value="array"/>
<env name="DB_CONNECTION" value="sqlite"/>
<env name="SESSION_DRIVER" value="array"/>
<env name="QUEUE_DRIVER" value="sync"/>
</php>
env.testing
APP_ENV=testing
APP_KEY=someimportantrandomstrings
APP_DEBUG=true
APP_URL=http://localhost
DB_CONNECTION=sqlite
config/database.php
'sqlite' => [
'driver' => 'sqlite',
'url' => env('DATABASE_URL'),
'database' => env('DB_DATABASE', database_path('database.sqlite')),
'prefix' => '',
'foreign_key_constraints' => env('DB_FOREIGN_KEYS', true),
],
Deleted database/database.sqlite file and runs the tests again. Still getting same error but this time there is no database.sqlite added on directory.