The United States and its Internal Revenue Service (IRS), as a general rule, taxes US citizens and US resident aliens on their worldwide income. For citizens and other covered individuals, the tax on worldwide income is typically imposed regardless of the country or jurisdiction in which the income was earned. However, non-resident aliens are subject to disparate tax handling. If an individual qualifies as a non-resident alien (NRA) then they are taxed only on the income they earn or derive from the US. In general, an NRA’s income is categorized into two separate categories: Effectively Connected Income (ECI) and Fixed or Determinable, Annual or Periodical (FDAP) income.
By default, FDAP income, income that is not connected with a trade or business, is taxed on the gross amount at a flat rate of 30%. However, FDAP may be taxed at a lower rate if a tax treaty provides for it or if other permissible reductions are available. By contrast, ECI is taxed at normal graduated income tax rates and deductions and credits are available. Categorizing your income as ECI and by utilizing other strategic measures it is possible to reduce your tax obligation.
Who is considered to be a nonresident alien?
Non-resident aliens (NRAs) are not US citizens nor are they considered a resident alien. A US citizen is an individual who was born in the United States, is the child of a parent who is a US citizen, has been naturalized as a US citizen, or an individual born in Guam, Puerto Rico or the US Virgin Islands. A resident alien is an individual who is not a US citizen, but they can satisfy either the substantial presence test or the green card test. An individual can be considered a NRA if they are a foreign person. Foreign persons can include an individual who is a non-resident alien, a foreign partnership, foreign trust, or foreign estate.
What is considered FDAP income?
The definition of FDAP is extremely broad; this means that nearly all types of income that are not considered ECI, are considered FDAP. Internal Revenue Manual (IRM) 22.214.171.124(11). FDAP income can include income that is fixed or otherwise determinable and is income that is paid annually or is paid periodically in non-regular intervals. Types of income that can typically be considered FDAP includes:
- Lottery winnings
- Lottery or slot machine winnings
- Other forms of FDAP profits or gains
FDAP income can also include income gained through the sale of intellectual property where compensation for the intellectual property is contingent upon their use productivity or disposition of the property. Capital gains from the sale of personal property may also be considered FDAP if the NRA has been in the US for 183 days or more in the tax year.
What income is considered ECI?
ECI is income that is connected to a person or entity that is engaged in business or a trade within the United States. However to establish that certain income is ECI and subject to typically more favorable tax treatment, certain steps and measures must be completed. To start, the beneficial owner must complete and file a withholding certificate (Form W-8ECI). On the withholding form, a US taxpayer identification number (TIN) must be provided. Further, the beneficial owner must, under penalty of perjury, certify that the income is sufficiently connected to a trade or business activities within the United States and that the ECI can be included in their gross income. Income that is identified as non-FDAP and may be treated as ECI for international tax purposes includes:
- Effectively connected income from a trade or business in the US. IRC §§ 871(a) & (b).
- Rental income that the taxpayer elects to handle as ECI. IRC § 871(d).
- Many, if not most, income from the sale of personal property
- Income from the sale of real property
- Interest income including portfolio interest, 80/20 company income, and interest in deposits in US financial institutions.
- Dividend income
- Certain gambling winnings including winnings from roulette, big-6 wheel, blackjack, baccarat, or craps.
While other forms of income have been specifically identified as non-FDAP income, the foregoing cover many of the more common types. Furthermore, as a practical concern, , it is essential to note that should an FDAP obligation exists, the 30% tax payment on FDAP income is collected by withholding at the source. This requires an NRA to withhold and remit this tax to the Internal Revenue Service (IRS).
Put our non-resident tax experience to work for you
At US Tax Help, CPA Ted Kleinman can help hard-working individuals identify US tax problems and to correct those issues. He is experienced with foreign tax issues affecting non-resident aliens (NRAs) including FDAP, ECI, FBAR, reporting requirements, and other aspects of tax compliance. To schedule a consultation regarding your tax issues with an experienced CPA, call (541) 923-0903 or contact us online.