Different Sources of Income Matter FDAP v. ECI - John R. Dundon II, Enrolled Agent
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Different Sources of Income Matter FDAP v. ECI

The Perturbing New Treatment of Patents Under the Tax Cut & Jobs Act (TCJA)

Different Sources of Income Matter FDAP v. ECI

Different Sources of Income Matter FDAP v. ECI

One of the issues difficult for some of my international clients to grasp about the United States is its taxation of citizens and resident aliens alike on their worldwide income without any regard to where the income is earned. Taxing US citizens on their world wide income is one matter but taxing US resident aliens on their world wide income is often times viewed as unbridled imperialistic skulduggery to many.

Hence the desire to be treated for income tax purposes in the United States as a Nonresident Alien (NRA) is HUGE as NRAs are ordinarily taxed only on their income earned or sourced in the U.S. Generally income for United States income tax paying NRAs falls into two main categories:

  1. Fixed or Determinable, Annual or Periodical (FDAP) income which is income not effectively connected with a trade or business and is taxed at a flat 30% rate or lower via income tax treaties. It is not reduced by deductions and/or credits.
  2. Effectively Connected Income (ECI) which is income attributed to a trade or business and is taxed at the normal graduated tax rates allowing for deductions and/or credits.

As a Nonresident Alien it is essential to categorize your income accordingly between FDAP and ECI to ensure it is correctly taxed. It is also important to note that the payment of the 30% tax on FDAP income is collected by withholding at the source. This means that if you are the payor of the FDAP income you are required to withhold and remit this tax to the IRS.

Most often, if a NRA has no effectively connected income and realizes fixed, determinable, annual or periodic income in which the tax was fully and properly withheld at the source, then the NRA is not necessarily required to file a U.S. tax return. If however the withholding was not sufficient to cover the tax due, then the NRA would have to file a tax return and pay the remaining tax due on such income.

For further detail about what constitutes FDAP income check out Internal Revenue Manual (IRM); and/or Commissioner. v. Wodehouse, 337 U.S. 369.

There are several key considerations to evaluate regarding FDAP income including:

  1. Determine precisely the taxpayers US Status as a resident alien or a non resident alien.
  2. Define and categorizing U.S. Sourced Income – U.S. asserts jurisdiction to tax NRAs on their U.S. sourced income, FDAP income received must be from sources within the U.S. to be taxed by the U.S.
  3. Determine what income earned or received is not effectively connected with a U.S. Trade or Business.
  4. Determine which treaty benefits exempt some forms of FDAP income and usually reduces the withholding tax rate from 30% to rates ranging from zero to 15% depending on the type of income and the terms of the specific treaty.

FDAP income is defined very broadly and generally includes all U.S. sourced income except gains derived from the sale of real or personal property and income specifically excluded from gross income such as tax-exempt interest and qualified scholarship income. It normally includes income that is:

  • fixed or for which the amounts to be paid are known ahead of time;
  • determinable or there is a basis for figuring the amount to be paid;
  • annual or paid yearly; or,
  • periodic or paid from time to time not specifically in regular intervals, IRC § 871(a) .

Specific examples of types of income generally considered FDAP income include:

  • dividends,
  • certain interest,
  • original issue discount,
  • pensions and annuities,
  • alimony,
  • rents,
  • royalties,
  • scholarships and
  • fellowship grants,
  • prizes,
  • awards,
  • purses for boxing,
  • compensation for personal services,
  • sales commissions paid monthly,
  • commissions paid for a single transaction,
  • distributable estate or trust non-ECI income,
  • distributed partnership non-ECI income,
  • salaries,
  • wages,
  • premiums,
  • annuities,
  • compensations,
  • gambling (other than excepted games),
  • remunerations,
  • emoluments,
  • Alimony,
  • Lottery winnings/Slot machine winnings
  • Gains realized on the disposition of timber, coal or domestic iron ore, with a retained interest covered by IRC § 631(b)
  • Realized income in the form of original issue discount, as defined in IRC § 871(g)
  • Gains from the sale of copyrights, patents and similar types of intellectual property where the payments are contingent on productivity, use, or disposition of the property
  • Capital gains from the sale of personal property by NRAs in the U.S. for 183 days or more during the taxable year – The 183-day rule above is unrelated to the substantial presence test under IRC § 7701(b) and is applicable to certain “exempt individuals” whose presence in the U.S. in excess of 183 days will not classify them as a resident alien.

There are several types of U.S. sourced income that are received by a NRA that are specifically identified as NOT FDAP, these include:

  • Effectively connected income (ECI) from a U.S. trade or business
  • Rental income treated as ECI via the election IRC § 871(d)
  • Most gains derived from the sale of personal property including market discount and option premiums
  • Gains derived from the sale of real property
  • Certain types of interest income: – Portfolio Interest – Interest on deposits in U.S. financial institutions including insurance companies – Interest from an existing 80/20 company
  • Certain types of dividend income: – Dividends from an existing 80/20 company – Dividends from a foreign corporation if 75% or more of gross income is foreign sourced
  • Certain Gambling winnings including blackjack, baccarat, craps, roulette and big-6 wheel
  • Annuities from a qualified annuity plan.

Other references for this post include:

Treas. Reg. §1.871-7(b)

Treas. Reg. §1.1441-2(b))

Park v. Commissioner, 136 T.C. 569 (2011)