Individuals and entities that are not U.S. citizens or residents may be required to report income that is effectively connected with a trade or business in the United States and certain passive U.S. source income. This Client Update discusses how the U.S. taxes nonresident aliens who do business in the U.S. or receive income from a U.S. source.
Who is a nonresident alien?
A nonresident alien (NRA) is a person who is not a U.S. citizen or a U.S. resident alien. In other words, an NRA is an alien who has not passed the green card test or the substantial presence test.
Generally, a nonresident alien is subject to U.S. tax only on income that is effectively connected with a U.S. trade or business (ECI), or income that is sourced within the United States that is Fixed, Determinable, Annual, or Periodical (FDAP).
What is effectively connected income?
Effectively connected income (ECI) is income that a nonresident alien derives from the conduct of a trade or business in the U.S. ECI is taxed at the same rates and in the same manner as a U.S. citizen or resident’s income.
Note. For ECI purposes “conducting a trade or business” usually means the NRA participates in substantial, regular, and continuous business activities in the U.S.
ECI includes income from the following sources:
- Personal services performed in the U.S.,
- Rental income from U.S. real property,
- Gains from the sale of U.S. real property or property used in a U.S. trade or business, and
- Interest, dividends, royalties, or other passive income that is attributable to a U.S. trade or business.
Note. ECI may be subject to mandatory income tax withholding. For example, the Foreign Investment in Real Property Tax Act (FIRPTA) requires a person who purchases real property from a nonresident alien to withhold 15% of the gain realized by the nonresident alien seller.
Note. The permanent establishment or personal services articles of a treaty may limit U.S. taxation of ECI. A list of current tax treaties can be found at United States Income Tax Treaties – A to Z.
What is U.S. source income?
U.S. source income is fixed, determinable, annual, or periodic (FDAP) income that is derived from sources within the U.S. but is not connected to the nonresident alien’s U.S. trade or business.
U.S. source income includes income from the following sources:
- Interest from U.S. banks or corporations,
- Dividends from U.S. corporations,
- Royalties from U.S. patents, copyrights, or trademarks,
- Salaries, wages, or pensions paid by U.S. entities,
- Prizes and awards, from U.S. sources, and
- Certain gambling winnings.
Note. FDAP can also be effectively connected income. FDAP that is ECI is taxed at the graduated rates imposed on U.S. citizens and resident aliens.
FDAP that isn’t ECI is generally subject to a flat 30% tax withholding rate unless a lower rate is provided by a tax treaty between the U.S. and the nonresident alien’s country of residence. The 30% tax is usually withheld at the source by the payer of the income.
Note. A list of current tax treaties can be found at United States Income Tax Treaties – A to Z.
Return requirements.
A nonresident alien with ECI or FDAP must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return. NRAs use Form 1040-NR to report ECI and to claim any related deductions or credits and any treaty benefits.
NRAs with FDAP income that is not effectively connected with a U.S. trade or business use Form 1040-NR and Schedule NEC (Form 1040-NR), Tax on Income Not Effectively Connected With a U.S. Trade or Business, to report their FDAP income and claim any treaty benefits.
For more information about the taxation of nonresident aliens, see Checkpoint’s Federal Tax Coordinator ¶ O-10100.
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