People and entities that aren’t U.S. citizens or residents may still be required to report income that’s effectively connected with a trade or business in the United States. This also holds true for those who generate certain passive U.S. source income. Here are four commonly asked questions about the taxation of such nonresident aliens (NRAs), as they’re known in tax parlance.
- Who’s a Nonresident Alien?
An NRA is a person who’s not a U.S. citizen or a U.S. resident alien. In other words, an NRA is an alien who hasn’t passed the green card test or the substantial presence test.
Generally, an NRA is subject to U.S. tax only on income that’s 1) effectively connected with a U.S. trade or business, or 2) income that’s sourced within the United States and that’s fixed, determinable, annual or periodical (FDAP).
- What is ‘Effectively Connected Income?’
Effectively connected income (ECI) is income that an NRA derives from the conduct of a trade or business in the United States. ECI is taxed at the same rates and in the same manner as the income of a U.S. citizen or resident.
For ECI purposes “conducting a trade or business” usually means the NRA participates in substantial, regular and continuous business activities within the United States. ECI includes income from the following sources:
- Personal services performed in the United States,
- 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’s attributable to a U.S. trade or business.
ECI may be subject to mandatory income tax withholding. For example, the Foreign Investment in Real Property Tax Act requires a person who buys real property from an NRA to withhold 15% of the gain realized by the NRA seller.
Also, 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 here on the IRS website.
- What is ‘U.S. Source Income?’
As mentioned, NRAs may also have to report U.S. source income. This is FDAP income that’s derived from sources within the United States but isn’t connected to the NRA’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.
FDAP income can also be ECI. If so, it’s taxed at the graduated rates imposed on U.S. citizens and resident aliens.
FDAP income 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 United States and the NRA’s country of residence. The 30% tax is usually withheld at the source by the payer of the income.
- What Are the Filing Requirements?
An NRA with ECI or FDAP income must file Form 1040-NR, “U.S. Nonresident Alien Income Tax Return.” NRAs use Form 1040-NR to report ECI as well as to claim any related deductions or credits and any treaty benefits.
NRAs with FDAP income that isn’t ECI need to 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 NRAs and assistance with filing, contact the international tax professionals at Sol Schwartz & Associates.