ECI Withholding: What It Is and How It Works

Effectively Connected Income (ECI) is income earned by foreign individuals or entities from U.S. sources connected to a U.S. trade or business. The U.S. government collects tax on this income through withholding, where the U.S. entity making the payment sets aside a portion and remits it to the Internal Revenue Service (IRS).

This system places the compliance burden on the U.S. payer, who must determine the foreign recipient’s status and the income’s nature. Proper application of these rules is necessary for U.S. payers with a legal obligation to withhold and for foreign recipients whose U.S. earnings may be subject to these requirements.

Identifying Effectively Connected Income

For income to be classified as ECI, a foreign person must be engaged in a trade or business within the United States during the tax year. Performing personal services in the U.S. constitutes being engaged in a trade or business. Once this condition is met, any U.S.-source income connected with that business is considered ECI. The IRS uses two main tests to determine if certain types of investment income, like interest and dividends, are effectively connected.

The first is the “asset-use test,” which examines whether the income is derived from assets used in the conduct of a U.S. trade or business. For example, if a foreign corporation operates a factory in the U.S. and holds interest-bearing accounts receivable from its product sales, the interest earned on those receivables would likely pass the asset-use test and be treated as ECI.

The second standard is the “business-activities test,” which looks at whether the activities of the U.S. trade or business were a material factor in generating the income. An example would be a foreign company with a U.S. office that actively manages and negotiates licensing agreements for its patents with U.S. companies. The royalties generated from these agreements would be considered ECI because the U.S. office’s activities were instrumental to earning that income.

Both tests help distinguish between passive investment income and income that is an integral part of a U.S. business operation. All other U.S.-source income that is not passive, such as from the sale of inventory, is treated as ECI by default if the foreign person has a U.S. trade or business. This framework ensures that income generated from active participation in the U.S. economy is taxed on a net basis, similar to a domestic business.

The Withholding Agent’s Core Responsibilities

A U.S. payer who makes payments to a foreign person is designated as a “withholding agent” and has duties related to tax compliance. The agent must determine if they must withhold tax from payments of U.S.-source income. The primary tool for this is the Form W-8 series, which are documents provided by the foreign recipient to certify their foreign status and claim any exemptions. Failure to collect a valid form requires the agent to withhold at a default 30% rate.

The specific form a foreign person provides dictates the agent’s actions. If the income is not connected to a U.S. business, the foreign person provides a Form W-8BEN (for individuals) or W-8BEN-E (for entities). If the foreign person asserts that the income is ECI, they must provide the withholding agent with a Form W-8ECI.

Receiving a valid Form W-8ECI changes the withholding agent’s obligation. This form certifies that the income is ECI and that the foreign recipient will report the income on a U.S. tax return. Upon receiving a properly completed Form W-8ECI, the agent is relieved of the duty to withhold tax on those payments. The form must include the foreign person’s U.S. Taxpayer Identification Number (TIN).

The withholding agent must exercise due diligence when accepting these forms. A Form W-8 is valid for the year it is signed plus the next three calendar years. The agent should review the form for completeness and reasonableness, and the foreign person must provide a new form if circumstances change.

Partnership Withholding Requirements

The rules for partnerships with foreign partners are an exception to the general withholding framework. A U.S. or foreign partnership with income effectively connected with a U.S. trade or business must withhold tax on a foreign partner’s share of that income. This withholding is required regardless of whether the partnership distributes the funds to the foreign partner, as the obligation is based on the allocable share of effectively connected taxable income (ECTI).

The withholding tax rate is based on the foreign partner’s status. For corporate partners, the rate is 21%, while for non-corporate partners, such as individuals or trusts, the rate is 37%. The partnership makes these withholding tax payments to the IRS on a quarterly installment basis.

A specific set of IRS forms is used to manage this process. The partnership uses Form 8813, Partnership Withholding Tax Payment Voucher, to remit the quarterly tax payments. At the end of the year, the partnership must file Form 8804, Annual Return for Partnership Withholding Tax, which is an annual summary of the total ECTI and tax withheld for all foreign partners.

To complete the reporting cycle, the partnership must also provide information to each foreign partner using Form 8805, Foreign Partner’s Information Statement of Section 1446 Withholding Tax. A separate Form 8805 is prepared for each foreign partner, detailing their share of the ECTI and the tax withheld on their behalf. The partnership provides a copy to the partner to use when filing their U.S. tax return, and a copy of every Form 8805 must be attached to the partnership’s Form 8804 filing.

Withholding on US Real Property Interests

A distinct set of withholding rules applies to the sale of U.S. real property interests by foreign persons, governed by the Foreign Investment in Real Property Tax Act (FIRPTA). Under FIRPTA, the responsibility for withholding falls on the buyer, who is referred to as the transferee. The transferee acts as the withholding agent and must deduct and withhold tax from the amount realized by the foreign seller on the disposition of the property.

The buyer must withhold 15% of the gross amount realized from the sale. The amount realized includes not just cash paid but also the fair market value of any other property transferred and any liabilities assumed by the buyer. A reduced rate of 10% applies if the buyer acquires the property to use as their personal residence and the residence is sold for between $300,001 and $1 million. If the residence is sold for $300,000 or less, no withholding is required.

The procedural aspects of FIRPTA are managed through specific forms. The buyer reports and remits the withheld tax using Form 8288, U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests. This form, along with the payment, must be sent to the IRS within 20 days of the closing date. The buyer also completes Form 8288-A for each foreign seller, which the IRS stamps and returns to the seller as proof of withholding.

In some cases, the 15% withholding on the gross price may exceed the seller’s actual tax liability on the gain. To address this, a foreign seller can apply to the IRS for a “withholding certificate” before the sale by filing Form 8288-B. This application is used to request a reduced or eliminated amount of withholding based on the seller’s calculated maximum tax liability. If the IRS approves the certificate, the buyer is permitted to withhold the lower amount specified.

Tax Filing and Reporting for the Foreign Person

The withholding of tax by a U.S. payer does not eliminate the foreign person’s own tax obligations to the IRS. A foreign person who earns ECI during the year is required to file a U.S. income tax return. This filing obligation exists even if no tax is ultimately due or if the amount withheld is sufficient to cover the entire tax liability.

Foreign individuals must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return. Foreign corporations that earn ECI are required to file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. On these returns, the foreign person reports all income that is effectively connected with their U.S. trade or business and calculates their tax liability on a net basis, meaning they can claim deductions for expenses related to earning that income.

A central part of this filing is claiming credit for any U.S. taxes withheld at the source. The information statements provided by withholding agents are necessary for this step. For example, a foreign partner would use the amount shown on Form 8805 to claim a credit, while a foreign person who sold U.S. real estate would use their stamped copy of Form 8288-A.

This process allows the foreign person to reconcile the amount of tax withheld with their actual tax liability. If the total tax withheld exceeds the final tax calculated on the return, the foreign person can claim a refund for the overpayment. Attaching the correct withholding documents to the tax return is necessary to substantiate the claim for credit.