Revenue Ruling 79-21 for Nonresident Alien Income

Revenue Ruling 79-21 provides guidance for nonresident aliens earning income from personal services performed in the United States for a foreign employer. The ruling establishes a framework for determining when this income is “effectively connected” with a U.S. trade or business. This classification determines how the income is taxed by the United States.

Determining Applicability of the Ruling

First, an individual must qualify as a “nonresident alien” (NRA) for U.S. tax purposes. An individual is an NRA if they are not a U.S. citizen and do not meet either the “green card test” by having lawful permanent resident status or the “substantial presence test.” The substantial presence test is based on the number of days an individual is physically present in the U.S. over a three-year period.

An individual meets the substantial presence test if they are in the United States for at least 31 days during the current year and 183 days during the 3-year period. This 3-year period includes the current year and the two years immediately before it. The 183-day total is calculated by counting all days in the current year, one-third of the days in the first preceding year, and one-sixth of the days in the second preceding year. Certain individuals, like students on specific visas, may be exempt from counting days of presence.

The ruling also requires that the services be performed for a “foreign employer.” A foreign employer is a nonresident alien individual, foreign partnership, or foreign corporation not engaged in a trade or business within the United States. If the employer is a U.S. entity or is engaged in a U.S. trade or business, the tests within this ruling do not apply.

The Core Analytical Tests

The ruling uses a two-part analysis to determine if compensation is effectively connected income (ECI). The first test is whether the foreign employer has an office or other fixed place of business in the United States. This implies a degree of permanence, such as a leased office space, rather than a temporary location like a hotel room for a short trip.

Factors that indicate a fixed place of business include owning or leasing office space, having employees regularly work from that location, and using the address for business correspondence. The substance of the arrangement must show the foreign employer has a tangible operational base within the country.

The second part is the “material factor” test. For income to be ECI, the employer’s U.S. office must be a material factor in the realization of that income. The activities conducted through the U.S. office must be a significant contributor to earning the compensation, not merely incidental or administrative.

For example, a nonresident alien engineer works for a European tech company with a U.S. sales office. If the engineer works from that office for three months to customize a product for a U.S. client, the office is a material factor. If the engineer only visits the office to check emails while attending a conference, the office would not be a material factor.

Tax Consequences and Reporting

If compensation is determined to be Effectively Connected Income (ECI), it is taxed at the same graduated rates that apply to U.S. citizens and residents. Individuals with ECI are also permitted to claim allowable deductions related to that income, which can reduce their overall tax liability.

Income classified as ECI must be reported on Form 1040-NR, U.S. Nonresident Alien Income Tax Return. To claim deductions, the nonresident alien must file a true and accurate return in a timely manner. A return is considered timely for this purpose if filed within 16 months of the original due date. Failure to file on time can result in the denial of deductions or credits.

If the compensation is not ECI, it is classified as Fixed, Determinable, Annual, or Periodical (FDAP) income. FDAP income is subject to a flat 30% tax on the gross amount with no deductions allowed. This tax is collected through withholding by the payer, though the rate can be reduced by an applicable income tax treaty.

The Role of Tax Treaties

An income tax treaty between the United States and the nonresident alien’s country of residence can override standard U.S. tax rules, including this ruling. The U.S. has tax treaties with many countries to prevent double taxation. These agreements contain provisions that define when a country has the right to tax income from personal services.

A primary concept in most tax treaties is the “permanent establishment” (PE) clause, which refers to a fixed place of business for an enterprise. The definition of a PE in a treaty is often more stringent than the “fixed place of business” standard in the revenue ruling. For instance, a treaty might require a location to exist for a specific duration, such as six or twelve months, to qualify as a PE.

If a nonresident alien’s foreign employer does not have a PE in the U.S. under the relevant tax treaty, the U.S. cannot tax the alien’s compensation. This is true even if the income would otherwise be ECI under this ruling’s tests. An applicable treaty can provide a complete exemption from U.S. tax.