What Is Section 871 and How Does It Impact Nonresident Aliens?

The U.S. tax system imposes specific rules on nonresident aliens earning income from U.S. sources. Section 871 of the Internal Revenue Code outlines how these individuals are taxed differently than U.S. citizens and residents, often at a flat rate depending on the type of income received. Understanding these rules is essential for foreign taxpayers and those making payments to them.

Failure to comply can lead to unexpected tax liabilities or penalties. To avoid complications, it’s important to know which types of income are affected, how withholding works, and whether tax treaties offer any relief.

Categories of Income Subject to Section 871

Nonresident aliens earning income from U.S. sources are taxed based on the nature of the income. Section 871 distinguishes between effectively connected income (ECI) and fixed, determinable, annual, or periodic (FDAP) income, each taxed differently.

ECI includes income connected to a U.S. trade or business, such as wages, salaries, and business profits. It is taxed at the same graduated rates as U.S. citizens and residents, ranging from 10% to 37%, depending on taxable income levels. To qualify as ECI, the income must have a direct link to business operations in the U.S. For example, a foreign entrepreneur running a branch office in New York or a consultant providing services while physically present in the country would have ECI.

FDAP income, generally passive, includes interest, dividends, rents, royalties, and certain pensions. It is subject to a flat 30% tax rate unless a tax treaty reduces it. FDAP income is taxed on a gross basis, meaning no deductions are allowed. For instance, if a nonresident alien earns $10,000 in U.S. dividends, they owe $3,000 in taxes, regardless of any investment-related expenses. Certain types of interest, such as portfolio interest on U.S. bonds, may be exempt from taxation under specific conditions.

Withholding Requirements for Payers

Entities making payments to nonresident aliens must withhold taxes at the time of payment. FDAP income is generally subject to a 30% withholding rate unless a tax treaty specifies a lower rate. This responsibility falls on the payer, which can include employers, financial institutions, corporations, or individuals in certain cases. Failure to withhold the correct amount can result in penalties and interest charges.

Payers must report withheld amounts to the IRS using Form 1042 and provide recipients with Form 1042-S, detailing income paid and tax withheld. These forms must be filed annually, typically by March 15 of the following year. If a payer does not properly document a nonresident alien’s tax status through Form W-8BEN or another applicable form, they may be required to withhold at the maximum 30% rate, even if a treaty reduction would otherwise apply.

Some payments are exempt from withholding under specific provisions. Interest on certain portfolio debt instruments qualifies for an exemption, provided the recipient meets the necessary documentation requirements. Similarly, payments for services performed outside the U.S. are generally not subject to withholding, as they do not constitute U.S.-sourced income. Proper classification of payments is necessary to avoid unnecessary withholding or compliance issues.

Tax Reporting for Nonresident Aliens

Filing requirements depend on the type of income earned and whether tax was withheld at the source. Those with effectively connected income must file Form 1040-NR, which serves as the primary tax return for foreign individuals without residency status. This form requires reporting of income, deductions, and applicable credits, similar to a standard U.S. tax return but with specific limitations.

Nonresident aliens may also need to file a return if they have overpaid taxes due to withholding or seek to claim a refund. This is common for individuals who had excess withholding on passive income or mistakenly had tax deducted on income that qualifies for an exemption. The IRS allows for refunds in cases where tax was withheld unnecessarily, but the taxpayer must file a claim and provide supporting documentation.

Deadlines for filing vary. Nonresident aliens with wages must file by April 15, while those without wage income have until June 15. Late filing can result in penalties, including failure-to-file fines and interest on unpaid tax liabilities. Those required to file but who fail to do so risk losing eligibility for future deductions or credits, particularly if they later become U.S. residents.

Treaty-Based Reductions

Tax treaties between the United States and various foreign countries provide opportunities for nonresident aliens to reduce or eliminate certain U.S. tax obligations. These agreements prevent double taxation and modify the default tax treatment under Section 871. The extent of these benefits depends on the specific treaty terms, which vary by country. Some treaties lower withholding rates on passive income, while others exempt specific types of earnings from taxation altogether.

One of the most significant advantages of tax treaties is the ability to claim reduced rates on investment income. For instance, under the U.S.-U.K. tax treaty, qualifying U.K. residents can benefit from a 15% withholding rate on dividends instead of the standard 30%. Some countries, such as Switzerland, have negotiated even lower rates for certain types of income.

In addition to lower withholding rates, many treaties provide exemptions for specific income types, such as pensions, scholarships, and royalties. The U.S.-India tax treaty, for example, allows Indian residents to receive certain scholarship payments tax-free, provided they meet eligibility criteria. Similarly, some treaties prevent U.S. taxation of business profits unless the foreign taxpayer has a permanent establishment in the country. This distinction is particularly relevant for consultants, freelancers, and service providers who work remotely but receive payments from U.S. clients.

Penalties for Incorrect Filing

Nonresident aliens and entities making payments to them must adhere to strict tax filing and withholding requirements. Failing to comply can result in financial penalties, interest charges, and potential legal consequences. The severity of these penalties depends on the nature of the violation, whether it involves underreporting income, failing to withhold the correct tax amount, or neglecting to file required forms.

The IRS imposes penalties for late or incorrect filings of Form 1040-NR, Form 1042, and Form 1042-S. If a nonresident alien fails to file a required tax return, they may face a failure-to-file penalty, which starts at 5% of the unpaid tax per month, up to a maximum of 25%. If tax is owed and remains unpaid, an additional failure-to-pay penalty of 0.5% per month applies. For payers who fail to withhold or deposit the correct tax amount, penalties can range from 2% to 15% of the unpaid withholding, depending on how late the payment is made. Intentional disregard of withholding obligations can lead to even steeper fines, and in extreme cases, criminal charges for tax evasion.

In cases where incorrect or missing information is reported on Form 1042-S, the IRS may impose penalties of $330 per form, with a maximum annual penalty of over $3 million for large entities. If the failure to file is due to intentional disregard, the penalty increases significantly, often doubling the standard amount. Nonresident aliens who fail to claim treaty benefits correctly may also face retroactive tax assessments, requiring them to pay the full 30% withholding rate plus interest. Given these potential consequences, both foreign taxpayers and U.S. payers must ensure compliance with Section 871’s reporting and withholding rules.