What Is US Source Income for Tax Purposes?

Understanding what constitutes US source income is a fundamental aspect of navigating the United States tax system. This concept refers to income considered to originate from within the United States for tax purposes. Its determination is a core element of US tax law, affecting various taxpayers, particularly those with international financial activities.

Significance of Income Sourcing

Income sourcing establishes the US’s jurisdiction to tax certain income. For non-resident aliens and foreign corporations, who are generally taxed only on US source income, these rules clarify tax obligations. Sourcing rules determine if income is US-sourced or foreign-sourced, directly impacting US tax liability. For US persons, sourcing rules also affect foreign tax credit calculations, preventing double taxation. US citizens and residents are taxed on worldwide income, while non-resident aliens are taxed only on US source income.

US source income for non-resident aliens and foreign corporations typically falls into two main categories: effectively connected income (ECI) and fixed or determinable, annual or periodical (FDAP) income. ECI is income linked to a US trade or business, while FDAP income generally includes passive income like interest, dividends, rents, and royalties not connected to a US trade or business. These categories have distinct tax treatments, making proper classification essential for tax compliance.

Rules for Key Income Categories

Income sourcing depends on the income type and applicable rules, which vary by payer’s residence, asset location, or service performance. Understanding these rules is necessary for accurate tax reporting.

Compensation for Services

Compensation for personal services, including salaries and wages, is sourced where the services are performed. If services are rendered in the United States, the income is US source, regardless of the payer’s residence or contract location. When services are performed both inside and outside the US, compensation is allocated based on days worked in each location. For example, if an individual works 60 days in the US out of 200 total workdays, 30% of their compensation is US source.

Interest Income

Interest income is generally sourced to the residence of the payer. Interest paid by the United States, any US agency, a state, a US resident individual, or a domestic corporation is typically US source income. Interest paid by a US branch of a foreign corporation is also treated as US source income.

However, exceptions exist. For example, interest on deposits with a foreign branch of a domestic corporation engaged in commercial banking is foreign source income. Interest paid by a foreign corporation or partnership engaged in a US trade or business can be US source income if paid by that US trade or business.

A significant exception applies to certain portfolio interest received by non-resident aliens, which can be exempt from US tax. Another exception relates to interest paid by an “80/20 company,” a foreign corporation or a US corporation that derives at least 80% of its gross income from foreign sources for a specified period. Interest from such an entity may be treated as foreign source income, even if the payer is a US entity.

Dividend Income

Dividends are generally sourced based on the corporation’s place of incorporation. Dividends from a domestic US corporation are typically US source income, while those from a foreign corporation are usually foreign source.

An exception applies to dividends from foreign corporations with a substantial US connection. If 25% or more of a foreign corporation’s gross income for the preceding three years was effectively connected with a US trade or business, a portion of the dividends may be treated as US source income.

Rents and Royalties

Income derived from rents and royalties is sourced to the location of the property. For rents from real property, the income is US source if the property is located in the United States. Similarly, royalties from intangible property, such as patents, copyrights, or trademarks, are US source income if the property is used in the United States. This rule applies regardless of the residence of the payer or recipient.

Income from the Sale of Real Property

Gain from the sale of real property is sourced to the property’s location. If the real property is in the United States, any gain from its sale is US source income, relevant for foreign investors.

The Foreign Investment in Real Property Tax Act (FIRPTA) addresses the taxation of foreign persons on US real property interests. FIRPTA ensures foreign sellers pay income tax on gains from US real estate, often requiring the buyer to withhold a percentage of the sales price at closing and remit it to the IRS as an advance payment toward the foreign seller’s tax liability.

Income from the Sale of Personal Property

Income from the sale of personal property is generally sourced to the seller’s residence. If a US resident sells personal property, the income is US source; if a non-resident sells it, the income is generally foreign source. Personal property includes items like machinery, equipment, stocks, and bonds. Exceptions exist for certain types of personal property, such as inventory or depreciable property, which have specific sourcing rules.

Other Common Income Types

Sourcing rules also apply to other income streams. Gambling winnings are generally sourced to the location where the gambling activity occurs. Scholarships, fellowships, and grants are sourced according to the residence of the payer. If the entity providing the scholarship or grant is created or domiciled in the United States, the income is generally US source.

Tax Consequences for Non-U.S. Persons

Once income is determined to be US source, the tax consequences for non-resident aliens and foreign corporations depend on its classification as either effectively connected income (ECI) or fixed or determinable, annual or periodical (FDAP) income. These two categories are subject to different tax treatments.

Effectively Connected Income (ECI) is income derived from a US trade or business. This can include profits from business operations, wages for services performed in the US, or actively managed rental income. ECI is taxed at the graduated US income tax rates, which are the same rates that apply to US citizens and residents. Taxpayers with ECI are generally allowed to deduct expenses related to that income, meaning they are taxed on a net basis. Form 1040-NR is used to report ECI.

Fixed or Determinable, Annual or Periodical (FDAP) income typically includes passive income such as interest, dividends, rents, and royalties, provided it is not effectively connected with a US trade or business. This income is generally taxed at a flat 30% rate on the gross amount, without deductions. This tax is often collected through withholding at the source by the payer. Certain types of interest, like interest on deposits with US banks, may be exempt from this tax for non-resident aliens.

Tax treaties between the US and other countries can significantly alter these tax consequences. The US has income tax treaties with over 60 countries, and these treaties often reduce or eliminate US tax on certain types of US source income for residents of treaty countries. For example, treaties may provide for lower withholding rates on FDAP income, or exempt certain business profits from US tax unless the foreign enterprise has a “permanent establishment” in the US. A permanent establishment generally refers to a fixed place of business in the US through which a foreign enterprise carries on business, such as an office or factory. However, activities of a preparatory or auxiliary nature typically do not create a permanent establishment.

Non-resident aliens with US source income are generally required to file a US income tax return, typically Form 1040-NR, even if the tax has been fully withheld. This filing allows them to claim any refund of overwithheld tax or benefit from deductions or credits. If a non-resident alien only has FDAP income and the 30% (or lower treaty) rate has been withheld, they may not be required to file a US income tax return. However, filing can still be beneficial to claim any applicable treaty benefits or refunds.