US taxes can feel overwhelming, especially for nonresidents. But, you must file taxes for your US-based income if you’ve established an LLC in the US or other business but are a nonresident alien.
Normally, that income falls into one of two categories under IRS criteria: FDAP income or ECI income. The tax ramifications for these two types of income differ, so it’s important to understand what each is and how to classify your US-sourced income. Read on to understand ECI vs. FDAP.
What Is Effectively Connected Income (ECI)?
ECI, or effectively connected income, is US-based income connected with a trade or business. With ECI income, there are no specific withholdings. Instead, nonresidents can claim relevant deductions and then file a tax return to report the income. Examples of ECI include income on merchandise or products sold in the US. These products or merchandise can be internationally sourced as well.
A simple example of FDAP would be income from a rental property. In that case, the tenant must deposit 30% of the rent with the IRS. However, since rental real estate has various deductions and expenses that may reduce the net income, rental real estate income can be modified from FDAP into ECI.
How Does ECI Work?
When creating a US business entity to access more service providers and workers. You could also get more work-related opportunities and access to new markets. You may even have a Canadian LLC. The good news about ECI is that earnings are not subject to tax withholding under the Foreign Account Tax Compliance Act (FATCA).
However, according to the IRS, you must be engaged in a trade or business during the tax year to treat income received as ECI. US trade or business includes personal services or other business activities in the United States. If you have a business that sells t-shirts, computer parts, or even offers coaching in the US, it would fall under ECI income.
You can make deductions against ECI. This income is also taxed at graduated or lesser rates under a tax treaty.
ECI Tax Treatment
ECI income is treated as individual income. With ECI, the taxpayer files Form 1040-NR to report the ECI income. You can make deductions against the income and claim treaty benefits between the US and your home country if applicable.
What Is Fixed, Determinable, Annual, and Periodic (FDAP) Income?
According to the IRS, Fixed, Determinable, Annual, and Periodic income, or FDAP, is fixed when paid in amounts known ahead of time. Rental income is generally considered FDAP. Dividends, interest, and compensation for personal services, such as commissions and gross performance proceeds, can also be considered FDAP.
Income is considered determinable whenever there is a basis for figuring the amount to be paid. Dividends or interests fall into this category. Income is considered periodic if it is paid from time to time. It is not required to be paid annually or at regular intervals.
How Does FDAP Income Work?
FDAP income includes all US-sourced income except gains derived from the sale of real estate, personal property, or tax-exempt interest, such as income specifically excluded from gross income like tax-exempt municipal bond interest and qualified scholarship income.
There are numerous examples of FDAP income, including the following from the IRS:
- Gross proceeds from performances
- Compensation for personal services
- Dividend equivalent payments
- Pensions and annuities
- Real estate property income, such as rent
- Income from the sale of real property
- Scholarships and fellowship grants
- Grants, prizes, and awards
- Winnings from gambling
- Sales commission paid or credited monthly
- Commissions paid for a single transaction
- The distributable net income of an estate or trust paid to a nonresident alien beneficiary
- A distribution from a partnership that is included in the gross income of a foreign partner
- Taxes, mortgage interest, or insurance premiums paid to a landlord by a tenant under the terms of a lease
- Prizes awarded for pictures exhibited in the United States
- Purses paid to boxers for prize fights in the United States
- Prizes awarded to professional golfers in golfing tournaments in the United States
- Payments made to third parties for the benefit of performance
FDAP Tax Treatment
FDAP is taxed on a gross basis, meaning you must make a withholding of 30% on gross income without deductions. This differs from ECI which is taxed on a net basis of gross income less allowable deductions at graduated rates. The 30% tax rate on FDAP income could be reduced or eliminated according to specific income tax treaties or domestic law.
Interestingly, certain Fixed, Determinable, Annual, or Periodic (FDAP) income types can be treated as ECI if they meet the required criteria. For example, according to certain Internal Revenue Code Sections, certain income or elections can be treated as ECI. An asset-use test defined by the IRS may allow you to treat income as ECI. In that case, the income must be associated with US assets related to the conduct of a US-based trade or business. In addition, the trade or business conducted in the United States must generate income.
Final Tips on ECI vs FDAP
As a nonresident, navigating the US tax code can be confusing. Ensuring compliance is essential for your business and tax standing. If you need help, consider doola books. If you need exceptional bookkeeping software for busy founders, doola Books can help you easily navigate ECI and FDAP filings while maximizing available deductions or credits. Get doola books here!
How can one determine if their income falls under ECI or FDAP?
FDAP refers to Fixed, Determinable, Annual, and Periodic income, which usually means passive income. ECI includes income generated from a trade or business based in the US. In some cases, such as rental income, it may qualify as ECI even if generally considered FDAP.
Can a non-U.S. resident be subject to both ECI and FDAP taxes?
Yes, a nonresident could be subject to both ECI and FDAP. ECI and FDAP are determined by the source of the income and both may apply to one individual.
Can the classification of income change from ECI to FDAP or vice versa?
The classification of income is usually either ECI or FDAP. However, some FDAP income may meet certain exceptions that allow it to be classified as ECI.
Does every non-U.S. resident need to worry about ECI or FDAP taxes?
Not everyone who is a nonresident needs to worry about ECI or FDAP taxes. You will generally only need to pay taxes on US-sourced income.
Can a non-U.S. resident claim tax credits for taxes paid on ECI or FDAP income?
Whether you can claim tax credits for taxes paid on ECI or FDAP income depends on the credit and whether you meet the criteria. With ECI income, you can file Form 1040-NR and take any relevant deductions or credit. Likewise, with FDAP you might qualify for certain credits. Speak with a CPA to understand applicable credits for your situation.