A Comprehensive Guide to Effectively Connected Income (ECI)

Foreigners making money by doing business in the U.S. need to report effectively connected income (ECI) on their tax returns. Reporting this income keeps your taxes in compliance, but knowing how it works can also help you lower your tax bill. Understanding effectively connected income can reduce your stress during tax season and help you avoid issues in the future. This comprehensive guide sheds light on what you need to know about ECI.

Effectively Connected Income Defined

Foreign workers and businesses frequently conduct business with U.S. entities. This setup helps everyone because business owners get access to more service providers and workers. Foreigners also get more work-related opportunities instead of only looking within their own countries. Money swaps hands throughout these types of relationships, and the IRS has a category for these types of exchanges.

The IRS considers the income generated from these activities as effectively connected income. This income source gets taxed at the graduated rate or a lesser rate based on a pre-established tax treaty. These earnings are not subject to tax withholding under the Foreign Account Tax Compliance Act (FATCA).

Types of Income Considered as ECI

ECI income is subject to different tax rates. Knowing which income falls under the ECI umbrella can help you plan out your taxes.

Fixed, Determinable, Annual or Periodical (FDAP) Income

It’s easier to explain FDAP income by explaining what it’s not. The IRS does not consider capital gains on property sales and income streams that do not show up in your gross income. The IRS lists qualified scholarship income and tax-exempt municipal bonds as items that don’t show up on your gross income.

That’s a small window of items that do not count as FDAP income. If you have generated income from any of these methods, it falls under FDAP:

• Compensation for performing services
• Grants
• Pensions
• Annuities 
• Rents 
• Dividends
• Royalties 

For example, a person in living and conducting business in India is providing online software consulting services to clients in the United States, this revenue is not taxable in the US.

Other Kinds of Foreign Source Income

The other kinds of foreign source income category covers additional funding sources foreigners receive from doing business and trade with U.S. companies. Dividend payouts, rental income, royalties and interest are some of the income streams treated as other kinds of foreign source income.

Effectively Connected Income vs. Not Effectively Connected Income

Effectively connected income involves trading with U.S. businesses and getting compensated for providing goods and performing services. The income can be treated as effectively connected income if you are a sole proprietor or part of a partnership. However, some U.S. business activity does not count as effectively connected income. If your only activity in the U.S. is buying and selling stocks, securities and commodities, you are not making effectively connected income. You would have to work for a U.S. company or have a client based in the U.S. for the income to be considered effectively connected.

Applicable Tax Rates

ECI is subject to taxation based on the tax treaty between the U.S. and the foreigner’s country. This income source gets taxed at the graduated rate or a lesser rate depending on that treaty. Temporary U.S. nonimmigrant residents with F, J, M and Q visas have their U.S.-based income treated as effectively connected income. You can use tax deductions to minimize how much of your effectively connected income gets taxed. 

The applicable tax rates follow the same structure as the one that U.S. citizens and foreigners use. Earning more money moves you up to a higher tax bracket. Instead of getting every dollar taxed at the highest rate, your money gets taxed in multiple brackets. You may have some of your money taxed at the 10% bracket and other portions of your income taxed at the 12% and 22% rates. The highest taxable income bracket is 37%, and the IRS adjusts tax brackets every year.

Staying on Top of Taxes

Effectively connected income gets taxed, but you can trim your tax bill with good bookkeeping. Preparing in advance helps you save more money and estimate your bill before it’s due. The optimal bookkeeping software can provide monthly financial reports, expert reviews and other features that reduce stress during tax season.

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