People and entities that aren’t U.S. citizens or residents may still be required to report income that’s effectively connected with a trade or business in the United States. This also holds true for those generating certain passive U.S. source income.

Here are five commonly asked questions about the taxation of such nonresident aliens (NRAs), as they’re known in tax parlance.

1. Who’s a Nonresident Alien?

An NRA is a person who is not a U.S. citizen or resident alien. In other words, an NRA is an alien who does not have a green card or does not pass the substantial presence test.

Generally, an NRA is subject to U.S. tax only on income that is:

1) Effectively connected with a U.S. trade or business, or

2) Income that’s sourced within the United States and that is fixed, determinable, annual or periodical.

2. What’s Effectively Connected Income?

Effectively connected income (ECI) is income an NRA derives from the conduct of a trade or business in the United States. ECI is taxed at the same rates and manner as the income of a U.S. citizen or resident.

For ECI purposes, conducting a trade or business usually means the NRA participates in substantial, regular and continuous business activities within the United States. ECI includes income from the following sources:

· Personal services performed in the United States

· Rental income from U.S. real property

· Gains from the sale of U.S. real property or property used in a U.S. trade or business

· Interest, dividends, royalties or other passive income attributable to a U.S. trade or business.  

ECI may be subject to mandatory income tax withholding. For example, the Foreign Investment in Real Property Tax Act requires a person who buys real property from an NRA to withhold 15% of the gain realized by the NRA seller.

Also, the permanent establishment or personal services articles of a treaty may limit U.S. taxation of ECI. A list of current tax treaties can be found on the IRS website. 

3. What is U.S. Source Income?

As mentioned, NRAs may also have to report U.S. source income. This is fixed, determinable, annual or periodical income derived from sources within the United States, but is not connected to the NRA’s U.S. trade or business. U.S. source income includes income from the following sources:

• Interest from U.S. banks or corporations
• Dividends from U.S. corporations
• Royalties from U.S. patents, copyrights or trademarks
• Salaries, wages or pensions paid by U.S. entities
• Prizes and awards from U.S. sources
• Certain gambling winnings

This type of income can also be ECI. If so, it is taxed at the graduated rates imposed on U.S. citizens and resident aliens.

However, if it is not, ECI is generally subject to a flat 30% tax withholding rate unless a lower rate is provided by a tax treaty between the United States and the NRA’s country of residence. The 30% tax is usually withheld at the source by the payer of the income.

4. What Are the Filing Requirements?

An NRA with these related types of income must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return to report ECI, as well as to claim any related deductions, credits and treaty benefits.

NRAs with fixed, determinable, annual or periodical income that is not ECI, need to use Form 1040-NR and Schedule NEC, Tax on Income Not Effectively Connected With a U.S. Trade or Business, to report their FDAP income and claim any treaty benefits.

5. Can a Treaty Protect an NRA from U.S. Taxation?

Yes, a treaty between the United States and the NRA’s country of residence may eliminate or reduce the amount of U.S. tax the NRA owes. If this is the case, the NRA will need to file a Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b) with their Form 1040-NR. To avoid or reduce U.S. withholding tax on U.S. source FDAP income, a Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals) will need to be filed with the U.S. payor of the income. This form is not filed with the IRS.

If you are an NRA with U.S. source income and have questions about your current tax position, contact Moore Doeren Mayhew's tax advisors today.