When Non-Residents Owe US Tax on Business Income

What US income does a non-resident pay tax on?

Two kinds: income effectively connected with a US trade or business (ECI), and US-source passive or periodic income that is not (FDAP). Other foreign-source income is not taxed by the US (IRS Pub 519, chapter 2).

These rules cover non-resident aliens (non-citizens who are not US residents for tax) and foreign companies.

Sources: IRS: ECI, IRS: FDAP, Form 1120-F instructions. Some FDAP is exempt, such as interest on US bank deposits (Pub 519, chapter 3).

When is a non-resident in a US trade or business?

For personal services, work done in the US at any time in the year usually counts. For other activity there is no bright-line test; the IRS weighs the facts (Pub 519, chapter 4).

• Working in the US. Performing personal services in the US at any time during the year usually counts.
• Running a US business. Owning and operating a business in the US that sells services, products or goods counts, with some exceptions.
• Being a partner. If a partnership you belong to has a US trade or business, so do you.
• People acting for you. Work done in the US by your employees or agents may also create a US trade or business. No Code section says when; it turns on the facts (Pub 519, chapter 4).
• Not by itself: trading. Trading stocks or securities, or exchange-traded commodities, for your own account is not a US trade or business; this rule does not cover dealers. Nor is trading through an independent US broker, as long as no US office of yours directs the trades (26 U.S.C. 864(b)(2)).

The IRS also says business activity must be "considerable, continuous and regular" to count, and applies that to personal services too (IRS: ECI). For services, the Code sets a lower bar: work in the US at any time in the year counts, apart from a narrow exception for short work for foreign employers (26 U.S.C. 864(b)). For other activity, where the line falls is often unclear.

Where is service income earned?

Where the work is done. Not where the client is, where the contract was signed or where you are paid (Pub 515, Source of income).

So work a non-resident does outside the US for US clients is generally foreign-source, and the US does not tax it. If you work in both places, split the income on the facts; often by days: US working days divided by total working days (Pub 519, chapter 2).

What about goods and royalties?

Different rules apply. Goods are sourced where they are sold or made, and royalties where the property is used (Pub 519, chapter 2).

• Goods you buy and resell: where they are sold, generally where title passes to the buyer.
• Goods you make and sell across the border: where they are made.
• Sales through a US office: generally US-source, even if the rules above point abroad.
• Royalties for patents, copyrights and similar property: where the property is used.

How is effectively connected income taxed?

Much like a US business's income: on net profit, at the rates US citizens pay (individuals) or the corporate rate (foreign corporations). Individuals get no standard deduction (except some students and business apprentices from India); only deductions tied to the US business, and a few others, reduce the income (Pub 519, chapter 5).

• Individuals file Form 1040-NR. If you had a US trade or business, you must file even with no income from it, or if a treaty exempts it (Form 1040-NR instructions).
• Foreign corporations file Form 1120-F, on the same basis (Form 1120-F instructions).
• File on time, or lose deductions. An individual's return generally must be filed within 16 months of its due date to claim deductions; a corporation's, within 18 months. A non-resident individual or foreign corporation unsure whether it has ECI, or relying on a treaty, can file a protective 1040-NR or 1120-F by that deadline to keep its deductions (Pub 519, chapter 7, Form 1120-F instructions).
• No self-employment tax, usually. Non-resident aliens do not pay US self-employment tax unless a social security (totalization) agreement puts them in the US system (Pub 519, chapter 8).
• Branch profits tax. A foreign corporation with a US business also owes 30% on after-tax US earnings it does not reinvest in that business, unless a treaty lowers it (Form 1120-F instructions, Section III).

How does FDAP withholding work?

The US payer withholds 30% of the gross payment and sends it to the IRS. You claim a lower treaty rate by giving the payer a W-8 form (Pub 519, chapter 8).

Pay for services a non-resident independent contractor performs in the US is also subject to 30% withholding unless an exemption applies (Pub 515). Tax withheld is credited on your 1040-NR or 1120-F; to get back any excess, you must file that return (Pub 519, chapter 7, Form 1120-F instructions).

What do tax treaties change?

A treaty can exempt a resident's business profits unless they are attributable to a US permanent establishment (Pub 519, chapter 9). A permanent establishment is generally a fixed place of business, such as an office, branch, factory or warehouse (Pub 901).

• Treaties differ. Some, including Canada's, can treat services performed in the US as a permanent establishment even without a fixed place (Pub 901). Some use an independent personal services article with a day limit and a "fixed base" test instead. Read your country's treaty on the IRS treaty list.
• Storage and agents. The US model treaty excludes a place used only to store, display or deliver your goods. It counts a US agent (other than an independent broker or agent) who habitually concludes contracts binding you as a permanent establishment, even without an office (US Model Tax Convention, Article 5). Check your own treaty's article on permanent establishment.
• You must qualify. Benefits go to residents of the treaty country, not citizens as such (IRS treaty list). Many treaties add limitation-on-benefits tests (Form 1120-F instructions).
• You still file, and disclose the position. A treaty exemption for business income does not remove the 1040-NR or 1120-F. Claiming that ECI is not attributable to a US permanent establishment generally requires Form 8833 with the return. The penalty for not disclosing is $1,000 per failure, or $10,000 for a C corporation (Form 8833).

How does the business structure change who pays?

The structure decides who the taxpayer is. A disregarded LLC or a partnership passes income to its owners, who apply the ECI and source tests above. A US corporation is taxed itself, on all its income.

• A disregarded LLC is looked through. Its activities are treated as the owner's (26 CFR 301.7701-2(a)), and the owner reports its items on their own return (Pub 519, chapter 7). Forming a disregarded US LLC does not by itself make foreign-source income taxable. When a US client pays your LLC, you, not the LLC, give the W-8 form in your own name; a foreign person may not give a W-9 (W-8BEN instructions, W-9 instructions).
• A US corporation is a US taxpayer. It pays 21% (Form 1120 instructions) on its worldwide income (26 U.S.C. 11, 61), including profit from work its owner does abroad. Dividends from a US corporation are US-source, so the foreign owner faces 30% withholding or the treaty rate.
• Partnerships withhold even without paying out cash. The rate is 37% for non-corporate foreign partners and 21% for corporate ones (IRS: Partnership withholding). The tax is paid in four installments during the year with Form 8813 (by the 15th day of the 4th, 6th, 9th and 12th months), with a penalty for missed ones, then reported on Forms 8804 and 8805 by the 15th day of the 3rd month after year-end (the 6th if the books are kept outside the US). Partners claim it as a credit with Form 8805 (Form 8804 instructions).
• Defaults can be changed. A US LLC is disregarded with one owner and a partnership with two or more, unless it elects to be taxed as a corporation (26 CFR 301.7701-3). A foreign company is not always a corporation for US tax: by default it depends on whether its owners have limited liability, and many can elect (26 CFR 301.7701-3(b)(2)). One taxed as a partnership passes its ECI to its partners and withholds on foreign partners' shares (IRS: Partnership withholding).
• A US entity that pays a foreign person is the withholding agent. When it pays dividends to a foreign owner or fees for US work, it must withhold and file Forms 1042 and 1042-S, and it is personally liable for tax it should have withheld (Pub 515).
• No S corporation. A non-resident alien cannot be an S corporation shareholder (IRS: S corporations).

Which forms will US payers and the IRS ask for?

Sources: W-8BEN, W-8BEN-E, W-8ECI, 8233, Pub 519, chapters 5, 7 and 8, Pub 515, Form 1120-F instructions.

Do states follow the same rules?

Not necessarily. Many states tax income sourced in the state under their own rules, and some do not honor US tax treaties (IRS treaty list). Check each state where you earn income.

Example

Illustrative only. All figures are in US dollars. Ana lives in a country with a US tax treaty and is not a US resident for tax. She consults for US clients in her own name, with no US entity. She earns $120,000 in fees over 240 working days.

Case 1: all work from home abroad. All $120,000 is foreign-source, because the work was done outside the US. She has no ECI and no US income tax on it, and with no other US activity or income, no US return to file. Her clients ask for Form W-8BEN; nothing should be withheld, since the fees are not US-source.

Case 2: 60 of the 240 working days at client sites in the US.

If her treaty exempts business profits and she has no US permanent establishment, the $30,000 may be exempt. She still files Form 1040-NR, with Form 8833. Whether 60 days on client sites creates a permanent establishment depends on her treaty's wording and the facts, such as whether an office is regularly available to her.

Her US days also count toward the test for US residency, and a US resident is taxed on worldwide income (Pub 519, chapter 1).

Case 3: she bills through a US corporation. The corporation is a US taxpayer on its worldwide profit, including profit from the work Ana does abroad. Reasonable pay it gives her for that work is generally a deduction for the corporation (26 U.S.C. 162) and foreign-source income to her (Pub 515); what is left is taxed in the corporation. Dividends it pays her face US withholding.

Different for you?

• You spend long stretches in the US. You may become a US resident for tax. Canadian residents, see snowbirds and US residency; others, see cross-border tax.
• You own a US single-member LLC. See filing for a foreign-owned single-member LLC.
• You live in Canada and own a US LLC. See Canadian owner of a US LLC.
• You are choosing a structure for US business as a Canadian resident. See US business for a Canadian resident.
• You need a 1040-NR, 1120-F or treaty position reviewed. See cross-border tax.
• You are setting up a US entity. See business formation.