Nonresident aliens are generally subject to U.S. federal income tax on income connected with the United States rather than on worldwide income. The tax treatment depends heavily on where the income is sourced and whether it is effectively connected income (ECI) or U.S.-source income that is not effectively connected with a U.S. trade or business. Income in the second category is often discussed under the FDAP rules.
How U.S. Taxation Works for Nonresident Aliens
For federal tax purposes, an alien is an individual who is not a U.S. citizen. The IRS generally classifies alien individuals as resident aliens or nonresident aliens for each tax year. Resident aliens are generally subject to U.S. tax on worldwide income, while nonresident aliens are taxed under narrower rules.
The IRS explains in Publication 519, U.S. Tax Guide for Aliens, that taxable income of a nonresident alien generally falls into two categories: income effectively connected with a U.S. trade or business and U.S.-source income that is not effectively connected with a U.S. trade or business.
U.S.-Source Income and Foreign-Source Income
The source of income is one of the first issues in nonresident taxation. Different sourcing rules apply to different types of income. Compensation for personal services is generally sourced according to where the services are performed. Dividends, interest, rents, royalties, scholarships, pensions, and gains can follow different rules.
For example, compensation for work physically performed in the United States is generally U.S.-source income even if the employer is foreign or the payment is deposited into a bank account outside the United States. Compensation for services performed outside the United States is generally foreign-source income, subject to specific exceptions.
Foreign-source income of a nonresident alien is generally outside U.S. federal income tax unless a rule causes that income to be treated as effectively connected with a U.S. trade or business. This differs from the worldwide-income system that generally applies to U.S. citizens and resident aliens.
ECI and FDAP: Two Different Tax Treatments
ECI and income taxed under the FDAP rules are treated differently. The distinction affects the tax rate, whether deductions are allowed, where income appears on Form 1040-NR, and how withholding may apply.
| Category | General Treatment | Deductions | Typical Reporting |
|---|---|---|---|
| Effectively Connected Income (ECI) | Generally taxed at the graduated rates that apply to U.S. citizens and resident aliens. | Allowable deductions connected with the income may generally be taken. | Reported through the applicable sections and schedules of Form 1040-NR. |
| U.S.-Source FDAP Not Effectively Connected | Generally taxed on the gross amount at 30% unless a treaty or another rule provides a lower rate or exemption. | Deductions generally are not allowed against this income. | Generally reported on Schedule NEC (Form 1040-NR) when return reporting is required. |
Effectively Connected Income
Effectively connected income is income connected with the conduct of a U.S. trade or business. The IRS explains on its Effectively Connected Income page that performing personal services in the United States will usually cause a foreign person to be treated as engaged in a U.S. trade or business.
Wages and other compensation for services performed in the United States are therefore common examples of ECI for nonresident individuals. Business income can also qualify. A foreign person who is a member of a partnership that conducts a U.S. trade or business may be treated as engaged in that U.S. trade or business as well.
ECI is generally taxed on a net basis. Allowable deductions connected with the income can reduce the amount subject to tax, and the remaining taxable income is generally subject to graduated federal income tax rates.
FDAP Income
FDAP means fixed, determinable, annual, or periodical income. When U.S.-source FDAP income is not effectively connected with a U.S. trade or business, it is generally taxed at 30% of the gross amount unless an income tax treaty or another federal rule provides a lower rate or exemption.
Dividends, rents, royalties, annuities, and certain interest payments are common examples. FDAP is often described as passive income, but the legal category is broader than passive investment income. The IRS notes that salaries, wages, and other compensation can fall within the general FDAP definition; compensation for services performed in the United States, however, is usually treated as ECI because performing those services generally constitutes a U.S. trade or business.
The IRS provides more detail on its FDAP income page.
How Deductions Differ Between ECI and FDAP
The difference between gross-basis and net-basis taxation can have a large effect on the final tax amount. A nonresident alien with ECI may generally deduct qualifying expenses that are properly connected with that income. The deduction rules still depend on the type of expense and the requirements that apply to nonresident taxpayers.
U.S.-source FDAP income that is not effectively connected is different. The 30% statutory tax generally applies to the gross payment, and ordinary deductions are not taken against that income. A treaty can reduce the rate for qualifying income, but it does not automatically convert the income into ECI.
Withholding and the Final Tax Are Not Always the Same
Much of the U.S. tax on payments to nonresident aliens is collected through withholding. A payer may withhold federal tax before paying dividends, royalties, scholarships, compensation, or other reportable income to a foreign person.
For U.S.-source FDAP income that is not ECI, withholding is commonly based on the 30% statutory rate unless a lower treaty rate or exemption has been properly documented. A foreign individual may provide Form W-8BEN to a withholding agent for certain payments when foreign status or treaty eligibility needs to be documented.
The amount withheld is not automatically the taxpayer’s final U.S. liability in every situation. A return may be needed to report other income, reconcile withholding, claim a refund, or apply tax treatment that was not reflected correctly when the payment was made.
Form 1042-S and Other Income Documents
A nonresident alien may receive Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, when a withholding agent reports certain payments made to a foreign person. The form identifies the income code, gross income, withholding rate, federal tax withheld, and other information used under the foreign-person reporting rules.
Form 1042-S can appear for dividends, royalties, scholarship or fellowship payments, compensation, treaty-exempt amounts, and other reportable payments depending on the circumstances. It is possible to receive more than one Form 1042-S, or to receive both a Form 1042-S and a Form W-2 during the same year.
A Form W-2 generally reports employee wages and wage withholding. The presence of a W-2 or 1042-S does not by itself determine whether the individual is a resident or nonresident for tax purposes.
Capital Gains Follow Separate Rules
Capital gains do not fit neatly into the common description of FDAP income. In general, capital gain income is not usually subject to U.S. federal income tax for a nonresident alien who is present in the United States for fewer than 183 days during the tax year, provided the gain is not effectively connected with a U.S. trade or business and no other special rule applies.
If a nonresident alien is present in the United States for 183 days or more during the tax year, certain U.S.-source net capital gains can be subject to a 30% tax or a lower treaty rate. This 183-day rule is separate from the weighted 183-day calculation used by the substantial presence test. A person can remain a nonresident alien under the residency rules and still reach 183 actual days of presence for the capital-gains rule.
The source of a capital gain can also depend on tax-home rules and the type of property being sold. Gains involving U.S. real property are subject to a separate set of rules.
U.S. Real Property Can Be Taxed Differently
Rental income from U.S. real property owned by a nonresident alien is generally subject to the 30% gross-basis rules when the income is not effectively connected with a U.S. trade or business and no lower treaty rate applies.
A nonresident alien who owns U.S. real property held for the production of income may be able to make an election under Internal Revenue Code Section 871(d) to treat the income as effectively connected with a U.S. trade or business. When the election applies, eligible expenses connected with the property can generally be taken into account and the net income is taxed under the ECI rules.
The IRS discusses the election on its Nonresident Aliens — Real Property Located in the U.S. page.
Sales of U.S. real property interests receive different treatment. Under the U.S. real property rules, gain or loss from the sale or exchange of a U.S. real property interest is generally treated as effectively connected with a U.S. trade or business. Separate withholding rules may also apply to the transaction.
Interest Is Not Always Taxed at 30%
The general 30% FDAP rate should not be applied mechanically to every interest payment. U.S. tax law contains exclusions for some types of interest received by nonresident aliens, and tax treaties can also affect the rate.
For example, certain portfolio interest can qualify for exemption from U.S. federal income tax when the statutory requirements are met. Certain deposit interest paid by U.S. banks and similar institutions can also receive different treatment. The exact result depends on the payer, account or debt instrument, beneficial owner, documentation, and any applicable exception.
Tax Residency Still Determines Which System Applies
The ECI and FDAP rules discussed here apply to a person who is a nonresident alien for federal tax purposes. If the person becomes a resident alien, the scope of U.S. taxation generally changes to worldwide income.
Federal tax residency is commonly determined through the green card test and substantial presence test. Some people can exclude qualifying days from the substantial presence calculation, and other exceptions or treaty provisions can affect the result.
For certain students, teachers, trainees, and other qualifying individuals, Form 8843 is used to explain excluded days of U.S. presence. This day-counting issue is separate from whether wages, scholarship payments, dividends, or other income are actually taxable.
International Students, Scholars, Teachers, and Trainees
International students and exchange visitors can remain nonresident aliens for tax purposes while certain days are excluded from the substantial presence test. During that period, their U.S. income is still analyzed under the nonresident income rules.
Wages for services performed in the United States are generally ECI. Scholarship and fellowship payments require a separate review because tax treatment can depend on what the payment covers, whether it is taxable under federal law, whether a treaty provision applies, and how the institution reports the payment.
Capital gains deserve separate attention for students and scholars who remain nonresidents for long periods. A person may continue to exclude days for substantial presence purposes while nevertheless accumulating 183 or more actual days of presence during the calendar year. The separate capital-gain rule can then become relevant.
Tax Treaties Can Reduce or Remove U.S. Tax
The United States has income tax treaties with many countries. A treaty may reduce the federal tax rate or exempt qualifying income when the recipient satisfies the requirements of the applicable treaty article.
Different treaty provisions can apply to dividends, interest, royalties, compensation, pensions, scholarships, students, teachers, researchers, or other income. Eligibility can depend on treaty residence, the type of activity, length of stay, time limits, saving-clause provisions, and required documentation.
A treaty rate is not based simply on citizenship. The specific treaty and article should be checked before applying an exemption or reduced rate. The IRS maintains current treaty documents and related material on its Tax Treaties page.
How Form 1040-NR Reflects the Tax Treatment
Nonresident aliens who are required to file an individual U.S. income tax return generally use Form 1040-NR. ECI and income that is not effectively connected are not simply combined and taxed in the same manner.
ECI flows through the applicable portions and schedules of Form 1040-NR and is generally taxed at graduated rates after allowable deductions. U.S.-source income that is not effectively connected and is subject to the flat-rate rules is generally reported on Schedule NEC (Form 1040-NR).
A person does not necessarily have to file Form 1040-NR merely because a U.S. payer withheld tax. Conversely, withholding does not prove that no return is required. The filing rules depend on the person’s activities, income, withholding, treaty position, and reason for filing.
Federal and State Income Tax Can Treat the Same Person Differently
Federal nonresident alien status does not determine state income tax residency. States use their own residency, domicile, part-year residency, and income-sourcing rules.
A person who files as a nonresident alien federally may therefore have a resident, part-year resident, or nonresident filing position at the state level. State treatment of wages, scholarships, investment income, and treaty-exempt federal income can also differ. The rules of the state connected with the person’s residence or income need to be checked separately.
Examples of How the Tax Rules Can Differ
| Situation | Possible Federal Treatment |
|---|---|
| Employee performs services in the United States | Compensation is generally U.S.-source ECI and is generally taxed at graduated rates. |
| Nonresident receives dividends from a U.S. corporation | Dividends are generally U.S.-source FDAP income subject to 30% withholding or a lower applicable treaty rate when not ECI. |
| Nonresident receives rent from U.S. real property | Rental income can be subject to the gross 30% rules, or the taxpayer may qualify to elect ECI treatment under Section 871(d). |
| Nonresident sells a U.S. real property interest | The gain is generally treated as effectively connected income under the U.S. real property rules, with separate withholding provisions potentially applying. |
| Nonresident sells stock while present in the United States for fewer than 183 days | Capital gain is generally not subject to U.S. federal income tax when it is not ECI and no special rule applies. |
| Nonresident is present for 183 or more days and has U.S.-source net capital gains | A separate 30% capital-gain rule may apply, subject to sourcing rules and any applicable treaty. |
Educational Note
Nonresident taxation can change when the source of income, connection to a U.S. trade or business, days of presence, real-property ownership, treaty eligibility, or an available tax election changes. This page provides general tax information rather than tax, legal, financial, or immigration advice. Current IRS instructions and the rules for the tax year involved should be checked before filing.
FAQ
Are Nonresident Aliens Taxed on Worldwide Income?
Generally, no. Nonresident aliens are generally subject to U.S. federal income tax on U.S.-source income and certain foreign-source income that is effectively connected with a U.S. trade or business. Resident aliens are generally subject to U.S. tax on worldwide income.
What Is the Main Difference Between ECI and FDAP?
ECI is generally taxed on a net basis at graduated rates after allowable connected deductions. U.S.-source FDAP income that is not effectively connected is generally taxed on the gross amount at 30% unless a treaty or another rule provides a lower rate or exemption.
Is All FDAP Income Passive Income?
No. FDAP is broader than passive investment income. Dividends, rents, royalties, and certain interest are common examples, but salaries and other compensation can also fit the general FDAP definition. Compensation for personal services performed in the United States is usually ECI because performing those services generally constitutes a U.S. trade or business.
Can a Nonresident Alien Deduct Expenses?
Deductions may generally be available when they are properly connected with ECI and otherwise allowed under federal tax law. Deductions generally are not allowed against U.S.-source FDAP income taxed on the gross basis under the 30% rules.
Are Stock Capital Gains Always Tax-Free for a Nonresident Alien?
No. Capital gains can be taxable when they are effectively connected with a U.S. trade or business, involve U.S. real property, or fall under the separate rule for certain U.S.-source capital gains of a nonresident alien present in the United States for 183 days or more during the tax year. Treaty provisions can also change the result.
Is the 183-Day Capital Gains Rule the Same as the Substantial Presence Test?
No. They are separate rules. The substantial presence test uses a weighted calculation involving the current year and two preceding years. The capital-gains rule looks at actual presence in the United States for 183 days or more during the tax year.
Can U.S. Rental Income Be Treated as ECI?
Yes. A qualifying nonresident alien who owns U.S. real property held for income production may elect under Section 871(d) to treat qualifying real-property income as effectively connected with a U.S. trade or business. The election changes the income from gross-basis treatment to net-basis ECI treatment when the requirements are satisfied.
Does Tax Withholding Mean No Form 1040-NR Is Needed?
Not necessarily. Withholding and filing are related but separate issues. A return may still be required, or a taxpayer may file to claim a refund or report other income. In some cases, correctly withheld tax can satisfy the tax on particular income without creating a filing requirement by itself.
Resources Used
- IRS Publication 519 — U.S. Tax Guide for Aliens — Explains federal taxation of resident and nonresident aliens, ECI, income subject to the 30% tax, deductions, and related filing rules.
- IRS — Taxation of Nonresident Aliens — Summarizes the different federal treatment of ECI and U.S.-source income that is not effectively connected.
- IRS — Effectively Connected Income — Explains U.S. trade or business rules, ECI tax treatment, partnership activity, personal services, and U.S. real property gains.
- IRS — Fixed, Determinable, Annual, or Periodical Income — Explains the scope of FDAP income and the general 30% gross-basis tax.
- IRS — Characterization of Income of Nonresident Aliens — Describes ECI, FDAP, deductions, and Form 1040-NR reporting treatment.
- IRS — Federal Income Tax Withholding and Reporting on Other Kinds of U.S. Source Income — Covers withholding and tax treatment for dividends, interest, royalties, capital gains, and other payments to nonresident aliens.
- IRS — Taxation of Capital Gains of Nonresident Students, Scholars and Employees of Foreign Governments — Explains the separate 183-day capital-gain rule and how it differs from substantial presence.
- IRS — Nonresident Aliens: Real Property Located in the U.S. — Explains gross-basis taxation of U.S. rental income and the Section 871(d) election for ECI treatment.
- IRS — About Form 1040-NR — Provides the federal income tax return used by nonresident alien individuals when filing is required.
- IRS — About Form 8843 — Explains the statement used by certain individuals when excluding days for substantial presence purposes.
- IRS — Exempt Individual Who Is a Student — Explains student day-count exclusions and related Form 8843 requirements.
- IRS — Tax Treaties — Provides U.S. income tax treaties and related federal treaty information.