Nonresident Alien Withholding: Key Rules for U.S. Source Income

(U.S. tax rules set clear lines for how the government taxes foreign workers and investors inside the United States, especially when it comes to nonresident aliens, withholding, and FDAP income.) The rules split taxable income into two buckets: income that is effectively connected to a U.S. trade or business (ECI), and income that is fixed or determinable, annual, or periodic—better known as FDAP income. The distinction matters because it determines the tax rate applied and whether tax gets taken out of a payment at the time it is made.

Two main income categories: ECI and FDAP

Under longstanding Internal Revenue Code provisions, a foreign person who is a nonresident alien is generally taxed only on U.S. source income. That income falls into two main groups:

• Effectively Connected Income (ECI)
  • Covers business earnings and personal service income tied to work done in the United States (e.g., wages and self-employment pay).
  • Taxed using the same graduated rates applied to U.S. persons.
• FDAP income (Fixed, Determinable, Annual, Periodic)
  • Covers most passive income, such as interest, dividends, rents, and royalties.
  • Usually taxed at a flat 30% rate, unless a tax treaty reduces that rate.

Withholding agent and liability

The withholding system sits at the center of this structure. Under sections 1441, 1442, and 1443 of the Internal Revenue Code:

• The person who pays U.S. source income to a foreign person—the withholding agent—must withhold the correct amount and remit it to the government.
• The withholding agent is personally liable for tax that should have been withheld, even if the foreign recipient later fails to file or pay any tax due.
• If neither party meets the obligation, both can face tax, interest, and penalties.

Important: The personal liability risk drives withholding agents to be conservative and to collect tax at payment when in doubt.

How U.S. source is determined

Source rules look at the type of income and the factor that ties it to the United States. Key rules include:

• Services (wages, contractor fees): source is where the services are performed.
• Interest: source is the residence of the payer.
• Dividends: source is the payer’s status as a U.S. or foreign corporation, with specific exceptions.
• Rents and royalties: source is where the property is located or where rights are used.
• Sales: rules look to where inventory is sold or produced; real property is sourced by location.
• Personal property sales: generally tied to the seller’s tax home, with special allocation rules in some cross-border cases.

When income is ECI vs. FDAP

The line between ECI and FDAP determines whether graduated rates or the flat 30% apply.

• ECI typically includes:
  • A nonresident running a business in the U.S.
  • Performing services in the U.S.
  • Profits from selling inventory in the U.S.
  • A share of a partnership’s U.S. business income
• Tests that can convert investment income into ECI:
  • Business Activities Test: Was the U.S. trade or business a material factor in producing the income?
  • Asset Use Test: Did U.S. assets used in the business produce the income?

If either test is satisfied, certain investment income may be treated as ECI instead of FDAP.

• FDAP is broader and generally covers almost all U.S. source income not tied to sale of real/personal property (and not excluded, like tax-exempt interest). Common FDAP examples are interest, dividends, rents, and royalties.
  • For payments to nonresident aliens, 30% withholding usually applies at payment unless a tax treaty reduces or eliminates the rate.
  • The payer should apply a treaty rate only when proper documentation supports the claim.

Personal services and treaty nuances

A frequent area of confusion is personal services:

• “Independent personal services” in tax treaty language refers to services performed by independent contractors (e.g., lawyers, physicians, accountants) who are not employees.
• If those services are performed in the United States, the income is generally ECI and taxed at graduated rates.
• If performed outside the United States, the payment is foreign source and not subject to NRA withholding.

Foreign workers without legal status

• Immigration status does not affect tax liability. Foreign workers who are in the country unlawfully still owe taxes under the same sourcing and withholding rules.
• Employers face separate enforcement from immigration authorities (fines, sanctions), but for tax purposes payments to such workers carry the same withholding and reporting duties as for other foreign workers.
• If an unlawful worker is a nonresident and receives income from independent personal services, 30% withholding applies unless a treaty or specific law provides an exception.
• If such a worker is a resident alien under tax rules, wages from dependent services are treated the same as pay to U.S. citizens for withholding.

Policy framework and common rates

The government’s approach is straightforward:

• Most U.S. source income paid to a foreign person faces 30% tax, collected through withholding.
• Two major carve-outs:
  1. ECI is taxed at graduated rates similar to U.S. persons (not the flat 30%).
  2. A tax treaty between the U.S. and the payee’s country of residence may reduce the 30% rate for FDAP income.

Practical application:

• Payers often default to 30% withholding on FDAP payments unless they have valid treaty documentation showing a lower rate.
• This default protects the withholding agent from personal liability.

Practical steps for payers and payees

The withholding agent’s responsibilities:

1. Identify whether the payee is a foreign person.
2. Confirm the source of the income.
3. Decide whether the income is ECI or FDAP.
4. Apply the correct rate (often 30% for FDAP absent a treaty claim).
5. Keep records documenting the decision and the documentation relied upon.

Consequences of failure:
– If the withholding agent fails to withhold and the foreign payee does not pay, both parties can be liable for tax, interest, and penalties.

Advice for nonresident payees:
– Track where services are performed.
– Know when income will be treated as ECI.
– Check whether a tax treaty could lower withholding on FDAP income like interest or dividends.

Common scenarios

• A foreign consultant performs all services outside the United States for a U.S. company → Foreign source payment; no NRA withholding.
• A nonresident doctor performs a short assignment in the United States → Fees are U.S. source and likely ECI, taxed at graduated rates.
• A foreign investor receives U.S. dividends → Payment is FDAP; payer withholds 30% unless a treaty reduces the rate and conditions are met.
• A partnership runs a business in the United States → A nonresident partner’s share of U.S. business profits is ECI, taxed at graduated rates.

Timing and special exceptions

• Timing rule: income from a sale, exchange, or service performed in another tax year can be treated as effectively connected in the year it would have been connected had it been recognized then. This preserves consistent treatment over time.
• Dividend source exceptions:
  • A dividend paid by a U.S. corporation can be foreign source when the corporation elects the Puerto Rico economic activity credit or possessions tax credit.
  • Part of a dividend paid by a foreign corporation can be U.S. source if at least 25% of its gross income was ECI over the three preceding tax years.

Summary of the core rules

• Source rules classify income based on place, payer, property, or activity.
• The ECI vs. FDAP split guides the tax rate (graduated vs. 30%).
• The withholding agent enforces the system in real time and bears personal liability for failures.
• Tax treaties can reduce or eliminate the 30% rate on FDAP payments when supported by proper documentation.

Key takeaway: Services done in the United States usually create ECI taxed at graduated rates, while passive investment income from U.S. sources generally faces 30% withholding unless a treaty reduces it.

For authoritative details, the IRS provides a full outline of the Nonresident aliens withholding framework, including definitions, rates, and examples. Review the agency’s page on NRA withholding here: IRS NRA withholding guidance.

(Analysis by VisaVerge.com noted that the two-part structure—ECI at graduated rates and FDAP at a flat 30% unless reduced by treaty—drives most payer decisions. The withholding agent’s risk of liability is a strong incentive to collect the correct tax at payment, especially for routine FDAP income like interest and dividends.)