Effectively Connected Income (ECI)

The United States taxes a foreign person's U.S. income in two completely different ways, and the label on your income decides which one you get.

The first way is called effectively connected income, or ECI. It means income that is connected to a trade or business you carry on in the United States. It is taxed on your profit, after you subtract your costs, at the same graduated rates Americans pay.

The second way applies to income that is not connected to a U.S. trade or business. That income can be taxed at a flat rate of 30% of the gross amount, with no deductions, and the tax is usually taken out before the money reaches you. Two people can receive exactly the same dollar and pay very different amounts of tax on it, depending on which category it falls into. This page explains how the United States decides.

What the rule actually says

The IRS states the rule in one sentence: "Generally, when a foreign person engages in a trade or business in the United States (USTB), all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI)."

So there are two questions, in order.

Question 1: are you engaged in a U.S. trade or business?

The IRS gives the general case: "A foreign person usually is engaged in a U.S. trade or business when the foreign person performs personal services in the U.S." But it adds a limit. The activities "must be 'considerable, continuous and regular' to qualify."

Each of those three words does work. A single sale is not continuous. A one-week trip is not regular. The IRS is looking at what you actually do inside the country, not at what your paperwork says.

Two situations get you there automatically:

• You are a partner in a partnership that is itself engaged in a U.S. trade or business. The IRS says that if a foreign person is a member of a partnership that is engaged in a U.S. trade or business "at any time during the tax year," then that foreign person is considered engaged in a U.S. trade or business too. You do not have to set foot in the country. Note the condition: it is the partnership's activity that triggers this, not the fact that the partnership was formed in the United States.
• You are in the United States on an F, J, M or Q visa. A nonresident alien in one of those categories is treated as engaged in a U.S. trade or business, as a nonimmigrant, by rule.

Question 2: is the income connected to that business?

If you are engaged in a U.S. trade or business, U.S. source income connected with that business is ECI. For business income this is usually obvious. For investment income it is not, so the IRS applies two tests:

• The asset-use test. "The income must be associated with U.S. assets used in, or held for use in, the conduct of a U.S. trade or business."
• The business-activities test. "The activities of that trade or business conducted in the United States are a material factor in the realization of the income."

If either test is met, investment income that would otherwise be taxed at the flat rate becomes ECI instead.

What ECI treatment does to your tax

The IRS says ECI "is taxed at graduated rates or lesser rates under a tax treaty on the net ECI," and that "deductions are allowed against gross ECI to arrive at taxable net ECI."

Here is what that means with numbers. Suppose you receive $100,000 of U.S. royalties and you spent $70,000 producing the thing that earns them.

• If the income is not ECI, the flat 30% rate applies to the gross amount. That is 30% of $100,000, so $30,000 of tax. Your $70,000 of costs change nothing.
• If the income is ECI, you subtract the costs first. You are taxed on $30,000 of net profit, at graduated rates that start low.

Same money, very different result.

Two special rules worth knowing

Real property. Gains and losses from the sale or exchange of U.S. real property interests are taxed as if the foreign person were engaged in a U.S. trade or business, and the foreign person must treat the gain or loss as effectively connected with it. Separately, income from renting out U.S. real property "may be treated as ECI if an NRA elects to do so." Rent is one of the few places where you choose the category, and the choice matters because only the ECI route lets you deduct rental costs.

Timing. Income you receive in a later year, from a transaction that happened while you were engaged in a U.S. trade or business, is treated as ECI in the year you receive it if it would have qualified in the year of the transaction.

🇺🇸 If the IRS counts you as a U.S. person

ECI does not change your own tax bill, and you can stop looking for it on your return.

A U.S. person pays U.S. tax on income earned anywhere in the world, at graduated rates, with deductions. The ECI and non-ECI split exists to decide how much of a foreign person's income the United States gets to tax, and how. You are already taxed on all of it, so the question never arises for you.

There are two places where it still lands on your desk.

• You pay a foreign person. If your U.S. company pays royalties, interest, service fees or dividends to someone outside the country, you are the one who has to decide whether to withhold. Under IRC §1461, a person required to withhold is "made liable for such tax," so failing to withhold leaves the payer holding the bill.
• You have a foreign partner. If your partnership is engaged in a U.S. trade or business, bringing a non-resident in makes that person engaged in a U.S. trade or business too, whether or not they ever visit. The partnership takes on withholding duties. Founders usually discover this after the operating agreement is signed.

🌏 If it does not

This is the central question of your U.S. tax life, and nobody sends you a letter about it.

Work through it in the same order the IRS does.

1. Are your U.S. activities "considerable, continuous and regular"? Be honest about what you actually do in the country, not about where the company is registered. Registering an LLC in Wyoming is a filing. Performing services in the United States month after month is an activity. The IRS looks at the second one.
2. If you are engaged in a U.S. trade or business, expect to file a U.S. return. ECI is not settled by withholding at the source. It is reported, with your deductions, and taxed on the net amount.
3. If some of your income is investment income, run the two tests. Ask whether the asset that produced it is used or held for use in your U.S. business (asset-use test), and whether your U.S. business activities were a material factor in earning it (business-activities test).
4. Check whether a treaty gives you a lower rate. The IRS text says ECI is taxed "at graduated rates or lesser rates under a tax treaty." Treaties are country by country, so the answer depends on where you are resident.

Two groups often get caught here. Students and trainees on F, J, M and Q visas are treated as engaged in a U.S. trade or business by rule, and the taxable part of a U.S. source scholarship or fellowship grant received in that status is treated as effectively connected. And anyone who joins a partnership that is engaged in a U.S. trade or business becomes engaged in one too, through the partnership alone.

What changes when the answer flips

Common mistakes

🇺🇸 If the IRS counts you as a U.S. person

• Looking for "ECI" on your own return. It is not there. Your worldwide income is taxed either way.
• Paying a foreign contractor, licensor or lender without deciding whether to withhold. The obligation sits with you as the payer.
• Adding a foreign partner to a U.S. partnership without checking what it does to that partner and to the partnership's withholding duties.

🌏 If it does not

• Assuming that registering a U.S. company automatically creates a U.S. trade or business. The test is about activities that are considerable, continuous and regular, not about a filing.
• Assuming the opposite: that because you have no U.S. office, no U.S. tax can apply. Personal services performed in the country, or membership in a U.S. partnership, can put you inside the rule.
• Treating tax withheld at the source as the end of the story. If the income is ECI, it belongs on a U.S. return, taxed on the net amount.
• Being on an F, J, M or Q visa and assuming you are outside all of this. You are treated as engaged in a U.S. trade or business, and a taxable scholarship or fellowship grant is treated as effectively connected.

FAQ

What is effectively connected income, in one sentence?

It is U.S. source income connected with a trade or business that a foreign person carries on in the United States. The IRS taxes it on the net amount, after deductions, at graduated rates.

Does forming a U.S. LLC make my income ECI?

Not by itself. The question is whether you are engaged in a trade or business in the United States, and the IRS requires activities that are "considerable, continuous and regular." A registration certificate is not an activity. What you actually do inside the country is what gets tested.

How is ECI taxed differently from income that is not effectively connected?

ECI is taxed on net profit at graduated rates, or at a lower rate under a tax treaty, and deductions are allowed against it. FDAP income, the main category of income that is not effectively connected, is taxed at a flat 30% of the gross amount. The IRS states that "deductions and netting are not allowed against FDAP income," and it is usually withheld before you receive it.

I am a foreign partner in a U.S. partnership. Am I engaged in a U.S. trade or business?

Only if the partnership is. The IRS says that if a foreign person is a member of a partnership that is engaged in a U.S. trade or business at any time during the tax year, that foreign person is considered engaged in a U.S. trade or business. Physical presence is not required. But the trigger is the partnership's activity, not the fact that it is a U.S. partnership.

I am on an F-1 visa. Does this apply to me?

Yes. A nonresident alien temporarily present on an F, J, M or Q visa is treated as engaged in a U.S. trade or business. The taxable part of a U.S. source scholarship or fellowship grant received in that status is treated as effectively connected income.

Is rent from a U.S. property automatically ECI?

No. Rental income from U.S. real property may be treated as ECI, but only if the nonresident alien elects that treatment. The election matters because rental expenses are usually large, and only the ECI route lets you deduct them.

I sold a U.S. property. Is the gain ECI?

Gains and losses from the sale or exchange of U.S. real property interests are taxed as if the foreign person were engaged in a U.S. trade or business, and the foreign person must treat the gain or loss as effectively connected with that business. This holds whether or not the property was a capital asset.

I closed my U.S. business last year but money from it arrived this year. Is it still ECI?

It can be. Income received in a later year, from a transaction that took place while you were engaged in a U.S. trade or business, is treated as ECI in the year you receive it if it would have qualified as ECI in the year of the transaction.

Can investment income become ECI?

Yes. The IRS applies two tests. Under the asset-use test, the income must be associated with U.S. assets used in, or held for use in, a U.S. trade or business. Under the business-activities test, the activities of that U.S. business must be a material factor in earning the income. If either is met, the income is treated as ECI instead of being taxed at the flat rate.