FDAP Income

An American company owes you $10,000 for a licence to your software. The money arrives, and it is $7,000. Nobody made a mistake. The payer withheld 30% and sent it to the IRS, because the IRS told them to.

That $10,000 was FDAP income. The letters stand for "fixed, determinable, annual, periodical," which is a phrase from the tax code and tells you almost nothing. What matters is the rule attached to it: a flat 30% of the gross amount, taken by the payer before you are paid, with none of your costs subtracted.

This page explains when that rule applies, when it does not, and what you can do about it. The short version is that FDAP is a non-resident rule. If the IRS counts you as a U.S. person, it does not touch your own income at all.

What the rule actually says

The IRS defines FDAP income by exclusion. It is all income except two things:

1. Gains from the sale of real or personal property.
2. Items of income that are excluded from gross income anyway.

Everything else is in. The IRS lists 24 examples on its FDAP page. The ones founders actually run into are:

• Compensation for personal services, including commissions and gross proceeds from performances.
• Dividends and interest.
• Royalties (software licences, patent licences, book royalties).
• Rents, and other income from real property, but not the gain when you sell it.
• Pensions and annuities, scholarships and fellowship grants, winnings from certain gambling games, alimony.

Two rules then decide what happens to that income.

Rule 1: the rate is 30%. The IRS states that "tax at a 30% (or lower treaty) rate applies to FDAP income or gains from U.S. sources." It is a flat rate. It does not go up or down with how much you earned.

Rule 2: deductions and netting are not allowed. This is the sentence that costs people money. The IRS says it plainly: "Deductions and netting are not allowed against FDAP income."

Take the $10,000 royalty again. Suppose you spent $9,000 on contractors to build the software. Your actual profit is $1,000. The tax is still 30% of $10,000, which is $3,000. You pay $3,000 of tax on $1,000 of profit. There is no line on any form where you subtract the $9,000.

The exception that changes everything

There is one condition in the IRS sentence that people skip over. The 30% applies to U.S. source income "but only if they are not effectively connected with your U.S. trade or business."

So the same $10,000 can be taxed two completely different ways:

• If it is not effectively connected: 30% of the gross, no deductions.
• If it is effectively connected (this is called ECI): it goes on your Form 1040-NR, you subtract your business expenses, and you pay the normal graduated rates on what is left.

That is why FDAP and ECI have to be read together, and why a lot of online writing about them is wrong. They are not two types of income. They are two ways of taxing the same money, and which one applies depends on whether you are running a U.S. trade or business.

Who actually pays it

You do not usually write a cheque for FDAP tax. The payer does it for you, and does it before you are paid.

The IRS calls this NRA withholding, and it is required under sections 1441, 1442 and 1443 of the tax code. The duty sits on the withholding agent, which means the U.S. person or company making the payment, not on you. They withhold the 30%, they send it to the IRS with Form 1042, and they send you a Form 1042-S showing what they took.

This is why the money can disappear without anyone asking your permission. The payer is following a rule that applies to them.

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

FDAP does not apply to your income. There is no separate 30% bucket for you.

Your U.S. and worldwide income is added together, your deductions come off, and you pay the normal graduated rates on your Form 1040. If you earn $10,000 of royalties and spent $9,000 producing them, you are taxed on the $1,000. The whole point of FDAP, taxing the gross amount, is a rule for people the IRS treats as foreign.

But FDAP can still reach you from the other side. You may be the withholding agent.

If your U.S. company pays U.S. source FDAP income to a foreign person, the withholding duty is yours. That includes paying royalties to a foreign licensor, paying interest to a foreign lender, or in some cases paying a foreign individual for services. The rules under sections 1441 to 1443 are written for the payer, and the payer here is you.

In practice that means three things:

• You collect a Form W-8BEN (individual) or Form W-8BEN-E (entity) from the foreign person before you pay them.
• You withhold 30%, or the lower treaty rate if the W-8 supports it.
• You file Form 1042 and issue a Form 1042-S.

Founders who hire abroad often assume "they are foreign, so it is not my problem." When the payment is U.S. source FDAP, it is exactly your problem, because the IRS asks the payer, not the recipient.

🌏 If it does not

FDAP is your rule. Here is what to do with it, in the order that matters.

Step 1. Find out whether your income is FDAP or ECI.

This one question changes the tax more than anything else you can do. Gross at 30%, or net at graduated rates. If you are actually running a business in the United States, the income is likely effectively connected, and the gross-basis 30% is not the right treatment. That is a separate page in this guide, and it is worth reading before you accept a 30% deduction as final.

Step 2. Check whether a treaty or a Code section lowers the rate.

The IRS says a reduced rate, "including exemption," may apply in two cases: if a section of the Internal Revenue Code provides for a lower rate, or if there is a tax treaty between your country of residence and the United States. Most writing on this only mentions the treaty. Both routes exist, and a treaty rate on royalties or interest is often well below 30%.

Step 3. Give the payer a Form W-8BEN before the payment goes out.

The payer cannot apply a treaty rate they do not know about. They withhold 30% by default, because they are the one on the hook if they get it wrong. A W-8BEN that arrives after the payment does not undo the withholding.

Treaty claims also carry a taxpayer identification number requirement. The instructions to Form W-8BEN say that to claim certain treaty benefits you must complete line 5 with an SSN or ITIN, or line 6 with a foreign tax identifying number. There are exceptions, including income from actively traded stocks and mutual funds. Read the instructions before you send the form, so it is not rejected for a missing number.

Step 4. Keep the Form 1042-S.

It is the proof of what was withheld. If too much was taken, you claim it back by filing Form 1040-NR. FDAP income that is not effectively connected goes on Schedule NEC of that return.

Where the two lanes split

Common mistakes

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

• Thinking FDAP has nothing to do with you. If your company pays U.S. source royalties or interest to a foreign person, you are the withholding agent, and the filing duty is yours.
• Paying a foreign contractor or licensor without collecting a Form W-8BEN first. Once the money is gone, you cannot go back and withhold it.
• Confusing Form 1099 with Form 1042-S. Payments to foreign persons are reported on 1042-S, not on a 1099.

🌏 If it does not

• Treating the 30% as the end of the story. Check first whether the income is effectively connected, and second whether a treaty lowers the rate.
• Assuming your expenses will reduce the tax. On FDAP income they do not. The tax is on the gross amount, even if your profit is smaller than the tax.
• Sending the Form W-8BEN after the invoice is paid. The payer withholds at 30% by default, and the form has to be in their hands before the payment.
• Not filing Form 1040-NR when too much was withheld. Over-withheld tax does not come back on its own. You have to claim it.

FAQ

What does FDAP actually stand for?

Fixed, determinable, annual, periodical. The phrase comes from the tax code and does not describe anything useful. The IRS defines FDAP income as all income except gains from the sale of real or personal property, and items already excluded from gross income.

Why did a U.S. client pay me less than the invoice?

They probably withheld 30% as required under sections 1441 to 1443 of the tax code. They should send you a Form 1042-S showing the amount. If a tax treaty gives you a lower rate, you need to give them a Form W-8BEN before the next payment.

Can I deduct my costs against FDAP income?

No. The IRS states that deductions and netting are not allowed against FDAP income. If you earn $10,000 and spent $9,000 earning it, the tax is 30% of $10,000, which is $3,000. This is the main reason people try to establish that their income is effectively connected instead.

What is the difference between FDAP and effectively connected income?

They are two ways of taxing the same money. FDAP is taxed at a flat 30% on the gross amount with no deductions. Effectively connected income is taxed on the net amount at the normal graduated rates, after your business expenses. The 30% FDAP rate only applies to income that is not effectively connected with a U.S. trade or business.

Does FDAP apply to me if I am a U.S. person?

Not to your own income. Your income is taxed on the net amount at graduated rates on Form 1040. But if you pay U.S. source FDAP income to a foreign person, you become the withholding agent and have to withhold, file Form 1042 and issue Form 1042-S.

How do I claim a lower treaty rate?

You give the payer a Form W-8BEN (or Form W-8BEN-E if you are a foreign entity) before they pay you. The IRS also has a taxpayer identification number requirement for treaty claims, so check the form instructions before sending it.

Too much tax was withheld. How do I get it back?

By filing Form 1040-NR. FDAP income that is not effectively connected goes on Schedule NEC of that return. The Form 1042-S from the payer is your evidence of what was withheld. Nothing is refunded automatically.

Is the gain when I sell U.S. property FDAP income?

Usually not. The IRS definition of FDAP income excludes gains from the sale of real or personal property. But the exclusion is not absolute: the IRS list of FDAP examples includes "capital gains (under specified conditions)," and Schedule NEC of Form 1040-NR is where a non-resident figures capital gains that are not effectively connected with a U.S. trade or business. Sales of property are governed by separate rules that this page does not cover.