IRS Income Sourcing Rules: US Tax of Resident & Nonresident Aliens

Sources of Income

IRS Income Sourcing Rules

IRS Income Sourcing Rules: One of the most important aspects of determining whether or not income is taxable in the United States is determining where the income is sourced. For example, is the income considered sourced in the United States or is it considered foreign income? To a US person who has a worldwide income tax requirement, it is not that big of an issue since the United States taxes individuals on their worldwide income (unless the SPT Closer Connection Exception or a Treaty Position applies). But, when it comes to nonresidents who have investments or other businesses in the USA, it can become a much more complicated and important issue. Below are some basic rules when it comes to sourcing for individuals — noting, there are many exceptions, exclusions, and limitations.

US Person vs. Nonresident Alien

It is important to take note of the difference between these two very important terms.

US Person

A US person refers to either a US Citizen, Legal Permanent Resident, or Foreign National who meets the Substantial Presence Test. When a person is considered a US person, they are subject to Citizen-Based Taxation (CBT). CBT is not just limited to citizens; it includes all US person individuals. When a person is considered a US Person, they are subject to US tax on their worldwide income. Thus, a US person is taxed on their global income whether or not they reside in the United States or abroad — and whether or not the income is sourced in the United States or outside the United States.

Nonresident Alien

A Nonresident Alien (NRA) is a foreign national individual who does not fall into any of the above-referenced categories identified under the US person title above. A Nonresident Alien is only required to pay US tax on their US-sourced income (FDAP or ECI) — subject to treaty exemptions. As a result, the sourcing rules are very important because it will impact whether or not they have US-sourced income.

Earned Income

The sourcing rules for earned income (such as wages or personal services) is generally determined by the location where the services are performed. For example, if a Nonresident Alien comes to the United States for a project — then absent some exception, exclusion, or limitation, the income is taxable as US-sourced. If only a portion of the services are performed in the United States, then the income sourcing is apportioned between the different locations in which the personal services were performed.

Rental Income

Since property is unique to each specific location, the sourcing rules for rental income is based on the location of the property and the rules can get complicated. For example, when an NRA owns property in the United States, the rental income they receive is considered FDAP. In addition, the renter is “supposed to” withhold 30% for submission to the IRS. The Nonresident Alien may be able to make an election to treat the rent as ECI in order to pay progressive tax rates and claim deductions for the property.

When it comes time to sell the property, if it is owned by a Nonresident Alien then it may become subject to FIRPTA — which is its own special type of headache.

Dividends

Dividends are typically sourced at the location of the company’s incorporation. Therefore, if it is a US company that issues dividends, those dividends will be considered US-sourced. If instead, it was a foreign company that issues the dividends, then they are considered foreign-sourced. Of course, there are many complexities with this rule, and when at least 50% of the corporation’s income (when averaged over three prior years) is US-sourced, then the dividend may be considered US-sourced even when it is from a Foreign Corporation. In addition, several other complicated exceptions, exclusions, and limitations do apply.

Capital Gains

In general, as long as a person does not exceed the 183-days present in the United States rule, capital gains are not taxable — except in certain situations or if they are effectively connected with a trade or business in the United States during the tax year.

Interest Income

Interest income is sourced in the country that the taxpayer resides in.

For example, if a US person resides in Taiwan and earns interest income from an account in Taiwan, then that income is considered Taiwanese income — and sourced in Taiwan.  If it is a a US person earning Taiwanese interest income, they would still have to report their Taiwanese income on their US tax return — because the United States taxes individuals on their worldwide income.

Meanwhile, a foreign national with Taiwanese interest income would not have to report either their Taiwanese income or US interest income on a US tax return (1040NR) because interest income is sourced in the country a person resides. A Nonresident Alien who resides outside of the United States is not a US person, so is not subject to tax on worldwide income. If they file a 1040NR to report US-sourced income, they would not include their foreign interest income.

Royalties

Royalty income is sourced where the royalty is being used. For example, if a person licensed the rights for use in the US, then the source of the income would be the United States  — even if the person who is using it resides outside of the US.

Sale of Real Property

The sale of real property is based on the location of the property. And, while capital gains earned from a US corporation is usually sourced in the US and not taxable to an NRA (unless they fail the 183-days test), USRPI such as real estate is excluded from this exception.

Sourcing of Pension and Retirement Plans

The sourcing of pension can be unnecessarily complicated. Generally, the contributions are based on where the person works. That is because the sourcing rules for personal services are where the services are performed. When it comes to the pension earnings and accruals, that will be the location of the pension fund. And, when it is time for distribution (at least with treaty countries), the pension is taxable (if at all) in the country of taxpayer’s residence.

Income Sourcing Rules are Complicated

The sourcing rules are very complicated and impact how certain income may be taxed. It can significantly impact the way something is taxed. Especially for unsuspecting taxpayers who misjudge how their income is sourced, it can lead to an unexpected tax liability. This is why tax planning is a very important exercise for international taxpayers.

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