Earning income in the U.S. is great, but it often comes with several questions. What is considered income? Where can it come from? How is it taxed? When it comes to U.S. taxes, the terms “U.S.-sourced income” and “effectively connected income (ECI)” often get mixed up. They sound similar, but they are two different ways that taxes are identified and how the IRS treats them. Here we will break down them individually, and explain how they compare.
What is U.S.-Sourced Income?
U.S.-sourced income simply refers to any income that come from a service, goods sold, or assets contained within the United States.
Some examples are:
- A nonresident providing consulting services while physically in the U.S.
- Rental income from U.S. properties
- Interest, dividends, or royalties paid by a U.S. payer
The main point is the location — where the income is coming from or where the activity happens.
Pros:
- Clear geo-map: if it happens in the U.S., it’s U.S.-sourced
- Helps determine withholding obligations for foreign payees
Cons:
- Not all U.S.-sourced income is taxed the same way. Some types may be exempt
- It doesn’t tell you how the income is taxed, just where it’s from
What is Effectively Connected Income (ECI)?
Effectively connected income (ECI) is income that’s connected to a trade or business in the U.S. This focuses more on how the income was generated, rather than where it came from. This is the main distinction between ECI and U.S.-sourced income.
Pros:
- ECI allows foreign taxpayers to be taxed on their net basis after deducting business expenses
- You may qualify for lower graduated tax rates similar to a U.S. taxpayer
Cons:
- Requires filing a U.S. tax return
- It can lead to complex situations if the income is only partly connected to U.S. operations
Where you can see this happen
You can see this happen whether it’s a foreign company operating a branch office within the U.S. and earning profits, or a nonresident selling goods through a U.S. distributor. Effectively connected income can come from both U.S.-sourced and foreign-sourced activities, as long as it’s linked to a U.S. trade or business.
Breakdown
| Type of Income | Sourced in the U.S.? | Considered ECI? | How it’s Taxed |
|---|---|---|---|
| Interest or dividends from a U.S. company | Yes | Usually no | Flat 30% withholding (unless reduced by a treaty) |
| Profit from a U.S. business activity | Yes | Yes | Taxed on a net basis (after deductions) |
| Rents from U.S. property (without election) | Yes | No | 30% withholding on gross |
| Rents from U.S. property (with ECI election) | Yes | Yes | Taxed as business income with deductions |
For example:
Let’s say a nonresident owns an apartment building in Florida. If they don’t make any elections, their rental income is going to be U.S.-sourced and subject to the 30% withholding. However, if they choose to treat the activity as a U.S. business, the same income becomes effectively connected, allowing them to deduct things like mortgage interest, maintenance, and property tax.
Manage your income accurately
At the end of the day, the difference between U.S. sourced income and effectively connected income comes down to where your money comes from and how it’s earned. Once you understand the difference, you will be able to manage your business more effectively. Not only will you know where your tax obligations are, but you will now be able to report your income correctly and make better choices about handling your U.S. earnings.
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