Effectively connected income explained for foreign owners

Why does ECI matter?

The US taxes non-residents on two kinds of US income, in two different ways:

Foreign-source income that is not effectively connected is generally not taxed by the US at all.

What is the first question?

Whether you are engaged in a trade or business in the United States during the year. Without a US trade or business there is generally no ECI. That question has its own guide: what counts as a US trade or business.

How is US-source income tested?

If you do have a US trade or business, your US-source business income, such as profit from selling goods or services through that business, is generally effectively connected. For US-source investment-type income, such as interest or dividends, two tests decide whether it is connected:

• The asset-use test: whether the income comes from assets used in, or held for use in, the US business, such as cash reserves held for the business's working capital.
• The business-activities test: whether the activities of the US business were a material factor in producing the income, as with a securities dealer's trading income.

Can foreign-source income be ECI?

Only in limited cases. Certain foreign-source income, such as some sales income, rents and royalties, can be effectively connected if it is attributable to an office or other fixed place of business you maintain in the US. Income from work performed outside the US is foreign-source, so a foreign owner who does all the work abroad without a US office generally has no ECI from it.

What does this mean for LLC owners?

• Single-member LLC: the LLC is disregarded, so any ECI is the owner's and goes on the owner's Form 1040-NR. See Form 1040-NR.
• Multi-member LLC: the partnership's trade or business is attributed to each partner, and the partnership generally withholds tax on foreign partners' shares of ECI. See Form 1065.
• LLC taxed as a corporation: as a US corporation it pays 21% on its worldwide income, and ECI is not the relevant question for the company. See LLC or C corp for a foreign founder.

Which deductions are allowed against ECI?

Expenses connected with the effectively connected income, such as business costs, depreciation and state income taxes on that income. Deductions are generally allowed only if a true and accurate return is filed on time, so filing late can cost you the deductions as well as penalties.

How do tax treaties change it?

Under many US tax treaties, a resident of the other country pays US tax on business profits only if they are attributable to a permanent establishment in the US, such as a fixed place of business or a dependent agent who habitually concludes contracts. Where a treaty applies, business profit that would otherwise be ECI can be exempt. Claiming this requires disclosure on Form 8833.

What is the practical takeaway?

The facts that matter are where the work is done, whether you have people, an office or stock in the US, and what kind of income it is. For the overall picture, see whether foreign-owned US LLCs pay US tax.

A foreign company with effectively connected income files Form 1120-F.

This guide is general information. It is not tax or legal advice for your situation.