Sergei Tokmakov, Attorney — California Bar #279869
The Critical Distinction
When I work with foreign investors, one of the first things I explain is the difference between Effectively Connected Income (ECI) and Fixed, Determinable, Annual, Periodical (FDAP) income. This classification determines how the IRS taxes your US-source income.
Get this wrong, and you could face unexpected tax bills, penalties, or missed opportunities to reduce your tax burden. Let me walk you through how each works.
What Is FDAP Income?
FDAP income is passive income that does not require your active involvement in a US trade or business. The IRS taxes FDAP income at a flat 30% rate (or lower treaty rate) with no deductions allowed.
Common Types of FDAP Income
- Dividends from US corporations
- Interest from US sources (with exceptions)
- Rents from US real estate (unless you elect ECI treatment)
- Royalties for use of intellectual property in the US
- Certain gains from disposal of timber, coal, or iron ore
- Gambling winnings from US sources
FDAP is taxed at 30% of the gross amount - not net. You cannot deduct expenses against FDAP income. If you receive $100,000 in rent but have $80,000 in expenses, you still owe $30,000 in tax (30% of $100,000), not $6,000 (30% of $20,000 profit).
What Is Effectively Connected Income (ECI)?
ECI is income connected to the conduct of a US trade or business. Unlike FDAP, ECI is taxed at graduated rates (like a US person) and allows deductions for business expenses.
Income That Is Generally ECI
- Income from operating a business in the US
- Wages or compensation for services performed in the US
- Income from selling inventory in the US
- Real estate income when you make the Section 871(d) election
- Partnership income from a US trade or business
With ECI, you file a US tax return (Form 1040-NR) and pay tax only on your net profit after deducting legitimate business expenses. For most active investments, this results in significantly lower taxes than the 30% gross FDAP rate.
Side-by-Side Comparison
| Characteristic | FDAP Income | ECI (Effectively Connected) |
|---|---|---|
| Tax Rate | Flat 30% (or treaty rate) | Graduated rates (10% - 37%) |
| Tax Base | Gross income | Net income (after deductions) |
| Deductions Allowed | No | Yes |
| Tax Return Required | Generally no (withholding is final) | Yes (Form 1040-NR) |
| Collection Method | Withholding at source | Estimated payments + annual return |
| Treaty Benefits | Reduced rates available | Exemptions may apply |
The Real Estate Election: Section 871(d)
For foreign investors in US real estate, there is a powerful planning tool: the Section 871(d) election. By default, rental income is FDAP (30% of gross rent). But you can elect to treat it as ECI.
Without Election (FDAP): You receive $120,000 in annual rent. Tax = $36,000 (30% of gross).
With 871(d) Election (ECI): Same $120,000 rent, but you have $80,000 in expenses (mortgage interest, property taxes, depreciation, management fees). Net income = $40,000. Tax at 22% bracket = approximately $8,800.
Savings: $27,200 per year.
The 871(d) election requires annual filing of Form 1040-NR. If you fail to file timely, you may lose the election benefits and face penalties. I always recommend my clients work with a US tax professional to maintain compliance.
Portfolio Interest Exemption
One important exception to FDAP taxation: the portfolio interest exemption. Interest on certain debt obligations is exempt from the 30% withholding tax if it qualifies as portfolio interest.
Requirements for Portfolio Interest
- The debt must be in registered form
- You cannot own 10% or more of the borrower (for corporations)
- The interest must not be contingent interest
- You must provide Form W-8BEN to the payer
This exemption is why many foreign investors prefer lending to US entities rather than taking equity positions - the interest can be tax-free while dividends face 30% withholding.
Branch Profits Tax: The ECI Penalty
There is a catch with ECI. Foreign corporations conducting business in the US face an additional 30% branch profits tax on earnings removed from the US. This is designed to approximate the dividend withholding that would apply if the foreign company had formed a US subsidiary.
For foreign corporations, the combination of regular corporate tax plus branch profits tax can result in effective rates exceeding what a US corporation would pay. Careful structure planning - possibly using a US subsidiary - may reduce total tax burden.
How I Help Foreign Investors
Navigating ECI versus FDAP classification requires understanding both tax law and your specific investment structure. When you work with me, I analyze:
- Whether your income should be classified as ECI or FDAP
- Available elections to optimize your tax treatment
- Treaty benefits that may reduce your rates
- Entity structuring to minimize overall tax burden
- Compliance requirements to avoid penalties
Need Help With US Tax Classification?
Schedule a consultation to discuss how ECI and FDAP rules apply to your specific investment situation.