Understanding how income is treated as effectively connected is essential for international taxpayers filing a U.S. tax return. This article explains effectively connected income and how the ECI tax applies to foreign persons engaged in a U.S. trade or business.
What is Effectively Connected Income?
Effectively connected income (ECI) is income earned by a foreign person—such as a nonresident alien or a foreign corporation—that is connected to a trade or business carried out in the United States. For income tax purposes, this income is taxed similarly to that of U.S. citizens and resident aliens, meaning it is subject to graduated rates rather than a flat withholding.
Examples include:
- A foreign person engaged in a trade of selling goods through a U.S. office.
- A consultant traveling to the United States selling services and being paid for personal services.
- Rental or real property interests from managing apartments in the United States.
This type of business in the United States is effectively connected with U.S. activities. The IRS applies tests like the asset use test and the business activities test to determine whether income should be treated as effectively connected.
How is ECI taxed for foreign persons?
The ECI tax is calculated on a net basis—a foreign person can claim deductions for related expenses before tax is applied. In contrast, passive or fixed income that is not effectively connected is generally taxed at a flat 30% withholding tax rate, unless a tax treaty provides relief.
- Individuals (nonresident aliens): ECI is taxed at progressive graduated rates. For the 2025 tax year, rates start at 10% on income up to $11,925 and go up to 37% on taxable income above $626,351.
- Foreign corporations: ECI is generally taxed at a flat 21%, though additional rules apply (e.g., branch profits tax).
Example:
- A foreign corporation receives amounts from business activities in New York. It can deduct rent, wages, and marketing expenses before calculating its effectively connected taxable income.
This ensures that income treated as ECI is aligned with how business income is taxed for domestic taxpayers. If a nonresident alien has effectively connected income, they must file Form 1040NR to report it. Foreign corporations file Form 1120-F. This is required even if deductions reduce the taxable income to zero.
To learn more about Form 1040NR, check out our guide here: Who Files 1040NR: Nonresident Alien Tax Return
What income types are treated as effectively connected?
Certain income categories are automatically treated as ECI when a foreign person engages in a U.S. trade or business:
- Personal services – wages or consulting fees for independent personal services performed in the United States.
- Rental income – payments from U.S. real property, especially if the taxpayer elects to treat income received from property management as ECI.
- Capital assets – sales of U.S. inventory property or inventory property purchased for resale.
- Real property interests – gains from a foreign person’s disposition of U.S. real property interests are always treated as effectively connected income under the internal revenue code sections dealing with FIRPTA.
This differs from investment income (like dividends or interest), which is typically subject to flat withholding, unless the business activities test or asset use test shows it is connected to U.S. operations.
How does the IRS determine if income is ECI?
The IRS applies two main tests:
- Asset Use Test – Was the income generated by assets used in a u.s. trade or business? For example, a factory in Texas owned by a foreign corporation producing goods for sale in the United States creates ECI.
- Business Activities Test – Was the income a material factor in business activities conducted in the United States? For example, a foreign payee represents a company selling products at U.S. trade shows, and the sales revenue is effectively connected trade income.
If the answer is yes, the income will be treated as ECI and included in the payee’s gross income for U.S. tax purposes.
What are the key differences between ECI and non-ECI income?
- ECI Income: Taxed at graduated rates, with allowable deductions. For example, if you perform personal services while temporarily present in the United States, you must receive effectively connected income and report it on Form 1040NR (for individuals) or Form 1120-F (for corporations).
- Non-ECI Income: Taxed at a flat 30% withholding tax purposes, unless a claim treaty benefits reduces the rate.
Example:
- A foreign partnership selling U.S. real property must pay tax on gains as effectively connected taxable income.
- By contrast, a fellowship grant received by a foreign person not engaged in a U.S. trade or business is subject to withholding at source unless certain exceptions apply.
What role do tax treaties play in ECI taxation?
A tax treaty between the United States and a foreign country can reduce or eliminate U.S. tax on certain business profits or passive income. However, when a foreign partner or foreign corporation receives amounts that are income effectively connected with a U.S. business, treaties usually allow the United States to tax them.
For example:
- Under a treaty, independent personal services performed in the United States may only be taxable if the foreign person has a fixed base in the country.
- A resident broker or personal holding company may still face U.S. tax even with treaty protection if the income is treated as ECI.
In short, when a foreign person is engaged in a U.S. trade or business, they must evaluate their income under the asset use test and business activities test to see if it is treated as ECI. That determination will dictate their U.S. tax liability for each tax year generally.
