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What Is Effectively Connected Income (ECI) and How Is It Taxed?

Effectively connected income (ECI) is any income earned by a non-resident alien or foreign corporation that is connected to a U.S. trade or business. ECI is taxed at the same graduated rates as income earned by U.S. citizens and residents (10% to 37% for individuals), and filers can deduct related business expenses to reduce their tax bill.

According to the IRS, whether income qualifies as ECI depends on factors like how assets are used and where business activities take place. The most common types of ECI include:

Active business profits from operating a business in the U.S.
Wages and salaries for services performed on U.S. soil
Actively managed rental income from U.S. properties
Consulting, freelance, or performance fees earned in the U.S.

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Here’s how ECI works, why it matters for both individuals and corporations, and why the classification of your income can mean the difference between a manageable tax bill and a costly surprise.

Why Does the ECI Distinction Matter?

The way the IRS taxes your U.S.-source income depends entirely on whether it qualifies as effectively connected income. The difference is significant, and getting the classification wrong can cost thousands of dollars in overpaid taxes or unexpected penalties.

Feature	ECI (Effectively Connected Income)	Non-ECI (Fixed, Determinable, Annual, Periodical Income)
How it’s taxed	Net basis (after deductions)	Gross basis (no deductions allowed)
Tax rate	Graduated rates: 10% to 37% for individuals; 21% for corporations	Flat 30% (or lower treaty rate)
Deductions allowed?	Yes, business expenses, depreciation, and other deductions	No
Common income types	Business profits, wages, actively managed rental income	Interest, dividends, royalties, passive rents
Filing form	Form 1040-NR (individuals) or Form 1120-F (corporations)	Typically handled through withholding at source

The net-basis taxation of ECI is often more favorable. Consider this example: a non-resident earns $100,000 from a U.S. consulting business with $40,000 in deductible expenses. If classified as ECI, they pay tax on $60,000 at graduated rates. If the same income were classified as non-ECI, they would owe 30% on the full $100,000 ($30,000), with no deductions allowed.

Pro Tip

For non-resident aliens with significant U.S. business activities, proper ECI classification and deduction planning can dramatically reduce your effective tax rate. This is one of the most impactful areas where professional tax guidance pays for itself.

How Does the IRS Determine If Income Is ECI?

The IRS uses two primary tests to decide whether income is effectively connected to a U.S. trade or business. If either test is met, the income is classified as ECI.

Asset-Use Test: This test asks whether the income comes from assets used in, or held for use in, a U.S. trade or business. For example, if a non-resident owns equipment leased to a U.S. company and that equipment is actively used in the company’s operations, the lease income can be ECI.
Business-Activities Test: This test examines whether business activities conducted in the U.S. were a material factor in generating the income. If a non-resident performs consulting services in the U.S., the fees earned from those services are ECI because the business activity itself happened in the U.S.

Some types of U.S.-source income receive special treatment. Certain investment income (interest, dividends, rents, and royalties) is generally treated as non-ECI for non-residents and taxed at the flat 30% withholding rate. However, this same investment income can be reclassified as ECI if it has a direct connection to a U.S. business. A non-resident who owns a U.S. rental property and is actively involved in managing it (selecting tenants, overseeing repairs, making operational decisions) may have that rental income treated as ECI rather than passive income.

Take Note

The line between ECI and non-ECI is rarely clear-cut. The IRS looks at the totality of facts and circumstances, including the frequency, regularity, and nature of your U.S. activities. An activity that seems passive on the surface can be reclassified as ECI if the IRS determines you had material involvement. This is one of the most frequently contested areas in international tax, and incorrect classification can trigger penalties, back taxes, and interest.

How Is ECI Taxed for Individuals?

Non-resident aliens with ECI are taxed at the same progressive rates that apply to U.S. citizens and residents. For the 2025 tax year (filed in 2026), the single filer brackets are:

Taxable Income	Tax Rate
Up to $11,925	10%
$11,926 to $48,475	12%
$48,476 to $103,350	22%
$103,351 to $197,300	24%
$197,301 to $250,525	32%
$250,526 to $626,350	35%
Over $626,350	37%

The key advantage of ECI treatment for individuals is deduction access. Non-residents with ECI can claim allowable business expenses such as rent, salaries, supplies, travel, and depreciation to reduce their taxable income before these rates apply. This is a meaningful benefit that non-ECI income does not receive.

Non-residents with ECI may also be eligible for certain tax deductions and credits that can further reduce their U.S. tax liability, including treaty benefits that may lower rates on specific income types.

How Is ECI Taxed for Foreign Corporations?

Foreign corporations with ECI pay the standard 21% corporate tax rate on their net effectively connected income. Like individuals, corporations can deduct expenses attributable to their U.S. business operations.

However, foreign corporations face an additional layer of taxation: the branch profits tax. This is a 30% tax (or a reduced rate under an applicable tax treaty) on the corporation’s “dividend equivalent amount,” which represents earnings that are considered repatriated to the foreign parent. The branch profits tax functions similarly to dividend withholding tax and can significantly increase the total tax burden on a foreign corporation’s U.S. operations.

Between the corporate income tax and the branch profits tax, the combined effective rate for a foreign corporation with U.S. operations can be substantially higher than 21%. Treaty planning is critical for managing this liability.

Who Needs to File, and Which Form?

Your filing requirement depends on whether you are an individual or a corporation.

Filer Type	Form	Standard Deadline	Extended Deadline
Non-resident alien individual	Form 1040-NR	April 15, 2026 (June 15 if no U.S. wages subject to withholding)	October 15, 2026
Foreign corporation with U.S. office	Form 1120-F	April 15, 2026	October 15, 2026
Foreign corporation without U.S. office	Form 1120-F	June 15, 2026	December 15, 2026

Important

Filing Form 1120-F on time is not just a compliance requirement. It’s a strategic necessity. Foreign corporations that fail to file a timely return lose the right to claim deductions and credits against their ECI. The IRS can then tax the gross income with no offsets, which can result in dramatically higher tax bills.

How Does ECI Affect U.S. Residents and Citizens?

While ECI is primarily a concept that applies to non-resident aliens and foreign corporations, U.S. citizens and resident aliens should be aware of how it intersects with their own tax situations.

If you are a U.S. citizen or resident alien who owns a foreign corporation with U.S. business operations, your corporation’s ECI has direct implications for your personal tax situation. The corporation’s U.S. tax liability affects distributions, and treaty planning around ECI and branch profits tax can impact your overall tax strategy.

U.S. residents who meet the Substantial Presence Test are taxed on worldwide income and do not have their U.S.-source income classified as ECI. Instead, they file Form 1040 and report all income. However, understanding ECI becomes relevant if they have foreign business partners, foreign-owned entities with U.S. operations, or are involved in transactions with non-resident aliens where withholding obligations depend on whether income is ECI or non-ECI.

Why Is ECI So Complex?

Several factors make ECI classification one of the most challenging areas of U.S. international tax:

The “trade or business” threshold is subjective: The IRS does not provide a simple checklist. Whether activities rise to the level of a U.S. trade or business depends on the regularity, continuity, and nature of the activities. A single transaction may not qualify, but a pattern of similar transactions could.
Income can shift categories: The same type of income (rental income, for example) can be ECI or non-ECI depending on the taxpayer’s level of involvement. This means two non-residents with identical rental properties can have entirely different tax obligations based on how actively they manage those properties.
Treaty interactions add layers: Over 60 U.S. tax treaties can modify how ECI is defined, which income is taxable, and at what rates. Treaty provisions related to permanent establishments, business profits, and specific income categories require careful analysis.
Penalties for misclassification are steep: Incorrectly treating ECI as non-ECI (or vice versa) can result in underpayment penalties, interest, and in extreme cases, fraud allegations. For foreign corporations, late filing means losing deduction rights entirely.

Let Greenback Handle Your ECI Tax Obligations

Whether you’re a non-resident alien with U.S. business income, a foreign corporation with U.S. operations, or a U.S. resident with cross-border business interests, ECI classification and reporting requires specialized expertise. The stakes are high: incorrect classification can mean paying far more tax than necessary, or missing deductions you are entitled to claim.

Greenback’s CPAs and Enrolled Agents specialize in international tax situations involving ECI. We’ll help determine whether your income qualifies as ECI, identify every available deduction and treaty benefit, and ensure your returns are filed correctly and on time.

No matter how late, messy, or complex your return may be, we can help. You’ll have peace of mind, knowing that your taxes were done right.

If you’re ready to be matched with a Greenback accountant, click the get started button below. For general questions on taxes or working with Greenback, contact us, and one of our Customer Champions will happily address all your concerns.

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This article is intended for informational purposes only and does not constitute legal or tax advice. While Greenback makes every effort to ensure the information is accurate and up-to-date, every tax situation is unique. For advice tailored to your specific situation, consult one of our expat tax professionals.

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