A Tax Professional's Guide to FDAP Income

What is FDAP Income? A Clear Definition

FDAP stands for Fixed, Determinable, Annual, or Periodical income. It is a classification used by the Internal Revenue Code to describe a broad category of U.S.-source income paid to foreign persons that is not effectively connected with a U.S. trade or business. The statutory authority for taxing FDAP income is found in IRC §871(a) for nonresident alien individuals and IRC §881(a) for foreign corporations.

Fixed means the income is paid in amounts known ahead of time. Determinable means there is a basis for calculating the amount to be paid. Periodical means the income is paid from time to time. Importantly, the income does not have to be paid annually or at regular intervals. A single lump-sum payment can qualify as FDAP income just as easily as a monthly royalty check.

The practical definition is even broader than the name suggests. Under Treasury Regulation §1.1441-2(b)(1), FDAP income includes essentially all items of gross income listed under IRC §61, with only a few specific exceptions. The two main exceptions are: (1) gains derived from the sale of real or personal property (including market discount and option premiums, but not original issue discount), and (2) items of income excluded from gross income without regard to the payee's U.S. or foreign status, such as tax-exempt municipal bond interest.

In plain terms, if a foreign person receives a payment from a U.S. source and it is not a capital gain from selling property, it is very likely FDAP income.

FDAP Income vs. Effectively Connected Income (ECI)

This distinction is the single most important concept in U.S. international taxation for foreign persons. The two categories are taxed under completely different regimes:

We have seen clients in our Culver City office lose thousands of dollars because income was misclassified. A nonresident alien who treats rental income as FDAP when they could have elected to treat it as ECI under IRC §871(d) may end up paying 30% on the gross rent, with no deduction for mortgage interest, property taxes, depreciation, or management fees. That election can be the difference between a large tax bill and a small one (or even a loss).

Common Types of FDAP Income

The scope of FDAP income is deliberately broad. The table below, drawn from IRS Publication 515 and the IRS FDAP income page, summarizes the most common categories.

One point that catches many people off guard: FDAP income can be a single lump-sum payment. For example, $50,000 in royalty income is FDAP whether it is paid in 10 monthly installments of $5,000 or in one check.

The 30% Withholding Rule: Chapter 3 of the Internal Revenue Code

The U.S. collects tax on FDAP income primarily through withholding at the source. This is not optional. Chapter 3 of the IRC (sections 1441 through 1443 and 1461 through 1463) establishes the framework.

How It Works

When a U.S. person (or any "withholding agent") makes a payment of U.S.-source FDAP income to a foreign person, the withholding agent must deduct and withhold 30% of the gross payment and remit it to the IRS. The foreign person receives only 70% of the payment.

The withholding rate is applied to the gross amount. No deductions, credits, or exemptions reduce the amount subject to withholding. This is a critical difference from ECI, where the tax is calculated on net income.

Who is a Withholding Agent?

Under Treas. Reg. §1.1441-7(a), a withholding agent is any person, U.S. or foreign, that has the control, receipt, custody, disposal, or payment of an item of income of a foreign person subject to withholding. This definition is extremely broad and includes:

• U.S. corporations paying dividends or interest to foreign shareholders
• Employers paying wages to nonresident alien employees
• Partnerships distributing FDAP income to foreign partners
• Banks, brokers, and other financial institutions
• Real estate management companies paying rent to foreign landlords
• Any individual making a payment to a foreign person

Withholding Agent Liability

This is where many businesses get into trouble. Under IRC §1461, the withholding agent is personally liable for the tax that should have been withheld. If the agent fails to withhold, the IRS can collect the full amount of the tax from the agent, regardless of whether the foreign person ultimately pays the tax.

Under IRC §1463, even if the foreign person files a U.S. tax return and pays the tax, the withholding agent is still liable for penalties and interest for the failure to withhold. We have seen this play out with clients who assumed they were off the hook because the foreign payee "took care of it." That is not how the IRS sees it.

Withholding Rate Summary (Chart C, Publication 515)

While 30% is the default, certain types of FDAP income are subject to different withholding rates under the IRC:

Tax Treaty Benefits: How to Reduce or Eliminate the 30% Withholding

The 30% statutory rate is the starting point, not necessarily the final answer. The United States has income tax treaties with more than 60 countries, and these treaties frequently provide for reduced withholding rates or complete exemptions on certain types of FDAP income. IRS Publication 901 provides a comprehensive summary of treaty benefits by country.

How Treaty Benefits Work

A tax treaty is a bilateral agreement between the U.S. and another country. The treaty overrides the default 30% rate for residents of the treaty partner country, provided the taxpayer properly claims the benefit. The process works as follows:

1. The foreign person determines whether their country of residence has a tax treaty with the U.S.
2. The foreign person identifies the specific treaty article that applies to their type of income.
3. The foreign person completes and provides a Form W-8BEN (individuals) or Form W-8BEN-E (entities) to the withholding agent, claiming the reduced rate.
4. The withholding agent reviews the form, confirms the claim, and applies the reduced rate.

Without a valid Form W-8 on file before the payment is made, the withholding agent must apply the full 30% rate. There is no retroactive application.

The U.S.-Turkiye Tax Treaty: A Practical Example

Because many of our clients at Arc & Ledger are Turkish nationals or Turkish-American dual citizens, the U.S.-Turkiye income tax treaty (signed March 28, 1996) is one we work with regularly. Here is how the treaty reduces withholding on common types of FDAP income:

These reductions are substantial. On a $100,000 dividend payment, the difference between 30% withholding ($30,000) and 20% treaty rate ($20,000) is $10,000 in cash flow. For a Turkish resident receiving regular U.S.-source income, proper treaty planning can save tens of thousands of dollars over time.

It is worth noting that the treaty benefits do not apply if the income is attributable to a permanent establishment or fixed base in the United States. In that case, the income is treated as ECI and taxed under the regular graduated rate structure.

Recent Treaty Developments

The international tax treaty landscape is not static. Recent developments that withholding agents and foreign persons should be aware of include:

• Hungary: The U.S.-Hungary tax treaty was terminated effective January 1, 2024, for withholding tax purposes. Hungarian residents are now subject to the full 30% statutory rate.
• Russia: The U.S. partially suspended the U.S.-Russia tax treaty effective August 16, 2024. Withholding at 30% is now required on most payments.
• Belarus: The U.S. partially suspended the U.S.-Belarus tax treaty effective December 17, 2024.

These changes underscore the importance of staying current on treaty status and not relying on outdated assumptions.

Key Exemptions from FDAP Withholding

In addition to treaty-based reductions, the Internal Revenue Code itself provides several important exemptions from the 30% withholding tax. These exemptions are worth understanding because they can apply regardless of whether a tax treaty exists.

Portfolio Interest Exemption (IRC §871(h) and §881(c))

This is one of the most significant exemptions in international tax. Interest that qualifies as "portfolio interest" is completely exempt from the 30% Chapter 3 withholding tax. The exemption was enacted to encourage foreign investment in U.S. debt markets.

To qualify, the following conditions must be met:

1. The debt obligation must be in registered form.
2. The withholding agent must receive documentation (typically Form W-8BEN) certifying that the beneficial owner is not a U.S. person.
3. The interest must not be received by a "10-percent shareholder" of the obligor.
4. The interest must not be "contingent interest" as defined in IRC §871(h)(4).
5. The interest must not be received by a controlled foreign corporation (CFC) from a related person.

Bank Deposit Interest Exemption (IRC §871(i)(2)(A))

Interest on deposits with domestic banks, savings institutions, and certain insurance companies is exempt from the 30% withholding tax when paid to a nonresident alien. This includes interest on certificates of deposit, open account time deposits, and Eurodollar CDs. This exemption makes U.S. bank accounts accessible to foreign depositors without triggering withholding.

Note, however, that this interest may still need to be reported on Form 1042-S in certain circumstances, particularly for residents of countries with which the U.S. has an information exchange agreement.

Effectively Connected Income (ECI) Exemption

Income that is effectively connected with the conduct of a U.S. trade or business is not subject to FDAP withholding. The foreign person must provide a valid Form W-8ECI to the withholding agent to claim this exemption. The income is then reported on the foreign person's U.S. tax return (Form 1040-NR or Form 1120-F) and taxed at graduated rates.

Other Notable Exemptions

Several other exemptions apply in specific circumstances:

• Short-term OID: Original issue discount on obligations with a maturity of 183 days or less from the date of original issue is exempt.
• Certain gambling winnings: Proceeds from blackjack, baccarat, craps, roulette, and big-6 wheel are exempt from withholding (though other gambling winnings are not).
• Certain insurance proceeds: Accelerated death benefits paid under a life insurance contract to a terminally or chronically ill individual may be exempt from tax entirely.
• Income from real property election: A nonresident alien who elects under IRC §871(d) to treat income from U.S. real property as ECI removes it from the FDAP regime entirely.

Reporting and Compliance: The Essential Forms

The FDAP system involves a web of forms, each serving a specific purpose. Understanding which forms apply to your situation is essential for staying compliant.

Forms for Withholding Agents

As of January 1, 2024, the electronic filing threshold for information returns has been lowered significantly. If you are required to file 10 or more information returns of any type during the calendar year, you must file Forms 1042-S electronically.

Forms for Foreign Persons (Recipients of Income)

Penalties for Non-Compliance

The IRS takes FDAP compliance seriously, and the penalties for getting it wrong can be severe. These penalties apply to withholding agents, and in some cases, to the foreign persons themselves.

Penalty Summary for Withholding Agents

Common Scenarios: Real-World FDAP Situations

Understanding the rules in theory is one thing. Applying them to real-world situations is another. Here are scenarios we encounter regularly in our practice.

Scenario 1: The E2 Visa Investor from Turkiye

A Turkish national enters the U.S. on an E2 investor visa and establishes a restaurant through a U.S. C corporation. The corporation is profitable and the owner wants to take money out of the business. There are two common ways to do this, and they have very different tax consequences:

Salary/Wages: If the E2 visa holder is a nonresident alien and receives a salary from the corporation for services performed in the U.S., this is ECI. It is reported on Form 1040-NR and taxed at graduated rates, with deductions allowed. The corporation withholds income tax using the graduated rates from IRS Circular E, just like for any employee.

Dividends: If the corporation distributes dividends to the owner, these are U.S.-source FDAP income. Without a treaty claim, 30% is withheld. With a properly filed Form W-8BEN claiming benefits under the U.S.-Turkiye treaty, the withholding drops to 20% (or 15% if the owner holds 10% or more of the voting stock, which they almost certainly do as the sole owner). The corporation reports the dividend and withholding on Form 1042-S.

The planning opportunity here is significant. The choice between salary and dividends, and the proper use of the treaty, can result in thousands of dollars in tax savings.

Scenario 2: The Foreign Ecommerce Seller

A company based in Germany sells products through a U.S. ecommerce platform. The company has no employees, office, or warehouse in the U.S. The platform collects payments from U.S. customers and remits them to the German company.

In this case, the income from the sale of inventory is generally not FDAP income. It is income from the sale of personal property, which is sourced based on where the title passes. If the title passes outside the U.S. (for example, at the foreign seller's location), the income may not even be U.S.-source.

However, if the same German company licenses its brand name to a U.S. company and receives royalty payments, those royalties are U.S.-source FDAP income. The U.S. company paying the royalties must withhold 30%, unless the German company provides a Form W-8BEN-E claiming a reduced rate under the U.S.-Germany tax treaty (which reduces the royalty withholding rate to 0% in many cases).

Scenario 3: The Nonresident Alien Landlord

A nonresident alien owns a rental property in Los Angeles. The property management company collects rent on behalf of the owner. By default, the rental income is FDAP income, and the management company (as withholding agent) must withhold 30% of the gross rent.

But the owner has an option. Under IRC §871(d), the owner can elect to treat the rental income as effectively connected with a U.S. trade or business. This election allows the owner to deduct expenses such as mortgage interest, property taxes, insurance, repairs, and depreciation. The net income (which could be significantly lower than the gross rent, or even a loss) is then taxed at graduated rates. This election is made by filing Form 1040-NR and attaching a statement.

We advise nearly every nonresident alien landlord client to consider this election carefully. In most cases, it results in a substantially lower tax liability.

Frequently Asked Questions

Key Legal Authorities and Resources

For readers who want to go deeper into the legal framework, here is a summary of the primary authorities governing FDAP income:

Internal Revenue Code Sections

Treasury Regulations

IRS Publications and Forms

Conclusion: Do Not Leave Money on the Table

FDAP income is one of those areas of tax law where the rules are straightforward in principle but complex in application. The 30% default withholding rate is a blunt instrument, and the Code and treaties provide numerous ways to reduce or eliminate it for those who know where to look.

Whether you are a nonresident alien receiving U.S.-source dividends, a Turkish entrepreneur on an E2 visa structuring your business, or a U.S. company making payments to foreign contractors, the stakes are real. Overpaying because you did not claim a treaty benefit is money lost. Underpaying because you did not withhold properly is a penalty waiting to happen.

At Arc & Ledger Accounting, we help international taxpayers and U.S. businesses get this right. If you have questions about FDAP income, withholding obligations, treaty benefits, or any aspect of international tax compliance, we are here to help.