Effectively connected income vs FDAP income

The two buckets

Almost everything in the tax treatment of a nonresident alien turns on which bucket an item of income falls into. The first bucket is income effectively connected with a U.S. trade or business. It is combined with other effectively connected income, reduced by the allowable deductions, and taxed at the rates that apply to citizens and residents. The second bucket is FDAP income that is not effectively connected, which is taxed at 30% of the gross amount, or at a lower treaty rate, with no deductions against it.

The tool above sorts a single item. It is not a full return, but it shows which tests the publication applies, and it uses the same words the publication does.

What counts as effectively connected

The starting point in the publication is the engagement in a U.S. trade or business. If you are engaged in one, all income, gain or loss for the year from U.S. sources, other than certain investment income, is treated as effectively connected, whether or not there is any connection between the income and the particular business activity. In limited cases, some foreign-source income is also treated as effectively connected.

Personal services income is the cleanest case. You are usually engaged in a U.S. trade or business when you perform personal services in the United States, and personal services income received in such a year is effectively connected. That includes wages, salaries, commissions, fees, per diem allowances and bonuses, paid in cash, services or property. Income received in a different year from services performed in the year it is effectively connected can also qualify, and pensions attributable to U.S. services after 1986 are effectively connected to the extent of contributions.

The two tests for investment income

Investment income, such as interest, dividends, rents, royalties and capital gains, is where the tests matter. The asset-use test applies to income not directly produced by business activities: if the income is from assets used in, or held for use in, the U.S. business, it is effectively connected. An asset qualifies if it is held for the principal purpose of promoting the business, acquired and held in the ordinary course of the business (an account receivable, for example), or held to meet the present needs of the business and not its anticipated future needs. Stock of a corporation is generally not treated as an asset used in the business.

The business-activities test applies when income comes directly from the active conduct of the business. If conducting the U.S. business was a material factor in producing the income, it is effectively connected. The publication says this test matters most for dealers in stocks or securities earning dividends or interest, licensing businesses earning royalties and servicing businesses earning fees. An item that passes neither test goes into the 30% bucket.

A frequent trap: wages alone do not convert investments

Suppose you are engaged in a U.S. trade or business only because you perform personal services here. The publication says income and gains from assets, and gains and losses from the sale of capital assets, are generally not effectively connected, unless there is a direct economic relationship between holding the asset and the personal services business. A student with a U.S. job and a brokerage account of U.S. stocks is the usual example. The wages go in the first bucket; the dividends, in most cases, go in the second, and are taxed at 30% or a lower treaty rate on the gross amount.

That is why the tool has a separate option for investment gains where the only business is personal services. It returns the second bucket, along with the exception that the publication states.

What FDAP income is

The publication describes FDAP as fixed when it is paid in amounts known ahead of time, determinable when there is a basis for figuring the amount, and periodic when paid from time to time, not necessarily annually or at regular intervals. Items specifically included are interest other than OID, dividends, dividend equivalent payments, rents, premiums, annuities, salaries, wages and other compensation. Royalties and other items may also be taxed. Some FDAP income is exempt, and the publication points to its chapter 3 for that question.

Treaties can lower the 30% rate, and the dual-status page shows how the same split applies to the nonresident part of a year of arrival or departure. The standard deduction page explains why the bucket also decides which deductions are available.

Why the bucket matters in practice

Take a nonresident with $40,000 of effectively connected wages and $2,000 of non-effectively-connected U.S. dividends. The wages are taxed at graduated rates after deductions. The dividends are taxed at 30% of $2,000, which is $600, unless a treaty rate is lower, and no deductions can reduce them. Getting the bucket wrong changes both the rate and the deductions, which is why the publication spends so much space on the tests. For the residency question that precedes all of this, use the substantial presence test calculator.

Sources

• IRS Publication 519, U.S. Tax Guide for Aliens (2025): Chapter 4, Effectively Connected Income; Investment Income; Personal Services Income; Fixed or Determinable Income; Chapter 6, How To Figure Your Tax. Read November 2, 2026.

Edition read: Publication 519 (2025), U.S. Tax Guide for Aliens, for use in preparing 2025 returns. Dollar figures on this page are the ones printed in that edition; check the current publication and form instructions for your tax year. This page summarizes the publication and does not replace it.