The sourcing of income has very important tax consequences for U.S. and foreign taxpayers. The IRS taxes U.S. taxpayers on all income, from any source derived; however, U.S. taxpayers will be relieved of double taxation and may utilize the foreign tax credit in many circumstances involving non-purely domestic taxation. Foreign taxpayers, on the other hand, will usually only pay U.S. taxes on income sourced in the U.S. Thus, the source of income rules are critical to determining where a taxpayer will pay applicable taxes. This article will examine both income sourced inside the U.S. and foreign-source income.
Income Source Determination
In order to determine the sourcing of income, income realized is first placed into certain categories (such as interest, dividends, rent, sale of property, etc.). At times, an item of income may overlap into more than one possible category, in which case, specific IRS rules will likely clarify the proper classification. Once income is categorized, income source rules will then be applied in order to ascertain whether the income is U.S. or foreign-source. As a rule of thumb, income will be either U.S. or foreign-source depending upon where property is located, or where the income was realized, however there are many exceptions to this principle.
Income Source Examples
In this section, common income categories such as dividends, interest, personal services income, rents and royalties, and sales or exchanges of property, and their income sourcing rules will be briefly explained (other common income source rules not detailed here apply to software income, and transportation and communications income).
Generally speaking, dividends received from U.S. (domestic) corporations are considered to be U.S.-source income. The fact that a domestic corporation may be distributing dividends derived from overseas operations usually will not matter for these purposes.
Conversely, dividends paid by a foreign corporation will generally be deemed foreign-source income. An important exception to this rule occurs in situations where a foreign corporation earns 25% or more of its gross income from income effectively connected with a U.S. trade or business for the three years immediately preceding the year of the dividend payment. In this case, that percentage of the dividend will be treated as U.S.-source income.
Interest income received from domestic corporations, the U.S. government and state governments, and non-corporate U.S. residents (among others) are deemed U.S.-source income.
There are some exceptions to this rule. For example, income will is deemed to be foreign-source if interest is received from a U.S. corporation which, over the prior three-year period, earned 80% or more of its active business income from foreign sources.
Personal services income
Personal services income includes such items as salaries, wages, fees, commissions. The location of where the services are performed will usually determine whether the personal services income is U.S. or foreign-source.
There are some exceptions to this general rule, including a limited commercial traveler exception for short business trips and de minimus amounts.
Rents and Royalties
For income received from the use of tangible property, the location of the property will determine its income sourcing. Other factors, such as where the property was manufactured, are not considered.
For income received for the use of intangible property (e.g. patents, copyrights, goodwill, etc.), in general, the location of where the property was used will determine its income sourcing.
Sale or Exchange of property
In general, the source of income relating to disposition of real property will depend upon the location of the property.
Broadly speaking, the sale of personal property (i.e, stocks, securities, equipment, inventory, intangible assets) will depend upon the residence of the seller. However, there are various exceptions to this rule. For example, if a item of purchased inventory is sold, the location of the sale will determine its income source.
Tax Treaty versus Regular Sourcing of Income Rules
Under certain circumstances, the sourcing source of an item of income or deduction could be changed by the provisions of a treaty. However, taxpayers claiming this benefit will need to file their tax return along with Form 8833.
Contact Sherayzen Law Office
This is a general overview of the taxation rules relating to sourcing of income. There are many other complex issues that may apply, depending upon the circumstances. Do you have questions concerning taxes relating to your international transactions or income? Sherayzen Law Office can assist you with these matters. Call (952) 500-8159 to set up a consultation today.