US Source Income vs Foreign Income: Main Differences and Examples
The US tax code contains a lot of provisions that regulate how and when international entities (individuals or businesses) must pay taxes in the US. One of the most important things that can determine who or what is subject to US tax laws is the exact source of income, or rather, whether the money that’s brought in by those international entities is foreign or US source income. Depending on the income source, a foreign individual, US citizen living abroad (i.e. Expat) or a business can be considered an international taxpayer by the Internal Revenue Service (IRS) and be required to pay US taxes.
In this article, we’ll discuss the two main types of income sources recognized by the Internal Revenue Service — US source income and foreign source income. We’ll tell all there is to know about them and how they can affect US taxes. We’ll also give you a couple of examples for both US source income and foreign source income, just to make the whole thing easier to understand.
Let’s start!
US Source vs Foreign Source Income: Table
| Income Type | Source Determiners (US or Foreign) | ||
| Salary, wage, and other kinds of earnings | Location where service was performed | ||
| Business income form services | Location where service was performed | ||
| Business income from the sale of inventory | Location where inventory was sold | ||
| Business income from produced inventory | Location where inventory was produced | ||
| Interest | Location or residence of the interest payer | ||
| Dividends | Location of the company paying out dividends (with some exceptions) | ||
| Rental income | Location of the property | ||
| Income from sale of a property | Location of the property | ||
| Income from patents, copyrights, etc. | Location where patents are used | ||
| Pension | Location where the pension was earned | ||
| Scholarship, Grants, Fellowship | Location or residence of the payer |
What Is US Source Income?
US source income is a type of income that is gained from sources located in the United States. The types of income can be varied and can include things like:
- Wages
- Salaries
- Interest
- Rental income
- Dividends
- Pension
- Grants, scholarships
The reason why source income is important, especially for nonresidents, is because it determines whether a person or an entity is required to pay US taxes.
A nonresident can open a US LLC as a foreigner and not be required to pay taxes in the US if the income their company generates does not come from the States (i.e., it’s not US source income). But, if the income comes from a US source, then that person must pay US taxes, and they have to file either a 1040 or 1040NR form (depending on their legal status).
If the above seems a bit difficult to comprehend, we’ve prepared a couple of examples to make the process of understanding what US source income is easier.
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US Source Income: Example 1
Mike Jones is a Canadian citizen who bought a rental property in the US. Because the property is generating income and is physically located in the States, that money is considered as US source income, and he needs to pay taxes on it in the US.
Mike travels to the US frequently to visit his property and for other business, and because of that, he needs to do the Substantial Presence Test before filing for taxes in the US. If he passes the test, by getting a score of 183 or higher, he will become a US resident for tax purposes and will be taxed on his worldwide income (instead of just the US source income he gets from his rental property). He will also need to provide the IRS with all of the information related to his bank accounts in Canada.
Luckily for Mike, he failed the SPT test and is viewed by the IRS as a nonresident for tax purposes. Because of that, he only needs to pay taxes on his US source income and should file the 1040NR tax form.
US Source Income: Example 2
Rakesh Gujarati is an IT specialist from India. Together with his partner, who is a US citizen, Rakesh formed an LLC in the US. Because one of the partners in the LLC is a US citizen, all income that the company generates will be considered US source income, and Rakesh will have to file the individual taxpayer form 1040NR.
US Source Income: Example 3
Elizabeth Walker is a UK citizen. More than a decade ago, she and her husband bought a house in Florida with the intention of vacationing there. And they did for many years. But now, with her eldest daughter getting married and her son starting college, the family needs money to help cover those expenses. After talking it through with her husband, they decided to sell the vacation house in Florida.
Now, because her property is physically located in the United States, income from selling the property will be considered as US source income and will be subject to US taxes.
What Is Foreign Source Income?
Foreign source income is a type of income that is gained from sources outside of the United States. The important thing to note here is how foreign income is taxed in the US and based on a person’s residency status for tax purposes:
US residents and citizens are taxed on their worldwide income (US source and foreign source income). US expats can get certain tax exemptions if they pass the Physical Presence Test but will always have to file for taxes on any type of income they generate outside of the US.
Nonresidents, on the other hand, are only taxed on their US source income unless they pass the Substantial Presence Test. If they pass the SPT test by scoring 183 or higher, nonresidents will be considered residents for tax purposes and must pay US taxes on their worldwide income (both US source and Foreign source income).
Now, if that seems a bit difficult to understand, don’t worry. We’ve prepared a couple of real-life examples to help you better understand what foreign source income is.
Foreign Source Income: Example 1
Fernando Torres is a graphic designer from Spain who owns a single-member LLC in the US. All of his clients are outside of the US, which means that the income he makes will be considered a foreign source income. Because of that and because he is a nonresident, Fernando won’t have to pay taxes in the States.
Foreign Source Income: Example 2
John Brown is a US citizen who lives and works in China. His income comes from his China-based employer, which means it’s considered a foreign source income. But, because John is a US citizen, he is taxed on his worldwide income (both US source and foreign source income). To get certain tax exemptions, John did the PPT test and passed it, which made him eligible for specific foreign earned income exclusions.
Foreign Source Income: Example 3
Michael Jones is a US citizen who lives and works in the US. A couple of years ago, he invested a substantial amount of money into the stocks listed on the Hong Kong Stock Exchange. Finally, after years of waiting for the price of his stocks to rise, he decided to sell them for a hefty profit.
Because the money he’ll make on selling stocks comes from a foreign country, it will be considered a foreign source of income. However, Michael is taxed on his worldwide income as a US citizen. This means that the source of income doesn’t make much difference regarding Michael’s tax obligations. And, because he still lives and works in the States, he is not eligible for the foreign-earned income exclusion, which is available to US expats. We also wrote about the US expat mortgages, so you can check that out.
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