Last week we discussed how, per our tax code, “by default, all income is gross income” (insight #4), from whatever source derived, unless specifically exempted. That’s the law.
The week before last we discussed who is a US tax resident and who is a nonresident for US tax purposes (Insight #3).
This week we are going to start discussing sourcing of income, the “from whatever source derived” part of last week’s insight. Why?
Because income sourcing ties Insight #3 with Insight #4 and brings us to Insight #5.
“US nonresidents are taxed on US source income, US tax residents are taxed on worldwide income”
What we call US source income is income from sources within the United States, and what we call foreign source income, is income from sources without the United States. The combination of US and foreign source income is what you have likely heard of as worldwide income.
Worldwide income = US source income + foreign source income.
Worldwide income = income from sources within the USA + income from sources without the USA
US citizens and green card holders have the unique “privilege” of always being taxed on their income within and without the United States, ie, their worldwide income. Whether they live within or without the United states is irrelevant. Aren’t they lucky?
How do we know if a specific item of income, for example, wages, is income from within or without the USA? Does the nationality of the employee matter? Does it matter where the employer is headquartered? Or where the employee is located? How do we determine this?
The answer is in the Internal Revenue Code (IRC), the most authoritative tax law of the land.
The IRC defines income from sources within the United States in Section 861. Income from sources without the United States is defined in Section 862. Section 862 is basically the anti-Section 861.
What do I mean by that? Let me give you an example.
Section 861 defines interest from sources within the USA as “Interest from the United States or the District of Columbia……” (it goes on for another 8 lines, very little is concise in the IRC)
Section 862 defines interest from sources without the USA as “interest other than that derived from sources within the United States as provided in section 861”
Kinda lazy, right? We are not going to be that lazy here.
Whether something is from sources within or without the USA depends on the type of income. There are different rules for interest income, dividend income, royalties, real estate, compensation for services, and on and on and on.
Since this is not intended to be a treatise on sourcing of income for a PhD dissertation, but a guide for regular taxpayers trying to make sense of their taxes, we are going to focus on the types of income that individuals most commonly have to deal with, in the most common types of situations.
- Income from personal services is sourced to the country where the services are performed. Example: wages or honoraria paid to a brain surgeon performing brain surgery in New York City are income from within the USA. Does the citizenship of the surgeon have any impact on the source? No! Does it make a different who is making the payment? No! Does it matter if the payment is in US dollars or Euro? No! The only factor that matters is where the surgeon is physically located when he performs the brain surgery. If the surgeon in within the USA, it’s US source income. If he is in a foreign country, it’s foreign source income.
- Interest is sourced to the country of residency of the payer. Interest paid by a US bank located in Los Angeles is interest from within the USA. Interest paid by a German bank located in Munich is……fill in the blanks, I know you can do it!
- Dividends paid by a US company are from within the USA. If the dividends are paid by a foreign company they are……. that’s correct, from without the USA. You are getting good at this. For example, Apple Inc. dividends are from sources within the USA, Total SA (French company) dividends are from sources without.
- Rents and gains from the sale of real estate are sourced to the location of the property. Rents received from renting a condo located in Miami are US source income. Rents received from renting a condo located in London are not. Selling the condo in Miami results in US source capital gains. Selling the London condo results in foreign source capital gains.
You are probably thinking, well…this is pretty straightforward, why were you making such a big deal about this?
We are not done yet.
Things can get a bit surprising with some other common types of income.
- Pensions are sourced to the country where the services that earned that pension were performed. So, for example, if you are self-employed abroad and contribute to a solo 401K, income from that solo 401k is from sources without the USA, even if you are back in the USA when you take the distribution. I bet you didn’t expect that!
- Royalties, such as patents and copyrights, are sourced to the location where the property is used. If, for example, you are a writer and write a book in Wilmington, NC and someone living in Japan buys a copy, the royalties from that sale are sourced to Japan. You wrote the book in the USA but received income from Japanese sources. I bet you didn’t expect that either!
- Scholarships are sourced to the residence of the payer. If you receive a scholarship from a foreign institution to study in the USA, you may be physically in the USA when you receive it, but that scholarship is foreign source.
- Personal property (such as stocks) that are sold at a gain generate income sourced to the country of residence of the seller, the country where the seller has their tax home. Remember those Apple dividends that were US source? Well, if you sell your Apple shares when you are living in Italy, those gains are Italian source. It doesn’t matter if you are an Italian citizen or a US citizen, it doesn’t matter that Apple is a US company, the capital gains on that sale are Italian source income. That one blew my mind the first time I heard it!
There are other situations that can be even more counter intuitive, but these are the most common situations that you are likely to encounter in your life as a globally mobile US taxpayer.
Understanding the sourcing rules for income subject to US tax is important particularly for taxpayers who change status from US tax resident to nonresident and viceversa.
Remember how we said at the beginning of this post that your tax status determines if you are taxed on your worldwide income or just your US source income?
If you are nonresident for US tax purposes, knowing what income is from sources without the USA allows you to understand what income you can exclude from your US tax return.
If you are a US citizen or a green card holder living outside the USA, understanding what items of income are from sources within and without the USA, allows you to properly calculate your foreign tax credits and your foreign earned income exclusion.
This post wound up being a lot longer than I anticipated, so I am going to let you be for the day. We’ll go over the implications of US and foreign income sourcing rules a little more in our next issue. We are going to focus on change of tax status situations and how tax planning can help you keep a lot more money in your pocket and lack of tax planning can cost very dearly!
Have a wonderful day and see you next week.