FDAP stands for Fixed, Determinable, Annual, and Periodic income, which is usually classified as passive income. Unlike Effectively Connected Income (ECI), FDAP income does not come from active business operations; instead, it is generated through passive activities.
FDAP income is taxed at a flat 30% withholding tax on the gross amount of U.S. source income without allowing any deductions for expenses. At the end of the year, the total withholding tax amount will be reconciled against the overall tax obligation.
The primary responsibility for withholding and remitting this tax lies with the U.S. payor or withholding agent.
For example, a multi-member U.S. LLC with foreign members that distributes FDAP income to its foreign members is required to withhold tax on those distributions and remit them to the IRS.
The withholding tax amount may be reduced under U.S. tax treaty rules.
For example, consider a French company, ABC Corp, that lends $500,000 to a U.S. corporation and receives $25,000 in annual interest payments. This interest income qualifies as FDAP income because it does not result from active business operations. In this case, the U.S. borrower automatically withholds 30% of the interest payments. However, under the U.S.-France tax treaty, the withholding rate on interest income is reduced to 15%. Therefore, ABC Corp will only be subject to a withholding of 15% on the $25,000 interest income.
A Foreign member of a U.S. LLC receiving FDAP income may have the following U.S. tax obligations:
Generally, the IRS requires payments made to foreign corporations or individuals to be reported annually on IRS Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding).
Form 1042-S reports non-wage U.S.-source payments subject to withholding and paid to non-U.S. payees.
According to the IRS, fixed, determinable, annual, or periodic (FDAP) income is considered reportable. Payments categorized as U.S.-sourced FDAP are generally subject to withholding and require reporting on Form 1042-S. This likely includes compensation for independent personal services performed in the United States by non-residents.
Any withholding agent (a person or institution, such as an employer, university, or business) that paid any amount subject to withholding to a foreign person is likely to submit an IRS Form 1042-S.
To withhold and report correctly on payments to foreign corporations, a U.S. payor must know the source of the income – U.S. or foreign – as defined by U.S. tax rules. If the income source is not known when the payment is made, the payor should presume it to be U.S.-source income and withhold accordingly (see Treas. Reg. 1.1441-2(a)).
If you are a non-resident alien and received a Form 1042-S, you generally need to report the income on your U.S. tax return, Form 1040 NR.
Foreign corporations and entities that receive income from U.S. sources may be required to report this income on their U.S. tax return, Form 1120 F.
Suppose the FDAP income wasn’t withheld adequately at the source. In that case, foreign individuals should report it on Form 1040-NR, and foreign corporations should report it on Form 1120-F and pay the corresponding taxes.