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I am confused about effectively connected income. I googled about it a lot, and I still not decipher what exactly it means, because different people said different things.

For example, if I hire a freelancer from abroad and I assign him work for business that goes on in USA, is it considered effectively connected income or not for him? It seems like it does, but then why are so many people asking their foreign-based employees to file W-8BEN when the correct would have been W-8ECI. Maybe "effectively connected" means the person has to be physically present in US, which is clearly not the case, hence W-8BEN applies.

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Welcome. Is this personal finance? This might be more business related, but if you could clarify that would be great. Also, don't forget to tag your question with your location. –  MrChrister Dec 19 '12 at 4:23
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@McChrister this is definitely personal finance. Many non-residents encounter this topic. –  littleadv Dec 19 '12 at 4:25
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1 Answer

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ECI is relevant to non-resident aliens who are engaged in trade or business in the US. For that, you have to be present in the US, to begin with, or to own a business or property in the US.

So the people to whom it is relevant are non-resident aliens in the US or business/property owners, not foreign contractors.

From the IRS:

The following categories of income are usually considered to be connected with a trade or business in the United States.

You are considered to be engaged in a trade or business in the United States if you are temporarily present in the United States as a nonimmigrant on an "F," "J," "M," or "Q" visa. The taxable part of any U.S. source scholarship or fellowship grant received by a nonimmigrant in "F," "J," "M," or "Q" status is treated as effectively connected with a trade or business in the United States.

If you are a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, you are considered to be engaged in a trade or business in the United States.

You usually are engaged in a U.S. trade or business when you perform personal services in the United States.

If you own and operate a business in the United States selling services, products, or merchandise, you are, with certain exceptions, engaged in a trade or business in the United States. For example, profit from the sale in the United States of inventory property purchased either in this country or in a foreign country is effectively connected trade or business income.

Gains and losses from the sale or exchange of U.S. real property interests (whether or not they are capital assets) are taxed as if you are engaged in a trade or business in the United States. You must treat the gain or loss as effectively connected with that trade or business.

Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.

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I learned something. Cool. –  MrChrister Dec 19 '12 at 4:28
    
great! so he needs to file W-8BEN then. I'm also confused about whether he needs to use itin or ein (for the same purpose). Again, I have already googled about this and yet I'm confused. –  user1831003 Dec 19 '12 at 5:22
    
If he's a person, why would he use EIN? He should either use SSN or ITIN, whatever is applicable. –  littleadv Dec 19 '12 at 7:24
    
does he need ITIN if he wants me to not withhold or as long as he files w8ben, he's good? Again, different people saying different things. –  user1831003 Dec 19 '12 at 22:55
    
ITIN is his tax ID if he doesn't have SSN. He must have either one (some foreigners have SSN if they lived in the US in the past, otherwise its ITIN). You withhold per the IRS regulations and remit the withholding, your accountant should know how to do that. He files a non-resident tax return for refund (he has to pay US taxes on US-sourced income unless there's a treaty). –  littleadv Dec 19 '12 at 22:59
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