Source of Income Rules

The source of income rules decide whether a payment is US-source or foreign-source, and that single determination drives whether US withholding and reporting apply to a foreign person at all. The rules differ by income type, but for contractor payments the controlling rule is the one for personal services: income is sourced to where the work is physically performed. The IRS sets this out on its source of income, personal service income page, and the underlying statute is Internal Revenue Code section 861. For a US company paying contractors abroad, these rules are the gate that everything else passes through.

How the US Sources Income by Type

The Internal Revenue Code assigns a source to each kind of income through sections 861 through 865. The general pattern:

• Personal services. Sourced to where the services are performed.
• Interest. Generally sourced to the residence of the payer.
• Dividends. Generally sourced to the residence of the payer corporation.
• Rents and royalties. Sourced to where the property is located or used.
• Sale of real property. Sourced to where the property is located.

For paying foreign contractors, the personal-services rule is the one that matters. It overrides intuition about where the money comes from.

Personal Services Income

The IRS is explicit on this point: “The source of income from labor or personal services is determined by where the services are performed, not where the contract is made, the place of payment, or the residence of the payer.” That means a contractor sitting in Manila who does all the work from Manila earns foreign-source income, even though a US company sends the payment from a US account under a contract governed by US law.

This is why most remote foreign contractor work falls outside US withholding. The income is foreign source income, so it is not US-source FDAP income, so NRA withholding does not reach it and there is nothing to report on Form 1042-S. The payer should still hold a valid Form W-8BEN or Form W-8BEN-E to document the foreign status and support the no-withholding position.

When the same contractor flies to the US and works onsite, the days worked in the US produce US-source income for those days. That portion is US-source FDAP income, subject to 30 percent withholding unless a treaty reduces it.

The Commercial Traveler Exception

There is a narrow carve-out for short US visits. Under section 861(a)(3), compensation for services performed in the US by a nonresident alien is not treated as US-source if all of these hold:

• The nonresident is temporarily present in the US for 90 days or less during the tax year.
• The total compensation does not exceed 3,000 dollars.
• The services are performed for a foreign employer, or a foreign office of a US entity.

The IRS describes this as the position where the income “is not considered U.S. source income” when those conditions are met. The thresholds are low, so the exception rarely covers a meaningful engagement, but it can apply to brief incidental US presence.

Why It Drives Withholding

The order of analysis for any foreign contractor payment is:

1. Confirm the payee is a foreign person, with a W-8.
2. Apply the source rules to the income type. For services, ask where the work was done.
3. If foreign-source, generally no US withholding and no 1042-S.
4. If US-source FDAP, apply 30 percent, or a lower income tax treaty rate.

Skip step 2 and a payer either over-withholds on foreign-source income or under-withholds on US-source income. Both are errors a withholding agent is liable for.

Common Pitfalls

• Treating the payer’s location as the source. Where the money comes from is irrelevant for personal services. Only where the work happens controls.
• Ignoring split engagements. A contractor who works partly in the US and partly abroad has both US-source and foreign-source income. The US days must be carved out and may need withholding.
• Relying on the 3,000 dollar exception too broadly. It requires a foreign employer and caps both days and dollars. Most direct US-company engagements do not qualify.
• No documentation. Without a W-8 on file, a payer cannot defend a foreign-source, no-withholding position if the IRS asks.

Related Forms and Terms

• Foreign Source Income: the result when services are performed abroad.
• FDAP Income: the category that becomes taxable only when US-source.
• NRA Withholding: the regime that applies to US-source income.
• Form 1042-S: required only for US-source payments to foreign persons.
• Income Tax Treaty: can reduce withholding on the US-source portion.

Omnivoo Contract Management records where each contractor performs the work and applies the source rules per payment, so US-source and foreign-source amounts stay separated and documented for any IRS review.