The one rule that decides everything
A US company pays a contractor abroad and wants to know one thing: does this payment owe US tax, and does it have to be reported to the IRS? That entire question turns on a single rule, the source-of-income rule. Get the source right and every downstream outcome, withholding and reporting alike, follows from it.
For personal services, the rule is short and it is not what most people expect. The income is sourced to wherever the work is physically performed. Not where your company is. Not where the contract was signed. Not where you paid from. Where the person sat while doing the work.
This guide gives the verified rule with the IRS citations attached, then walks the two outcomes it produces and the reporting that goes with each. A quick note before we start. This is general information, not tax or legal advice. Withholding and reporting outcomes turn on the facts of your situation, so confirm the specifics with a qualified tax professional before you pay.
What the IRS actually says
The rule comes straight from the IRS source-of-income rule for personal services, which states:
“The place, where the personal services are performed, generally determines the source of the personal service income, regardless of where the contract was made, or the place of payment, or the residence of the payer.”
Read what that sentence rules out. The place the contract was made does not matter. The place of payment does not matter. The residence of the payer, meaning your company, does not matter. All three of those are the things US payers instinctively reach for, and the IRS dismisses every one of them in a single line.
What is left is the only thing that counts: where the personal services are performed. That is the whole test for personal service income.
The two outcomes
Once you know where the work happened, the payment lands in one of two buckets.
Foreign-source: work performed entirely outside the US. A foreign contractor doing all their work from their home country produces foreign-source income. The IRS page “Foreign Source Income - Form 1042-S Reporting Not Required” states:
“Foreign source income (non-U.S. source income) paid to a nonresident alien is normally not subject to U.S. tax under either chapter 3 or 4. Income from sources outside of the United States is exempt from NRA withholding under Internal Revenue Code Section 1441(a). It is normally not required to be reported on an information return.”
So for the common case, a foreign person working abroad, there is generally no US withholding and generally no Form 1042-S. You still collect and keep a valid Form W-8BEN to document the contractor’s foreign status, but the payment sits outside the US tax net.
US-source: work performed inside the US. Work physically performed on US soil is US-source income, even if the contractor is a foreign national who normally lives abroad. US-source FDAP income paid to a foreign person is the trigger for the withholding regime. The IRS NRA withholding page states that “Most types of U.S. source income received by a foreign person are subject to U.S. tax of 30%,” under the chapter 3 regime in Internal Revenue Code sections 1441 through 1443. That 30 percent statutory rate may be reduced or eliminated by a tax treaty between the contractor’s country of residence and the US. US-source income of this kind is reported on Form 1042-S, and the payer files Form 1042 as the annual withholding return.
Decision table
| Where the work is performed | Source of income | US withholding | IRS reporting |
|---|---|---|---|
| Entirely outside the US, by a foreign person | Foreign-source | Generally none. Exempt under IRC section 1441(a) | Generally none. Not required on an information return |
| Inside the US, by a foreign person | US-source | 30 percent NRA withholding by default, reducible by treaty | Form 1042-S, payer files Form 1042 |
| Partly inside and partly outside the US | Apportioned, US-source for the in-US portion | On the US-source portion only | Form 1042-S on the US-source portion |
| Income effectively connected with a US trade or business | US-source, taxed differently | Net-basis graduated rates, not flat 30 percent | Documented on Form W-8ECI, reported on Form 1042-S |
The residence of your company, the place the contract was signed, and the bank account you pay from do not appear in this table, because none of them change the source.
The mixed-location case
What happens when a contractor does most of the work from abroad but flies to the US for a two-week sprint? The pay is split.
The IRS apportions personal service income that is earned partly inside and partly outside the US on a time basis. Per the source-of-income rule, the US-source amount is the total pay multiplied by the fraction of days the services were performed in the US over the total number of days worked. The IRS illustrates this with a worker earning $150,000 over 242 total work days, of which 194 days were in the US, producing $120,248 of US-source income from the day-count fraction.
For your contractor, that means the in-US sprint creates a US-source slice that may need 30 percent NRA withholding and a Form 1042-S, while the rest stays foreign-source. The moment any work moves inside US borders, the analysis changes for that portion, so flag it before you pay.
The effectively connected exception
There is one more path that changes the math. If the contractor’s income is effectively connected income, meaning it arises from a US trade or business the foreign person conducts, it is not taxed at the flat 30 percent that applies to FDAP. Effectively connected income is taxed on a net basis at the same graduated rates that apply to a US person, after deductions.
A contractor in that position documents the status to you on Form W-8ECI rather than a W-8BEN, which removes the payment from standard NRA withholding. This is a narrower situation than a simple cross-border service payment, but it matters when a foreign person has a genuine US business presence. If you think it might apply, get tax advice on the specific facts before you withhold.
Why “where the work happens” trips people up
The reason this rule surprises US payers is that almost every other instinct points the wrong way.
The contract was signed in the US. It does not matter. The IRS explicitly excludes where the contract was made.
The money came from a US bank account. It does not matter. The place of payment is excluded too.
The company is a US company. It does not matter. The residence of the payer is excluded.
The contractor invoiced in dollars. Currency has nothing to do with source.
Every one of those is a reasonable guess, and every one is wrong. The single fact that decides US-source versus foreign-source for personal services is the physical location of the work. Hold onto that and the rest of the analysis is mechanical.
A quick decision path
Three questions, in order, for any contractor you pay:
- Where did the contractor physically perform the work? All outside the US means foreign-source. Any inside the US means at least part is US-source.
- For any US-source portion, does a treaty apply? The 30 percent default may drop, sometimes to zero, under the treaty with the contractor’s country of residence. Collect a valid W-8BEN that claims the treaty rate.
- Is the income effectively connected with a US trade or business? If so, it is taxed on a net basis at graduated rates and documented on Form W-8ECI, not subject to the flat 30 percent.
Run those three and you have the source, the withholding, and the reporting for almost every contractor relationship. To get the underlying documentation right, work through our W-8BEN collection checklist before your next payment. It is free, instant, and walks the steps with the IRS citations attached.
How this connects to the 1099 question
Source-of-income is the same rule that decides whether a foreign contractor gets a Form 1042-S or no IRS form at all, which we cover in do you send a 1099 to foreign contractors. The short version: a foreign person doing all the work abroad gets neither a 1099-NEC nor a 1042-S, because the income is foreign-source. Source-of-income is the test underneath that outcome.
When a platform handles it for you
A US founder paying one foreign contractor can run this analysis by hand. A US team paying contractors across several countries is tracking source-of-income calls, treaty positions, W-8BEN and W-8ECI forms, and reporting deadlines, and that is where the manual approach starts to leak.
Omnivoo Contract Management handles it for a flat $49 per finalized contract. We collect the right tax form, run the KYC, draft and manage the contract, and pay your contractors in 150+ countries, end to end. Transaction fees are passed through at cost, with no FX markup and no subscription.
Want the answer for your specific setup? See how Omnivoo Contract Management handles foreign contractors end to end, or talk to our team.