ECI (effectively connected income) is U.S. tax terminology for income that foreign taxpayers earn from a U.S. trade or business—subject to U.S. taxation at net rates, not just passive withholding.

How it works

Foreign investors generally invest in U.S. startups through funds or holding companies to manage U.S. tax exposure. When a fund realizes gain from operating companies (not purely portfolio debt or certain passive structures), the IRS may classify some income as ECI.

ECI requires foreign investors to file U.S. tax returns and pay tax on net income connected to U.S. operations—different from fixed-percentage withholding on passive FDAP income.

Fund lawyers use blocker corporations, offshore feeders, and treaty analysis to reduce ECI and FIRPTA complications for non-U.S. LPs. Terms vary by investor domicile (pension, sovereign wealth, corporate).

Founders rarely calculate ECI daily, but cross-border cap tables—European angels, Asian strategics, offshore funds—raise questions at exit when buyers withhold or demand tax representations.

Why it matters

• Founders: Large foreign ownership may influence deal structure at IPO or M&A. Buyer counsel asks tax reps; surprises delay closing.
• Investors: Non-U.S. LPs diligence fund documents for ECI policy and gross-up clauses. Unexpected ECI hurts net returns.
• Fund counsel: Side letters and entity choice are driven partly by ECI and UBTI (for tax-exempt U.S. investors).

Common mistake

Assuming offshore incorporation alone eliminates U.S. tax on U.S. operating company gains. Operating business income can still flow through as ECI depending on structure and activity level.

Related ideas

• FIRPTA — U.S. real property holding tax on foreign sellers
• Blocker corp — tax block between foreign LP and U.S. assets
• ERISA — separate U.S. regulatory concern for pension capital
• Withholding tax — passive vs ECI treatment differs