Tax Considerations for Doing Business in the United States

The following provides an overview of the key tax issues that must be considered if conducting a business in the United States.  This article discusses the primary income tax implications of residency and entity structure selection, as well additional tax issues that should be considered, including withholding tax requirements, transfer pricing, and employment taxes.

The U.S. market is one of the largest, most competitive, and easiest global economies to enter, offering low regulatory barriers and a transparent, but sometimes litigious, legal system. Success requires navigating a decentralized structure where federal, state, and local governments share overlapping powers, particularly regarding taxes.

The U.S. assesses federal tax on its residents on worldwide income and gains, subject to certain exceptions. For this purpose, residents include U.S. citizens, non-citizens who meet applicable residency tests (see separate discussion), U.S.-formed companies, and certain trusts and estates. The U.S. federal tax system generally taxes individuals on taxable income after allowed deductions, while taxing businesses based on their federal entity classification (detailed further down).

The U.S. has an extensive income tax treaty network that may reduce or eliminate withholding tax on certain payments to non-resident individuals or companies. For example, the U.S.-Japan income tax treaty generally eliminates withholding tax on most cross-border interest and royalty payments and reduces dividend withholding, which would be taxed at a default rate of 30%, to 0%, 5%, or 10%, depending on the circumstances. Each treaty can have nuances that makes it unique, and each U.S. income tax treaty is negotiated separately, so its definitions, rates, limitations-on-benefits rules, withholding relief, and procedural requirements should be reviewed treaty-by-treaty rather than assumed to match another treaty.

State Taxes

Similar to the federal rules, states across the U.S. will generally also impose corporate or individual income taxes on residents, including businesses with operations within the state. Operations of a business, once they reach a certain level, are what can cause a business to create a taxable “nexus” in a state and make it subject to its income or other taxes. Nexus is generally triggered when a company has people or property in a state, or a threshold level of sales to customers in the state, known as economic nexus. Nexus factors generally include sales (goods or services provided to customers in state), property (including rent and inventory), and payroll (e.g., employees in state).

Some states do not impose corporate or individual income taxes and instead tax other activities. For example, Washington state does not impose a corporate income tax but does assess a business and occupation tax. The state of Nevada does not impose a personal income tax but does impose a commerce tax on certain business entities. Each state must therefore be analyzed separately.

There is no federal uniform sales tax (consumption type tax) or federal property tax. Instead, these taxes are administered at the state and local levels. States generally impose sales and use taxes on the sale or use of tangible personal property, typically based on the destination of the product, and can extend these taxes to certain intangible property and specified services. Only five states do not impose a sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon,.

In addition, many states are increasingly considering or enacting taxes on digital products and services as part of broader efforts to expand their tax bases and address budgetary needs.

Nearly all states and local governments impose annual property taxes on commercial and residential real estate. Many also tax business personal property. Some states and localities impose additional taxes, such as real estate transfer taxes or taxes on specified commercial activities, particularly where those activities are significant revenue sources.

States aggressively compete for business by offering tax credits for research and development (R&D) activities performed in state, job creation, and capital investment.

Notable Highlights:

• Forty-four states levy a corporate income tax. Rates range from 2.5% in North Carolina to 11.5% in New Jersey.
• Four states, including Alaska, Illinois, Minnesota, and New Jersey levy top marginal corporate income tax rates of 9 % or higher.
• Eleven states, including—Arizona, Arkansas, Colorado, Georgia, Indiana, Missouri, Nebraska, North Carolina, North Dakota, Oklahoma, and Utah have top rates at or below 5%.
• Nevada, Ohio, Texas, and Washington impose gross receipts taxes instead of corporate income taxes. Delaware, Oregon, and Tennessee impose gross receipts taxes in addition to their corporate income taxes.
• South Dakota and Wyoming are the only states that levy neither a corporate income nor gross receipts tax.

Non-Residents

Non-residents may also be subject to U.S. income tax if they conduct a trade or business in the U.S., work in the U.S., or earn income effectively connected with a U.S. trade or business. Non-U.S. residents are generally subject to 30% withholding tax on certain U.S.-source payments, including dividends, certain interest, rents, royalties, and other fixed or determinable income, unless the income is effectively connected with a U.S. trade or business, or otherwise reduced by treaty or other statutory exception. The payor is generally responsible for withholding and remitting the tax. In some cases, the non-U.S. recipient may also have a U.S. tax return filing obligation.

Capital gains realized by a non-US resident are generally not subject to U.S. withholding tax unless associated with U.S. real-property interests. A non-U.S. resident’s excess capital gains from U.S. sources over capital losses from U.S. sources are subject to U.S. income tax (often enforced by withholding tax at the time of sale or allocation) if such gains are effectively connected with a U.S. trade or business (including, for this purpose, capital gains from the sale of a U.S. real-property interest) or may be subject to withholding tax if the non-resident otherwise resides within the U.S. for a certain period of time within such taxable year, unless such gains are exempted under an applicable income tax treaty.

U.S. Tax Residency Rules and 183-Day Test

As a general rule, U.S. persons are subject to U.S. tax on their worldwide income, which is reported on their individual income tax return, Form 1040. By contrast, non-U.S. persons are generally subject to U.S. tax only on U.S.-source income, which is reported on Form 1040-NR.

U.S. Citizens are, by default, U.S. Persons under the IRC Section 7701(a)(30)(A). Non-U.S. Citizens are only U.S. Persons if they are U.S. Residents (i.e., a resident alien or green-card holder).

Physical presence is a main test for determining U.S. residency.  A resident alien falls into one or two of the following categories:

• lawful permanent resident (e.g., someone holding a green card); and/or
• someone meeting the substantial presence test.

The substantial presence test is based on days present in the U.S. It is formula based and is satisfied when someone is physically present in the U.S. on at least:

• 31 days during the current year; and
• 183 days during the three-year period that includes the current year and the two years immediately preceding the current year.

The days counted for these elements of the substantial presence test include all of the days a person was present in the current year, plus:

• 1/3 of the days present in the first year before the current year; and
• 1/6 of the days present in the second year before the current year.

While the 183-day analysis is fairly straight forward, some complicating elements exist with respect to capital gains.  Generally, a non-resident alien is not subject to tax on any capital gains other than gains related to U.S. property or otherwise where gains are effectively connected to a U.S. trade or business.  However, if a non-resident alien is present in the U.S. for at least 183 days, this person becomes subject to taxation on their gains on the sale of capital assets located in the U.S.  Several rules also exist to navigate which stipulate what constitutes actual presence, when residency ends, and several exceptions. Thus, due care should be exercised when relying on the substantial presence test.

Lastly, if someone does not have a green card and does not satisfy the substantial presence test but still wants to be a U.S. resident for income tax purposes, there is an election to facilitate this under IRC Section 7701(b)(4).  However, taxpayers should proceed with caution when making this election as it is predicated on current and future residency with resulting tax implications.

Income Tax Residency and Treaties

Tax residency generally aligns with a taxpayer’s tax home. A taxpayer’s tax home is the location of the individual’s regular or principal place of business. If the individual does not have a regular or principal place of business, the tax home is generally the individual’s regular place of abode.

Even where an individual satisfies the physical presence test, the individual may still avoid classification as a U.S. resident if he or she:

• Is not present in the U.S. for 183 days in the current tax year;
• Maintains a tax home in a foreign jurisdiction; and
• Has a closer connection to that foreign jurisdiction.

Choice of Business Entity

Common business entities are C-Corporations, limited liability companies, and partnerships (general or limited). Many states provide for certain variations of these entities, such as limited liability partnerships. Formation of a company can be in the state where the business is located or in a state that offers the most favorable legal jurisdiction. Ultimately, several factors may influence which state is best suited for forming a business.

If a business is formed in a state other than where it is transacting business, it will generally be required to qualify (or register) to do business in the state where the company is transacting business.

For state income tax purposes, most states generally follow federal entity classification and calculate a tax base that is aligned with federal adjusted gross income or federal taxable income. However, states often require specific adjustments. These may include sales apportionment factors, state tax incentives, additions for deductions allowed federally, or other modifications to determine state taxable income.

U.S. C-Corporations:

The C-corporation is subject to federal income taxation on income as an entity separate from its owners, and the corporate shareholders are also taxed on their receipt of dividends when distributed. Generally, shareholders are not personally liable for corporate obligations (assuming they have not independently agreed with a creditor to be liable for those obligations, and the corporation is properly organized).

Corporations can be incorporated quickly (often in a single day) in any state in which the incorporators intend to begin a trade or business by filing with the applicable state agency articles of incorporation and paying a filing fee. The state jurisdiction of incorporation does not impact the corporation’s federal or state income tax liability.  However, other tax issues should be considered (e.g., franchise tax such as that imposed by Delaware).  Often the choice of jurisdiction is based on the unique state corporation laws and their impact on the desired internal governance structure of the corporation.

Corporations file Form 1120 annually and pay federal income tax at a flat 21% rate on the entity’s taxable income, and very large corporations may also be subject to the 15% corporate alternative minimum tax if average adjusted financial statement income exceeds $1 billion. The United States does not impose a qualified domestic minimum top-up tax, but it does have a tax regime intended to tax offshore low-taxed income on an annual basis. Capital gains are taxed in the same manner as ordinary income, while capital losses can, subject to limitations, be used to offset only capital gains in the year incurred. State corporate tax rates vary widely from 0% to 11.5%, with an average of 6.5% for states that impose a corporate income tax or gross receipts tax.

Shareholders generally are not taxed on corporate earnings until the corporation distributes cash or property as dividends to the extent of the corporation’s current or accumulated earnings and profits. Excess distributions generally reduce stock basis first, and amounts beyond basis are treated as capital gain. This creates potential double taxation when corporate earnings are taxed once to the corporation and again to shareholders when distributed as dividends, which is sometimes the main drawback of operating as a C-corporation.

A C-corporation formed under state law may have one or more non-U.S. resident shareholders. Non-U.S. resident shareholders of a domestic C-corporation are subject to US withholding tax rules on distributions of income to such non-resident shareholders, subject to reduction or elimination under an applicable income tax treaty (as described above).

U.S. S-Corporations

Many non-corporate businesses are taxed as pass-through entities rather than as separate income-tax-paying corporations.  Certain corporations with U.S. owners are eligible to elect to be “S-corporations” for federal income tax purposes. S-corporations generally are not subject to federal income tax, rather, income from businesses operated through S-corporations is subject to only one level of tax by causing income to flow through and be taxed to its shareholders.

 

An S-corporation is often attractive for closely held operating businesses where owners want pass-through treatment, relatively simple pro rata economics, and potential self-employment tax savings on allocable income after paying tax on reasonable compensation paid as wages and reported on Form W-2. Further, the qualified business income deduction can allow shareholders to deduct up to 20% of their share of qualified business income, reducing individual-level taxable allocable income without changing the S-corporation’s pass-through character.

An S-Corporation files form 1120-S annually to report its activity to its shareholders. Its main drawbacks are shareholder eligibility limits, one-class-of-stock restrictions, pro rata allocation requirements, limited debt basis for losses (i.e., debt basis only available for shareholder loans), and less favorable treatment of appreciated-property distributions.

Foreign Corporations

A foreign corporation that conducts a trade or business in the U.S. is subject to tax on net income derived from such activities. This activity is reported on Form 1120-F annually. The determination of whether a corporation is conducting a trade or business in the United States is very fact-specific and does not depend on whether the foreign corporation formally has a “branch” in the U.S. The rules generally require regular and continuous activities to create a U.S. trade or business. In addition, the rules treat a foreign corporation owning U.S. real property as being engaged in a U.S. trade or business.

If the foreign corporation is resident in a country with which the U.S. has an income tax treaty, and if the foreign corporation is eligible to claim the benefits of that income tax treaty, it will generally be exempt from U.S. income tax on its business profits except to the extent the profits were attributable to a permanent establishment in the U.S.

A foreign corporation that is subject to 21% U.S. corporate income tax (i.e., because it is engaged in the conduct of a trade or business in the U.S. and, if it is eligible for the benefits of a U.S. income tax treaty, has a permanent establishment in the U.S.) will also be subject to branch profits tax (detailed further below), which is intended to level the tax profile for foreign companies operating in the U.S. to that of C-corporations.

The branch profits tax is designed to put a foreign corporation operating in the U.S. in a position similar to a foreign corporation operating through a U.S. subsidiary. A foreign corporation is first taxed on its effectively connected income from a U.S. trade or business, as mentioned, then there is imposed a second-level 30% branch profits tax on the foreign corporation’s “dividend equivalent amount,” which approximates the dividend withholding tax that would have applied if a U.S. subsidiary had earned the income and repatriated it as a dividend to its foreign parent.

The “leveling” function is that a foreign parent using a U.S. subsidiary would face two layers: U.S. corporate tax at the subsidiary level and U.S. withholding tax when earnings are paid out as dividends. Without the branch profits tax, a foreign corporation could operate directly through a U.S. branch, pay only the regular U.S. tax on effectively connected income and avoid the dividend withholding layer. The imposition of the branch profits tax fills that gap by imposing a branch-level tax on earnings treated as withdrawn from, rather than reinvested in, the U.S. branch.

Treaties can reduce or eliminate the branch profits tax, but only if the foreign corporation is a qualified resident of a treaty country and satisfies the treaty and limitation-on-benefits requirements.

Limited Liability Companies

All states permit the organization under applicable state law of a limited liability company (LLC). As with other business entities, an LLC can be formed quickly, usually within one day. Generally, an LLC provides the members with protection from the liabilities of the LLC in the event the LLC becomes insolvent or is dissolved, and, in this regard, an LLC is similar to a state-law corporation. However, absent an election to be treated as a C-corporation, an LLC formed under state law that has more than one member is treated as a partnership for federal income tax purposes (and usually for state income tax purposes, though this should always be verified).

Accordingly, it retains the status of a “pass-through entity” for tax purposes similar to that of state-law partnerships, thereby avoiding the double taxation inherent in the C-corporation structure.

A wholly owned domestic LLC is generally taxed only at the tax-owner level because, by default, a single-member LLC is disregarded as an entity separate from its owner for federal income tax purposes, unless it elects to be taxed as a corporation. If the owner is an individual, the LLC’s business income and expenses are reported directly on the owner’s individual income tax return. If the owner is a corporation, partnership, or another LLC, the wholly owned LLC is generally treated as a branch or division of that owner, so its tax items are included on the owner’s federal income tax return rather than reported on a separate LLC income tax return.

Partnerships

A state law partnership (whether a general, limited or limited liability partnership) is generally treated as a fiscally transparent, or “pass-through,” entity for U.S. federal income tax purposes. While such entities are required to file annual Form 1065 with the IRS (and most states), it is the partners of the partnership, rather than the partnership itself, who are subject to federal and state income tax on their allocable share of the partnership’s income, gains, etc. at their individual level. However, in connection with a partnership audit, the IRS may assess and collect federal income taxes directly from the partnership, absent an election to the contrary.

A partnership formed under state law and operating within the U.S. may have one or more non-U.S. resident partners. Non-U.S. resident partners of a domestic U.S. partnership that is engaged in a trade or business in the U.S. and generating effectively connected income will be subject to U.S. federal tax filing requirements and withholding tax rules on distributions of income to such non-U.S. resident partners. In addition, a sale of an interest in such U.S. partnership by a non-U.S. partner is potentially subject to U.S. tax.

Trusts

A trust also can be used as an entity for holding investment assets and commonly used in the estate planning context, but generally not for the operation of a business. If a trust is used as the legal entity to conduct a business, the trust will be treated as a partnership or a corporation for federal tax purposes. A trust can be a grantor trust (disregarded as separate from its grantor for federal income tax purposes) or a regular trust (i.e., a “true trust”, filing Form 1041). In some situations, ownership interests in a trust may be widely distributed as ownership units that are regularly traded on a securities exchange.

FDAP Income / FIRPTA Rules

FDAP income means “fixed or determinable annual or periodical” income, generally referring to U.S.-source non-business income paid to foreign persons. FDAP includes broad categories of gross income such as interest, dividends, rents, royalties, compensation, pensions, annuities, prizes, awards, and similar payments, unless a specific exclusion applies. The payment does not have to be annual or recurring. A lump-sum payment can still be FDAP if it falls within the FDAP class, and an amount is “determinable” if there is a basis for calculating it later. Capital gains from sales of property generally are not FDAP, subject to exceptions such as certain contingent intangible-property payments.

Withholding tax generally applies to FDAP income and generally requires a withholding agent to withhold 30% of the gross U.S.-source FDAP payment to a foreign person unless an exemption, effectively connected income treatment, or reduced treaty rate applies, typically supported by Form W-8 documentation.

The disposition of a U.S. real property interest by a foreign person (the transferor) is subject to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) income tax withholding. FIRPTA authorized the United States to tax foreign persons on dispositions of U.S. real property interests.

A disposition means “disposition” for any purpose of the Internal Revenue Code. This includes but is not limited to a sale or exchange, liquidation, redemption, gift, transfers, etc. Persons purchasing U.S. real property interests (transferees) from foreign persons, certain purchasers’ agents, and settlement officers are required to withhold 15% of the amount realized on the disposition.

A U.S. real property interest is an interest, other than as a creditor, in real property (including an interest in a mine, well, or other natural deposit) located in the U.S. or the U.S. Virgin Islands, as well as certain personal property that is associated with the use of real property (such as farming machinery). It also means any interest, other than as a creditor, in any domestic corporation unless it is established that the corporation was at no time a U.S. real property holding corporation during the shorter of the period during which the interest was held, or the 5-year period ending on the date of disposition (applicable periods).

An interest in a corporation is not a U.S. real property interest if:

• Such corporation did not hold any U.S. real property interests on the date of disposition,
• All the U. S. real property interests held by such corporation at any time during the shorter of the applicable periods were disposed of in transactions in which the full amount of any gain was recognized, and
• For dispositions after December 17, 2015, such corporation and any predecessor of such corporation was not a RIC or a REIT during the shorter of the applicable periods during which the interest was held.

Additional exceptions and structuring steps can generally assist in avoiding FIRPTA withholding.

Transfer Pricing and the Arm’s Length Standard

U.S. transfer pricing rules are primarily governed by IRC Section 482 and its regulations These rules authorize the IRS to allocate income, deductions, allowances, basis, or other tax items among commonly owned or controlled organizations, trades, or businesses when necessary to prevent tax evasion or clearly reflect income. IRC Section 482 and the OECD Transfer Pricing Guidelines substantially overlap, because both are built around the arm’s-length principle: related-party transactions should be priced as if the parties were independent enterprises dealing under comparable circumstances.

U.S. Treasury and the IRS generally view IRC Section 482 and its regulations as consistent with treaty obligations and the OECD Guidelines, although U.S. domestic law controls outside the treaty competent-authority process.

The objective is to determine the “true taxable income” of controlled taxpayers (i.e., the income that would have resulted if related parties had dealt with each other at arm’s length).

Transfer pricing documentation is important, because the IRS can impose accuracy-related penalties for substantial or gross valuation misstatements involving transfer pricing adjustments. Penalty protection generally requires contemporaneous documentation showing that the taxpayer reasonably concluded its method was the most reliable method under the IRC Section 482 rules, and the taxpayer must provide that documentation to the IRS within 30 days of request.

The transfer pricing penalty is generally 20% of the underpayment for a substantial valuation misstatement and 40% for a gross valuation misstatement. For transactional penalties, a substantial valuation misstatement generally exists if the reported price is 200% or more, or 50% or less, of the correct arm’s-length amount; a gross valuation misstatement generally exists if the reported price is 400% or more, or 25% or less, of the correct arm’s-length amount.

In practice, U.S. transfer pricing analysis usually requires identifying the controlled transaction, selecting the best method, evaluating comparable uncontrolled transactions or companies, making reliable comparability adjustments, and maintaining contemporaneous documentation. The central question is whether the related-party pricing produces the same economic result that unrelated parties would have reached under comparable circumstances, as required by the IRC Section 482 rules.

Employment Taxes

Payroll taxes are taxes tied to paying employees. Their purpose is to collect and fund federal income tax, Social Security, Medicare, and unemployment programs through the payroll system.

Employers that hire employees are required to withhold and pay over to the IRS income and related Social Security and Medicare taxes on behalf of such employees. Payroll taxes make employers part of the tax collection system. Instead of employees paying all taxes once a year, employers withhold certain taxes from each paycheck and deposit them during the year. The withheld income tax, Social Security tax, and Medicare tax are considered “trust fund taxes” because the employer holds them in trust for the U.S. until paid over.

To the extent an employee may be subject to both U.S. and foreign social security taxes, a Social Security Totalization Agreement may eliminate double payroll taxation for a U.S. employer with employees outside the US or a foreign employer with employees in the U.S.

Employers are also required to withhold from each employee’s compensation and pay over to the IRS the employee’s allocable share of premiums under the federal unemployment insurance program.

States also impose similar income and unemployment insurance payroll taxes that must be withheld by an employer from each employee’s compensation.

Individual Income Tax

Individual U.S. taxpayers are generally subject to federal income tax rates (currently, up to 37%) on their worldwide gross income, less certain allowable deductions and credits. Individual U.S. taxpayers may also be subject to state and local income tax in the state where they reside or earn their income.

Generally, for individuals who are U.S. citizens and residents, capital gains from the sale of assets that are held for more than one year are subject to a maximum federal income tax rate of 20% and capital losses may, subject to limitations, be used to offset capital gains. However, in certain circumstances, capital gains may be upwards of 28% in the case of the sale or exchange of certain properties referred to as “collectibles” (normally artwork, jewelry and related high-value personal items) or up to 25% of the gain on certain depreciable property. Some taxpayers with income levels above a certain threshold will also be subject to a 3.8% federal tax on their net investment income, which includes capital gains and other investment income.

As with foreign corporations, non-resident individuals who conduct business in the U.S. or who dispose of certain U.S.-real property during a taxable year are required to file an income tax return. Non-resident individuals subject to withholding tax due to their being considered to be engaged in the conduct of a U.S. trade or business (e.g., through an ownership interest in a pass-through entity) are also required to file certain federal tax returns for the year of the withholding.

Indirect Taxes – Sales & Use Taxes

Most states tax retail sales of tangible personal property, but services are taxed only when specifically enumerated or otherwise included under state law. Common exclusions or exemptions include sales for resale, ingredient or component parts incorporated into products sold at retail, certain manufacturing machinery and equipment, and food for home consumption, but the scope and documentation requirements are state-specific. Sales for resale are commonly exempt because sales tax is intended to apply to the final retail sale to the end consumer, not to intermediate sales in the distribution chain. Sellers typically need to obtain and retain properly completed resale or exemption certificates to support exempt sales.

A seller generally must collect and remit sales or use tax only if it has nexus with the taxing state. Physical presence still creates nexus in many cases, such as in-state property, employees, agents, delivery, repair, or similar activities.

After the court case South Dakota v. Wayfair, physical presence is no longer required for substantial nexus under the Commerce Clause, and states may impose collection duties based on economic contacts with the state.

Every sales-tax state has adopted economic nexus rules for remote sellers and marketplace facilitators, commonly using thresholds tied to dollar sales, often $100,000, and sometimes transaction counts, often 200 transactions, although the computation varies by state. U.S. sales and use tax is highly state-specific. The same transactions, especially software, SaaS, digital products, cloud services, shipping charges, or bundled products and services can be taxable in one state and exempt or differently sourced in another.

Real Property Transfer Taxes

State and local transfer taxes generally apply to transfers or acquisitions of real property in most jurisdictions, with rates set by the applicable state or locality. These taxes are typically ad valorem taxes based on the value of the property transferred and, in some states, may apply to transfers of either legal or beneficial interests in real property, subject to specified exceptions. Certain cities also impose additional high-value real estate transfer taxes, commonly referred to as “mansion taxes,” on transactions exceeding specified thresholds.

Final Thoughts

The decision to do business in the United States triggers multiple tax considerations, including income tax, employment tax, sales tax, and other indirect taxes.  FGMK can assist you with this analysis to ensure an optimal tax structure that considers U.S. tax impact, as well as interplay with foreign taxes.  Please reach out if you have any questions about your existing or future U.S. business operations.