Top 10 Tax Issues for Foreign Start-Ups in USA – Polo Tax
Setting the right business foundations is crucial to a foreign business seeking to expand into the U.S., and a foreign start-up can be confronted with a number of issues, in this regard:
- Entity choice – LLC v Corporation?
- Debt vs equity funding – which should you use?
- Choose a state: will any State do?
- Where are your owners based – in the U.S. or abroad?
- What is the R&D Tax Credit in the U.S. and how does it compare to other countries?
- Are you building to sell? Where are your likely acquirers based and what will be the nature of the transaction?
- State income tax – what is it and why is it important?
- State sales tax – what is it and why is it important?
- Depreciation – what is it and why is it important?
- “Active trade or business” – what is it and why is it important?
Each of these issues is considered in detail below.
Entity choice – LLC v Corporation
The choice of entity through which to operate a business in the U.S. requires consideration of a number of factors, including asset protection, corporate governance, and tax.
An “LLC” is a limited liability company with a flexible structure, which separates personal liability from business assets and is governed by State corporate laws. Generally, an LLC established in Delaware or Wyoming can be preferable due to the corporate governance, asset protection and privacy laws extended by those States.
An LLC can elect to be taxed as a C corporation (“C corp”) or an S corporation (“S corp”). An S corp is considered a “pass-through entity,” with the income of the LLC being attributed to the member(s) and taxed at the member level. LLCs taxed as C Corps are taxed at the corporate level (at the corporate tax rate of 21%) and members are taxed on distributions of profits from the LLC.
An LLC with one member is treated as a sole proprietor, and an LLC with more than one member, is treated as a partnership for tax purposes. In this sense, it can represent a “simple” corporate structure for U.S. (only) purposes. However, it can be a complex structure for tax planning purposes if the LLC members are located in multiple jurisdictions, as the LLC is not recognised as a corporation outside of the U.S unless it is a C corp.
A corporation (Inc.) provides the asset protection and corporate governance advantages extended by an LLC, but does not have the flexible structure or flow through basis for tax purposes. It does have the advantage of being recognized as a corporation outside of the U.S. and can be a preferred option for external investors and IPOs.
Debt vs equity funding
The funding of a newly formed entity’s operations within the U.S. can be of critical importance to the viability of the business, cash flow, and repatriation of profits, especially when external (third party) funding is difficult to obtain in the absence of an established business. Consequently, initial funding may need to be provided by debt and/or equity, from within the larger (foreign) group or directly or indirectly from individual stakeholders.
Funding by way of equity increases the stakeholder’s interest in the business. The return on their investment is funded by way of dividend payments from profits generated by the business, with the stakeholder being taxed on the dividend payments and bearing the business risks associated with that form of funding.
Funding by way of a loan or debt funding can have the following advantages, provided that the funding qualifies as “debt” – where the loan must be repaid at the end of the loan term, and interest is payable on the outstanding principal, at a specified commercial rate:
- interest payments from the U.S. debtor entity to the creditor are deductible, whereas dividend payments to shareholders are not. If the creditor is a foreign entity, withholding taxes can be withheld and paid in accordance with the applicable treaty provisions; and
- repayments of loan principal are tax free.
It is important to ensure that anti-avoidance rules are also complied with in ensuring that the funding arrangement qualifies as debt. These limitations include:
- the allowable interest expense deductions – which cap the amount of deductible business interest expense in a given tax year to the sum of the taxpayer’s business interest income for the year, 30% of the taxpayer’s adjusted taxable income for the year, and the taxpayer’s “floor plan financing” interest expense for large capital expenditure that year;
- the earnings stripping rules – which apply where a corporation has a debt-to-equity ratio exceeding 1.5 to 1, or its interest expense exceeds 50% of adjusted taxable income, or if the recipient is not fully taxed in the U.S. on the interest income;
- the thin capitalization rules which apply where the debtor is highly leveraged, and where the debt financing exceeds that of comparable taxpayers; and
- the limitation on accrued but unpaid interest – which defer deductions for interest accrued on a related party debt to align with the creditor’s receipt of the interest payment at a later date.
Choose a State: will any State do?
A number of factors must be considered when expanding your business into the U.S. – for example, visas for yourself and your employees, and Federal taxes and business regulations (depending on your business structure). Additionally, depending on which State your business is located in, State taxes and regulations can also be a crucial factor.
The following States do not tax earned income:
- New Hampshire
- South Dakota
The following States have higher income tax rates:
- New York
- New Jersey
The following States do not impose sales tax:
- New Hampshire
The following States impose the highest capital gains tax rates:
- Washington, DC
- New Jersey
- New York
Other factors when choosing a State, include its business regulations, employment laws, minimum wage, the cost of living, and work force. Texas, Florida, Utah, Wyoming, and Nevada consistently rank highly in this regard.
Where are your owners based – in the U.S. or abroad?
The location of a business’ owners can have a significant impact on its tax position, and in turn, its profitability. This is because the U.S. treats “U.S. persons” and “foreign persons” differently for tax purposes.
The Internal Revenue Code, defines “U.S. person” as:
- a citizen or resident of the United States
- a domestic partnership
- a domestic corporation
- any estate other than a foreign estate
- any trust if:
- a court within the United States is able to exercise primary supervision over the administration of the trust, and
- one or more United States persons have the authority to control all substantial decisions of the trust; and
- any other person that is not a “foreign person”.
The term “foreign person” refers to:
- a non-resident alien individual
- a foreign corporation
- a foreign partnership
- a foreign trust
- a foreign estate
- any other person that is not a “U.S. person”
- the U.S. branch of a foreign corporation or partnership is treated as a foreign person
U.S. Persons are taxed on their worldwide income, whereas foreign persons are taxed on their U.S. sourced income. Dividends, profit distributions, royalties, and distributions of capital gains from a domestic corporation or trust to a foreign owner is generally subject to withholding taxes of up to 30% under the Internal Revenue Code, unless a provision of a tax treaty applies between the foreign person’s country of residence and the U.S.
What is the R&D Tax Credit in the U.S. and how does it compare to other countries?
The Research and Development (R&D) Tax Credit (RDTC) is a tax incentive extended to businesses that conduct R&D activities in the U.S. A deduction is also available for R&D expenses (excluding expenses incurred to acquire depreciable property). The Federal RDTC and deduction were entrenched through tax reforms for the tax years beginning after December 31, 2015. These incentives are replicated in most States.
The purpose of these incentives is to encourage innovation and technology and provide businesses with an incentive to undertake these activities in the U.S., bring foreign investment into the country and provide knowledge and IP based employment locally.
The RDTC may apply to a business that incurs expenses for performing “Qualified Research Activities” (QRA) in the U.S. Such expenses include wages, supplies used and consumed in the R&D process, research expenses paid to a third party contractor for performing QRAs (capped at 65%) and payments to qualified educational institutions and scientific research organizations (capped at 75%).
In order to be a QRA, the activities must be shown to have been conducted to:
- resolve technological uncertainties;
- rely on a hard science, such as engineering, computer science, biological science, or physical science;
- develop a new or improved business product, process, software, technique, formula, or invention to be sold or used in the taxpayer’s trade or business; and
- test and evaluate alternatives.
The RDTC may be claimed for current and prior tax years. Therefore, businesses should document their R&D activities to ensure that they are claiming all relevant activities. This can be done by reference to payroll records, general ledger expenses, project documentation, and employee testimony.
For the 2016 tax year onwards, start-ups with no federal tax liability and less than $5 million in gross receipts, may qualify for up to $1.25 million (or $250,000 each year for up to 5 years) as a refundable credit against payroll taxes.
The tax incentives provided by the U.S. can be seen to have fostered an environment of innovation and increased R&D spending, with the U.S. leading the world in R&D spending, with almost 3% of GDP being spent on R&D activities each year. China, Japan, Germany, South Korea and India, are the other leading countries in high levels of R&D expenditure. However, the U.S. can be seen to lead the way in R&D incentives, with other countries now reviewing their tax policies in response to U.S. tax reform (as noted in the EY Worldwide R&D Incentives Reference Guide 2018).
Are you building to sell? Where are your likely acquirers based, and what will be the nature of the transaction?
You will need to consider a number of factors if you intend to ultimately sell your U.S. based business or the entity through which it operates. Therefore, these factors should be considered at the outset when establishing your business in the U.S.
A sale of a business or the entity through which it operates will generally be in the nature of a capital transaction generating a capital gain or loss, taxable either at the entity level or shareholder level, depending on how the sale is structured (asset sale vs entity sale) and the type of entity through which the business operates.
Asset sales: Profits from the sale of the assets of an LLC (that has elected to be treated as an S corp) or a sole proprietorship, will be taxed as a capital gain at the member level only, as these entities are disregarded entities for tax purposes. In contrast, if a C corp sells its assets it is taxed on the sale. Additionally, its shareholders must each pay taxes on distributions of profits made to them from the sale of the assets
Business interest: An interest in a partnership, JV, corporation is a capital asset, the sale of which would trigger a capital gain or loss.
A transaction that is structured as a “reorganization” may be tax-free if you receive stock in the buyer’s company in exchange for the assets of your business or the stock in your company.
Offering “seller financing” (vendor finance) to a buyer may be another option for structuring a sale of business. The buyer in such a case would make fixed monthly payments as consideration for the sale price. The total consideration is usually much higher under such a sale, with interest payments being factored into the monthly repayments, in order to compensate the seller for deferring the receipt of the total sales proceeds, and bearing the risks associated with the transfer of the ownership and control of the business to the buyer.
State Income Tax:
It often comes as a surprise to foreign companies expanding into the U.S. that state taxes are levied over and above Federal taxes. Understanding State tax is equally important as choosing an entity as each state is responsible for its individual tax rules. Thus, it is important that businesses that want to expand or operate in multiple states need to understand and be compliant with each states’ tax code.
State income taxes are levied in the proportion of income associated with the state. There are many types of state taxes, but state income tax is considered the most critical one. Most states also levy a corporate net income tax at the corporate level.
An entity has to pay state income taxes it establishes a ‘nexus’ with that state. This means that the company has created a substantial connection in the operation of their activities with that state. This connection could be a physical one such as owning offices, warehouses, having employees etc. It could also be an economic one such as online sales that meet a certain threshold level set by that state.
Most state tax rules are linked to or are a close variation of federal income tax decisions. Therefore, state tax rules tend to change in a comparable way to any change made in federal income tax rules.
Currently, 32 states tax in the same way as the federal tax structure, that is a progressive structure. On the other hand, examples of states with a flat rate income tax system are Massachusetts, Pennsylvania, Illinois, Colorado, and North Carolina among many others. States with no income taxes are Washington, Alaska, Wyoming, Florida, Nevada, Texas and South Dakota.
State Sales Tax:
Another kind of state tax imposed on business activity is a state sales tax. Sales tax is a tax imposed on any item sold by a retailer in any state. Sales tax is levied on buyers and the retailer is responsible for its collection and payment to the State.
In the previous article, we discussed what a ‘nexus’ means. If your business has established a ‘Sales tax nexus’ in any state, you are required to collect sales taxes on your transactions. Therefore, if the entity reaches a certain level of connection, whether economic or physical, a sales tax nexus is established between that entity and the state. The entity is responsible for registering with the state and collective sales tax from its customers.
To complicate things further, sales tax rates can either be ‘origin-based’ or ‘destination-based’. An ‘origin-based’ sales tax is collected in the state where the seller is located where as a ‘destination-based’ is collected in the state where the customer is located. States that have an origin-based sales tax are Illinois, Missouri, Ohio, Tennessee, Utah, Arizona, Mississippi, New Mexico, Pennsylvania, Texas and Virginia. While the rest are destination-based, California is the only state with a mixed form of the two.
If you have established a sales tax nexus, you will be required to obtain a state tax permit and levy sales tax on your consumers. Furthermore, you will need to be aware of each state’s filing requirement and frequency and ensure that you are compliant.
Depreciation: What is it and why is it important?
The intuitive definition of depreciation is the decrease in value of a property over time. The Internal Revenue Code defines depreciation as the “exhaustion, wear and tear and reasonable allowance for obsolescence of property”. Deductions for depreciation are allowable for property used in trade or business or held for the production of income as a means to recover capital. The key phrase here being ‘held for the production of income’.
In relation to foreign corporations, depreciation is deductible only for property that is used in generating income within the U.S. Foreign corporations can elect for their real property to be treated as effectively connected with the conduct of trade or business within the U.S. Deductions associated with the depreciation of these properties’ is allowable when the election is made.
Determination of whether a foreign corporation is engaged in U.S. trade or business is a question of fact. Property held for investment purposes or for sale to customers is not considered as being used in a trade or business or held for the production of income. An emphasis is placed by on the property being used in the operation or activities of the firm in order to for its depreciation to be deductible.
Foreign start-ups in the U.S. should evaluate their properties, plant or equipment required for the operations of their business activities and elect for them to be treated as effectively connected to the U.S. in order to be able to deduct depreciation. It is imperative that when need be the corporation can prove to the IRS that all property is being used to produce income.
Active Trade or Business: What is it and Why is it important?
According to the IRS, A corporation is to have an “Active Trade or Business” generally if it is performing or significantly engaging in operative and management functions. It does not include any investments in securities or properties or the operation of real property such as leasing.
The IRS defines start-up expenditures as any amount paid in creating or acquiring an active trade or business. Thus, it important to understand whether foreign company has start-up expenditures while expanding into the U.S. as these expenditures are deductible in your companies’ tax filing. The Internal Revenue Code Section 195 discusses deductions in relation to start-up expenditures.
According to Internal Revenue Code section 195, A taxpayer can elect to deduct start-up expenditures up to the lesser of:
(i) The amount of expenditure with respect to the active trade or business; or
(ii) $5,000 reduced by amount in excess of $50,000.
The remainder of start-up expenditure is deductible for a 180-month period after the month in which the active trade or business was established.