Entity Choices for Foreigners Doing Business in the U.S.
by Kevin Stickle, CPA/MS-Tax
Foreign persons may choose to conduct a business or hold an investment in the U.S. using a business entity that provides a legal level of liability protection, unlike personal ownership of the business or investment. Before deciding on an appropriate entity choice, however, foreigners should consider both the U.S. federal, state and resident country tax implications. Let’s look at some (but certainly not all) important tax considerations that should be considered.
A foreign corporation that engages in business may form a U.S. “branch” to do U.S. operations. A branch is simply a division or arm of the foreign corporation that operates in the U.S., as opposed to a separate legal entity. This structure typically provides anonymity in the U.S. for the ultimate owners, but it must separate its taxable income that is effectively connected with the conduct of a U.S. trade or business from its other non-U.S. income and expenses.
The net income from the U.S. operations (barring possible income tax treaty relief) is subject to federal and, perhaps, state income taxes. Additionally, there can be a branch profits “surtax” when the profits are withdrawn from the U.S. back to the home country of the corporation. This surtax may not apply in the year the branch is terminated or shut down.
The federal corporate income tax rate (currently 21%) applies to the U.S. branch net income. If there is a loss from the U.S. branch, the foreign corporation can typically deduct the loss against home country net income, and U.S. income taxes assessed on U.S. profits may be used as a foreign tax credit on the home-country corporate income tax return.
It’s important to note that, for U.S. real estate holdings, a 10-15% withholding tax based on gross sales price of the real estate sold may apply to any foreign corporation selling U.S. real estate. The U.S. estate tax does not apply to owners of foreign corporations.
A domestic corporation (i.e., a company incorporated inside the U.S.) generally pays U.S. (and applicable state) income taxes on its worldwide net income. The fact that foreign persons own the corporation's stock does not prevent U.S. taxation at the corporate level, although the foreign ultimate owners can also be provided U.S. anonymity under this structure as well, especially when a foreign corporation owns the U.S. corporation as a subsidiary.
For business or tax reasons, foreign persons may wish to form more than one domestic corporation. One example of this is the formation of “brother-sister” corporations for liability segregation purposes (e.g. one corporation holds real estate, the other runs the operations that occur on the real estate).
A domestic corporation that sells its assets is liable for U.S. tax on all the net gains. The corporation's foreign shareholders themselves generally incur no U.S. income taxes on the receipt of stock redemption/liquidation proceeds (there may be resident country income taxes on this transaction, however).
If a domestic corporation distributes cash or other property to its foreign shareholders as part of normal operations, the shareholders generally have taxable dividend income to the extent that the corporation has current or accumulated earnings and profits. A withholding tax rate of 30% generally applies, although an income tax treaty may reduce that rate. Thus, a double tax generally applies to distributed earnings of U.S. corporations.
The foreign shareholders may be able to avoid the shareholder-level tax, however, by having the U.S. corporation retain its earnings until a sale, redemption, or liquidation, or by structuring the U.S. corporation with debt financing rather than equity. Management or administration fees (where appropriate) may also be another way of moving cash back to the home country to avoid the “double-tax” issue that impacts domestic corporations.
Many states that impose income tax use a starting point of “worldwide net income.” So, using a U.S. corporation separate from the non-U.S. operations of the home country corporation may possibly serve to reduce state tax exposure as compared to branch operations of a foreign corporation.
The U.S. federal estate tax (“death tax”) can create a major disadvantage for foreign individuals directly holding a U.S. corporation. If the individual dies, the estate tax applies with respect to the discounted value of the individual's stock in a domestic corporation. The estate tax does not apply if a nonresident alien owns the stock of a foreign corporation that owns the stock of a domestic corporation. Foreigners living in certain countries that have a treaty with the U.S. may be able to reduce or eliminate U.S. estate tax exposure.
Consequently, if nonresident alien individuals are involved, then either foreign corporation operation of the U.S. business (a branch) or use of a U.S. corporation that is owned by a foreign corporation (a subsidiary) may be preferred structures to avoid U.S. estate tax.
Unlike the foreign corporation, sale of U.S. real estate by a U.S. corporation is not subject to federal withholding tax.
U.S. Limited Partnership or LLC
A partnership (or an LLC with more than one owner) pays no entity-level taxes. Instead, the partners generally pay current U.S. taxes on their allocated shares of the partnership's net income after expenses. Actual distributions of profits from a partnership to the partners aren’t taxed a second time, thus providing a possible tax advantage over corporations.
However, if the partnership has income that is effectively connected with the conduct of a trade or business within the U.S., or from sales of U.S. situs assets, the partnership may have to undertake an onerous withholding tax deposit remittance requirement on the foreign partners' shares of that income.
It is important to note that foreign individual partners must have a U.S. Tax Identification Number and file personal income tax returns, thus — U.S. anonymity is lost. The foreign partners can of course insert a foreign or U.S. corporation between themselves and the partnership if they desire, to maintain privacy. Additionally, home country tax treatment of any U.S. partnership profit or loss allocation to the foreign partner should be determined.
The U.S. estate tax may possibly apply to certain partnership interests held by nonresident alien individuals at death. The exact conditions under which the estate tax applies, however, are not completely clear and a discussion on this point is beyond the scope of this article.
It is important to note that Canadian resident persons should not directly invest in U.S. LLC’s due to the disparate tax treatment of these entities between the U.S. and Canada. First, the U.S. by default treats an LLC as a disregarded entity, like a partnership, whereas Canada treats them as corporations. An LLC passes through its profit or losses to the members and the members report this on their U.S. tax returns.
However, this treatment does not apply in Canada. Instead, Canada treats the distributions from the LLC to the member as income. Canada will also not permit a foreign tax credit for any U.S. tax imposed on flow-through profits, unless perhaps the distribution occurs in the same year as the profit allocation. Thus, there can easily be situations where double taxation exists for a Canadian holding an LLC interest. The first level of tax occurs when the share of LLC profit is taxed on the Canadian member’s U.S. income tax return. The second level occurs when the cash distribution from the LLC to the Canadian member is taxed by Canada, with no offsetting foreign tax credit.
Choosing a U.S. entity is an incredibly strategic decision to minimize overall tax liability for both the business and its owners. If you’re a foreigner doing business in the U.S., contact us to learn more about the most advantageous entity option for your unique circumstances.
Call us at (360) 734-4280 or fill out the form below and we'll contact you to discuss your specific situation.
Kevin Stickle, CPA/MS-Tax
Kevin Stickle joined Larson Gross in 1998 and has been an integral part of the firm’s tax practice growth since 1999. He is the firm’s former tax director, serving in that role for 9 years, and a current technical leader for the firm’s international tax service line.