Entering the US Market: Tax Considerations

US residents pay the government corporate or income tax (on their worldwide income and gains). Certain exceptions apply to the income of non-US companies. So-called residents include individuals (US citizens and non-US citizens, resident aliens), corporations formed in the USA, and trusts and estates that meet a residency test.

Federal income tax is levied under the Internal Revenue Code of 1986, as amended, and the income tax regulations issued by the US Treasury. So-called non-residents who run a business in the US, work there or receive income from other US sources are also subject to US income tax.

Most US states also levy corporate and income taxes on businesses and individuals that are resident in the state or do business there. Other states tax other activities. Nevada, for example, has no corporate income tax for businesses operating there, but taxes gambling revenue and the like separately; Florida has no personal income tax, but does have a corporate income tax. That is why every US state has to be looked at separately from a tax perspective.

Here are the 10 most popular US states for foreign direct investment.

You will find everything on how businesses and individuals are taxed in the USA here and in our US tax guide for beginners and our guide to US income tax.

As a rule, a company's federal tax classification as a corporation or partnership also carries over to state income tax. Taxable income is taxed in a similar way. Most US states calculate their tax based on federal taxable income. The exact calculation and any deductions vary from state to state, though, so they should always be looked at case by case.

The Internal Revenue Code also imposes a withholding tax on dividends, interest, rents, royalties and certain other kinds of gross income paid to non-residents that is not effectively connected with a US trade or business. The US payer is responsible for withholding this tax and paying it over. In some cases the non-resident recipient must also file US income tax returns on that income. The US withholding rules for payments to non-residents are complex.

The USA has many income tax treaties that can reduce or eliminate the withholding tax rate on certain income. Between the USA and the UK, for example, most cross-border interest and royalty payments carry no withholding tax, and the rate on dividends is reduced to 0, 5 or 15%.

At federal level there is no general sales or property tax for businesses or individuals. Instead, targeted excise taxes are levied on the manufacture, distribution or sale of certain products in the USA, such as alcohol and firearms.

At state level, most states charge a sales tax at varying rates. In some cases it also applies to intangible goods and certain services. Each state sets its own nexus rules.

On top of that, virtually every US state has annual local property taxes on real estate and businesses. Many local governments also tax the tangible personal property of businesses. In some states where real estate or certain business activities are a major source of revenue, additional specific taxes, such as real estate transfer taxes, may apply.

1Legal system

The US legal system is generally based on common law. The federal government only passes federal laws, while the individual states pass their own laws. The federal government regulates interstate commerce, for example, while state laws apply only within that state. State law governs things like forming and dissolving companies and the property rights of locally resident businesses and individuals.

2Tax authorities

The federal tax system is run by the Internal Revenue Service (IRS). State income taxes and sales tax are administered by each state's own tax authority. Their names vary, but they are generally referred to as the state's department of revenue or treasury.

Take a business or individual based in New York City: the IRS collects federal income tax, while state income tax, sales tax and other state taxes go to the New York Department of Taxation and Finance. Many state tax departments also collect various taxes on behalf of local governments and pass the revenue on to them.

3Legal forms

In the USA, the formation, organization and management of a company, whatever its legal form, are governed by the laws of the relevant state. A company operating in several states is subject not only to the laws of its state of formation but also to those of every other state it operates in.

In every state, the most common business forms are the corporation, the limited liability company (LLC) and the partnership (general or limited). Many states also allow variants of these, such as the limited liability partnership. A business trust is also possible in the USA, but because of a number of complex issues it is usually not recommended.

3.1Partnerships

Partnerships formed under state law (whether general, limited or limited liability partnerships) are generally treated as tax-transparent or "pass-through" entities for US federal income tax. They must file annual tax returns with the IRS (and in most states), but the partners themselves are taxed on the income, gains, losses, deductions and credits at federal and state level. Find out more about how the LP is taxed.

A partnership operating in the US and formed under the law of a state can have one or more non-resident (i.e. non-US) partners. Partners who are not US residents are subject to complex US withholding rules when income is distributed and, if they sell their interest, to any income tax treaties that govern how such payments are taxed in the US. Read more about how your US company is taxed in your country of residence.

3.2Corporations

Corporations are formed under the law of the state in question. In every state, shareholders are generally not liable for the company's debts. Corporations can be formed quickly everywhere (often within a day) by filing the articles of incorporation with the relevant state authority and paying a state fee. Whichever state the company is formed in, it is subject to federal income tax. The choice of entity often comes down to the laws of the state and how they affect the internal structure you want for the company.

For federal and state tax purposes, corporations are not treated as "pass-through" entities. Instead, all profits and income, as well as income distributed to shareholders, are taxed at the company level. These companies are known as C Corporations. C Corporations are therefore subject to a form of double taxation. Not only are the company's profits taxed at federal level, along with any state income taxes, but so are any dividends paid out afterwards, or any repayments to shareholders that exceed their investment in the corporation.

Unlike C Corporations, the Internal Revenue Code allows certain shareholders (usually individuals who are US citizens or US residents) to form a corporation that is treated as a "pass-through" company at federal level. These "pass-through entities" are known as S Corporations. Like other pass-through entities, an S Corporation does not pay federal income tax at the company level. All income and gains, as well as losses, deductions and credits, are passed directly through to the shareholders, who must report these items on their personal tax returns. Unlike partnerships, however, S Corporations must pass these items through pro rata to their shareholders, which makes them less flexible for tax purposes than other pass-through entities such as state partnerships and LLCs (see below), which are taxed as partnerships for federal income tax purposes. Despite their tax transparency, S Corporations keep the same liability protection as other corporations. The federal tax rules for S Corporations are complex, and not every state recognizes their pass-through status.

Like partnerships, corporations doing business in the US may have one or more non-resident shareholders. Foreign shareholders of a domestic C Corporation are subject to US withholding tax rules on distributions, unless the tax is reduced or eliminated under an applicable income tax treaty.

3.3Limited Liability Companies

Every US state allows you to form a limited liability company (LLC). Like other entities, an LLC can be set up quickly, usually within a day. It protects its members and their personal assets if the LLC becomes insolvent or is dissolved, and in terms of liability it is comparable to a corporation. For federal income tax purposes (and usually for state income tax too, though you should always check), an LLC with more than one member is always treated as a partnership, unless it elects to be classified as a C Corporation. Like a partnership, it therefore counts as one of the "pass-through entities" and avoids the double taxation that comes with a C Corporation. Read more about how your US company is taxed in your country of residence here. An LLC with only one member, known as a single member LLC, is called a "disregarded entity" . It is registered for tax purposes, but ignored for most tax purposes (provided the LLC is not treated as a C Corporation). Our sister site zerotax.llc explains how such an LLC without a US permanent establishment can be used tax-free.

3.4Foreign company (with or without a US branch)

A foreign company doing business in the US is taxed on the resulting taxable income, meaning the income from that business after deducting operating expenses. Whether a business activity is taxable depends on the specific situation and is highly fact-specific. As a rule, it does not depend on whether the company has a branch in the US.

If the foreign company is based in a country that has a tax treaty with the US, it is generally exempt from US income tax on its business profits. This does not apply if the profits are earned through a permanent establishment in the US.

A foreign company subject to US corporate income tax (because it carries on a trade or business in the US) must also pay branch profits tax, whether or not it can claim the benefits of a US income tax treaty; a treaty can lower the rate (see details below).

As mentioned, the Internal Revenue Code imposes a 30% withholding tax (which may be reduced or eliminated by treaty) on payments to non-resident individuals and on US income of foreign companies that is not "effectively connected" with a US business. The US payer (for example a corporation paying dividends to a foreign shareholder or an LLC making distributions to one or more foreign members) must withhold the amount and pay the tax over to the IRS.

4Financing a subsidiary

4.1Equity financing

Contributions in exchange for shares

Payments or contributions to a company's capital in exchange for shares are not included in gross income for federal income tax purposes. Cash contributions in exchange for shares are generally not taxable for the shareholder. The same applies to contributions in kind if, immediately after the transaction, the shareholder (alone or together with other contributors) holds at least 80% of the voting power and at least 80% of the remaining shares.

Contributions without issuing additional shares

Depending on the circumstances, the company may also issue no shares to the shareholder in exchange for the contribution.

Distributions

Distributions to a shareholder are usually taxed as dividends to the extent the company has current or accumulated "earnings and profits". Anything above the company's current and accumulated earnings and profits is treated as a non-taxable return of capital up to the shareholder's basis in the shares, or as a gain from the sale or other disposition of the shares. Because non-residents do not pay US tax on gains from selling company shares (unless the company is a US real property holding company), distributions to non-resident shareholders are often not taxed in the US, even where they would produce a taxable gain for a US resident shareholder.

4.2Debt financing

Impact of withholding tax

Subject to important exceptions for portfolio interest and bank deposit interest, interest income that a foreign person receives from US sources and that is not effectively connected with a US trade or business is subject to a 30% withholding tax. As mentioned, the withholding rate can be reduced or eliminated under an applicable income tax treaty. For example, the treaty between Canada and the US eliminates withholding tax on cross-border interest payments (except participating interest).

Thin capitalization

Domestic companies may borrow money (whether from related or unrelated parties) without it counting as gross income for tax purposes. In addition, full repayment of the principal of such debt has no tax consequences in the US. Interest payments are subject to income tax for the recipient (or withholding tax for non-residents not considered engaged in a US trade or business). Subject to statutory limits, the payer can usually take current interest deductions or, in certain cases, capitalize interest payments.

How a taxpayer classifies funding as debt or equity, especially across borders, is a major concern for the IRS. Over the decades, an extensive body of common law case law, along with statutory and regulatory measures, has grown up around this issue. Here, thin capitalization of a purported foreign or domestic borrower relative to the debt it takes on is a factor that the IRS and the courts treat as a sign that a debt instrument looks more like equity. Combined with other factors, this can lead to debt instruments being recharacterized as equity for tax purposes. One consequence, among others, is the loss of deductions for financing costs.

There are no objective standards for what makes a borrower thinly capitalized for this purpose. Taxpayers are nonetheless very careful to support their equity or debt financing properly to avoid these problems.

4.3Stamp duty

The US levies no federal stamp duty on debt or equity financing.

5Corporate income tax

5.1Income tax rate

The federal corporate income tax rate is currently 21%. Rates vary widely from state to state, and as mentioned, some states levy no corporate income tax at all.

5.2Capital gains and losses

Capital gains of corporations are taxed as ordinary income, while capital losses can, with limits, only offset capital gains in the year they arise. Excess capital losses can, with limits, be carried forward to later years to offset taxable gains. The Internal Revenue Code restricts the use of capital losses (and net operating losses) by corporations after a change of control.

5.3Branch profits tax

The branch profits tax applies to foreign companies engaged in a trade or business in the US. It is 30% of the "dividend equivalent amount" for the tax year. It comes on top of corporate income tax and is levied on taxable income effectively connected with the US business. Foreign companies are subject to the branch profits tax if they hold an interest in a partnership, trust or estate that does business in the US or earns US income. Tax treaties can reduce or eliminate the branch profits tax in the same way as for dividends.

5.4Calculating taxable income

Tax base

A corporate taxpayer is taxed on the taxable income from its business activities. This is gross income less deductible expenses, with any credits then applied.

Deductions

Business taxpayers can deduct their "ordinary and necessary" expenses. As a rule, capital expenditures must be capitalized into the basis of the related property and are not currently deductible. The Internal Revenue Code does, however, provide certain exceptions to this rule, such as depreciation.

5.5Income tax returns

Domestic and foreign corporations doing business in the US, or selling certain US real property during the tax year, must file an annual corporate income tax return. Likewise, nonresident individuals and foreign companies subject to withholding tax because of a US trade or business must file federal tax returns for the year of withholding.

Corporate tax returns are generally due by the 15th day of the fourth month after the end of the company's tax year (so April 15 for calendar-year companies) to avoid late-filing penalties. Estimated tax payments must be made for the current year. Interest on unpaid tax accrues from the return's due date. If a foreign corporation fails to file a federal tax return, it may lose the right to take deductions from gross income.

6Cross-border payments

6.1Transfer pricing

US transfer pricing rules generally follow those of the Organisation for Economic Co-operation and Development (OECD), although special royalty provisions apply to transfers of intangibles. Under Section 482 of the Internal Revenue Code, the IRS can make a transfer pricing adjustment to a related-party transaction that does not meet certain conditions. US taxpayers can face substantial penalties if the IRS finds an adjustment appropriate and the taxpayer cannot promptly produce, on request, documentation for the transactions covered by the transfer pricing rules.

6.2Withholding tax on payments abroad

Payments by a US person to a nonresident (including nonresident partners and shareholders) of certain types of interest, rents, royalties, dividends, and management and administration fees are subject to withholding tax of 30%. This rate can be reduced under an applicable income tax treaty. Capital gains realized by a nonresident are generally not subject to US withholding tax. However, the excess of US-source capital gains over US-source losses must be taxed with US income tax (often via withholding) if those gains are effectively connected with the US (including gains from selling US real property). If the nonresident otherwise lives in the US for a certain period during the tax year, withholding tax applies unless the gains are exempt under an applicable income tax treaty.

6.3Multilateral Instrument

The US has not signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), which targets abuse of double tax treaties. Instead, the US relies on the limitation-on-benefits provisions in its existing income tax treaties and on domestic law to implement the standards against base erosion and profit shifting.

7Payroll taxes

7.1Income & payroll taxes for US employees

US employers paying wages to employees must withhold the related income tax and Social Security and Medicare taxes and pay them over to the IRS. If an employee is liable for social security in both the US and another country, a totalization agreement can prevent double taxation. This applies both to US employers with staff outside the US and the other way round.

7.2Unemployment insurance

Employers must also pay federal unemployment tax (FUTA) to the IRS.

7.3State payroll taxes

States also levy similar payroll taxes on income as well as unemployment insurance. At state level, too, the employer usually bears the latter.

8Individual income tax

Individual US taxpayers pay income tax of up to 37% on their worldwide gross income, less certain allowable deductions and credits.

For individuals who are US citizens or residents (i.e. resident in the US), capital gains on assets held for more than a year are taxed at a maximum of 20%. Capital losses can, with limits, be offset against gains. In some cases, though, capital gains tax can reach up to 28% when so-called "collectibles" (usually art, jewelry and similar valuable personal items) are sold or exchanged, or up to 25% of the gain on certain depreciable real property. Some taxpayers also pay a 3.8% tax on net investment income (Net Investment Income Tax), which includes capital gains and other investment income.

9Indirect taxes

9.1Tax on goods and services

The US has no national VAT or goods and services tax. As mentioned, however, there are certain excise taxes on specific goods made, sold or used in the US.

9.2Harmonized sales tax

There is no uniform sales tax. Each state authorizes and collects its own sales and use tax on goods sold to its residents.

9.3Real estate transfer tax

There is no specific federal real estate transfer tax. As a general rule, however, any gain from selling real property counts toward federal gross income.

Some states charge a real estate transfer tax when you buy property. In some, it applies whether the purchase is of a legal or a beneficial interest in the property. There are, however, certain exemptions.

You will find more on the US tax system in our beginner's guide and in our quick introduction to US tax law for European entrepreneurs. For the full picture of entering the US market, see our market entry hub and the page on tax-efficient US expansion.

Mount Bonnell Advisors supports you with whatever you need, from ongoing tax support for your US company to building a professional website.

Here you'll find the key terms and facts about US health insurance.

In short

• At the federal level, the US taxes under the Internal Revenue Code; most states also levy their own corporate and income taxes, each under its own rules.
• Partnerships and multi-member LLCs are tax-transparent; C Corporations pay tax themselves, and their dividends are taxed a second time.
• On dividends, interest, rents and royalties paid to foreigners, the US payer withholds 30% tax, unless a treaty lowers the rate.
• Foreign companies doing business in the US pay the branch profits tax on top of corporate income tax; the IRS reviews transfer pricing between related companies under Section 482.
• There is no national VAT; each state levies its own sales and use tax.

How we help you

• Corporation tax returnForm 1120 and Form 5472 for your US corporation.
• Withholding taxW-8 forms, withholding and treaty benefits, done right.
• PayrollPayroll, payroll taxes and filings for your employees in the USA.
• Sales taxRegistration and returns in the states where you have nexus.
• Tax structureA clean structure between parent company and US subsidiary, or between you and your US company, coordinated with your accountant.
• US Tax ConsultationYour US tax question, answered by people who know both sides.