Are you considering starting a US business but are still determining if you are eligible? Foreign persons may establish or own a business in the US because residency and citizenship are not typically required for business ownership. When starting a business in the US, you must consider the types of business entities you can legally own, the state where they will be formed, tax implications, and filing requirements. Navigating US tax laws and reporting requirements can be challenging due to the country’s multi-tiered income tax system. To help you navigate US taxation on foreign founders, we’ve created a Foreign Founders Tax Guide for your Cleer path to success.
Definition of Foreign Founders for Tax Purposes
The IRS defines a foreign person as “any nonresident alien, foreign corporation, foreign partnership, foreign trust, foreign state, or other non-US person.” Qualified foreign branches of US financial institutions are also included. Generally, U.S. branches of foreign corporations and partnerships are considered foreign persons.
Taxation of Nonresident Aliens
Nonresident aliens’ income earned in the US is subject to two different rates and is not eligible for the standard deduction or other tax credits typically available to US persons.
- FDAP: The gross amount is taxed at 30% or a lower treaty rate.
- Net ECI and personal service income earned in the US are taxed at the same progressive rates applicable to US persons.
Nonresident Aliens’ Tax Filing Requirements
You must file Form 1040 NR if you are engaged in trade or business in the US, have other US source income on which tax withholding did not fully satisfy the tax owed, or are claiming a refund. If you want to claim treaty benefits, attach Form 8833 to Form 1040-NR.
Nonresident Aliens’ Filing Deadline
- April 15: If you had wages subject to income tax withholding and filing on a calendar-year basis
- June 15: If you did not have any earnings subject to income tax withholding and filing for the calendar year
Taxation of Dual-Status Aliens
An alien has dual status if he is both a nonresident and a resident alien in the same tax year, which is usually the year of entry or departure from the United States. An alien’s US income tax liability for a dual-status tax year is calculated differently for the resident and nonresident parts.
Requirements for Residency Election
If a non-US citizen fails the green card or substantial presence test (SPT), he is classified as a nonresident alien for tax purposes. Visit our blog to learn more about how US tax residency is determined. If certain conditions are met, a nonresident alien who becomes a US resident under the SPT in the following tax year may elect to be treated as a dual-status resident for part of the previous year. Chapter 1 of Publication 519, U.S. Tax Guide for Aliens, outlines the specific requirements.
Tax Credits and Restrictions for Filing Dual-Status Tax Returns
In general, dual-status aliens can claim tax credits under the same rules as resident aliens. However, certain restrictions may apply when filing a tax return for a dual-status tax year, such as the inability to deduct personal expenses and the standard deduction on Form 1040. You may refer to this page for the complete list of restrictions for Filing Dual-Status Tax Returns.
Dual-status taxation
You will be subject to distinct tax regulations during the periods of the year in which you are a US resident and a nonresident alien. Notably, whether foreign income is taxable is determined by the date of receipt.
The tax rates are as follows:
- Your resident alien worldwide income and nonresident alien income connected to a US trade or business are combined (less deductions) and taxed at progressive rates like US persons.
- During your time as a nonresident alien, gross income not related to trade or business in the US is taxed at 30% or a lower treaty rate.
Filing Requirements for Dual-Status Aliens
Use Form 1040-NR to report US-sourced income for the nonresident period and Form 1040 to report worldwide income for the resident period.
- Any dual-status alien who becomes a US resident during the year and remains a US resident at the end of the year must file Form 1040 along with Form 1040-NR.
- Any dual-status alien who gives up US residence during the year and is not a nonresident at the end of the tax year must file Form 1040-NR with Form 1040 attached.
Dual-Status Alien Filing Deadline
- If filing on a calendar year: April 15.
- If filing on a basis other than the calendar year: The 15th day of the fourth month following the end of your tax year.
- If you did not have wages subject to withholding and filing based on a calendar year: June 15 following the end of your tax year.
- If you report your income other than on a calendar year: The 15th of the sixth month after the end of your tax year.
How Can Foreign Persons Start a Business in the US
When establishing a business or expanding a foreign company’s operations in the United States, several factors must be considered, including the type of business structure and state of registration. When deciding where to incorporate a business, evaluate factors such as tax advantages, regulatory burden, and ease of formation. Delaware is a popular choice among foreign founders due to its simple filing process, liberal corporate law requirements, and friendly business environment. There is no sales tax, and the franchise tax is based on authorized shares rather than income. Delaware corporations that do not conduct business in the state are exempt from state income taxes and do not require a license. You may also consider South Dakota and Wyoming, the only states without a corporate income or gross receipts tax. The procedure for foreigners establishing a business in the US is the same as for US residents. The general process is as follows.
- Choose the type of business entity you believe will be most beneficial to you.
- Select a state in which to register your business.
- Register the company.
- Apply for an IRS EIN.
- Open a bank account.
Need help registering your business? We can assist you in registering your business in any of the 50 states in US. If you have yet to decide which state to register your business, we can help you figure it out based on your specific needs, goals, and the tax benefits that will prove most advantageous for you. With Cleer as your partner, you can be confident that you will get off to a good start and be fully compliant.
Business Structures Available to Foreign Founders
Nonresident aliens may form, own, or be members of a US partnership, corporation, or limited liability company (LLC). US persons can own S-Corporations, but nonresident aliens cannot. Foreign companies can establish their US operations through a representative office, branch, or wholly owned subsidiary.
Partnership
For tax purposes, a partnership is not a separate legal entity from its partners, who are generally personally liable for the partnership debts and obligations. Limited partners in limited liability partnerships and limited partnerships, on the other hand, have liability protection.
Overview of Partnership Taxation
- Partnerships do not pay federal income tax at the entity level because revenue, loss, deductions, gains, and credits are “passed through” to partners, who report and pay their distributive share of partnership tax items even if no distribution occurs.
- Tax laws vary by state. Many states treat partnerships as pass-through entities, but there are some exceptions (for example, New Hampshire and Tennessee) where the partnerships are taxed directly.
Corporation
Corporations are regarded as distinct legal entities for taxation purposes, and by default, they are taxed as C-corps. Corporations are commonly used to establish businesses because they can raise funds quickly through stock sales, provide investors with limited liability protection (like LLCs), transfer interests freely, and retain earnings in ways other business entities cannot.
Overview of Corporate Taxation
C-corporations are subject to 21% income tax (after losses, credits, and deductions), whereas shareholders are subject to dividend tax. Corporate profits are thus subject to double taxation. A C-corporation may also be subject to state income taxes ranging from 0% to 11.5%. Visit our Complete Guide for C-Corporation.
Limited Liability Companies (LLCs)
A limited liability company (LLC) is a type of business entity in which individuals, corporations, other LLCs, and foreign entities can all be members. Members have limited liability, just like shareholders in a corporation. The Internal Revenue Service will treat an LLC as either a corporation, partnership, or disregarded entity, depending on the elections made by the LLC and the number of members.
Tax Classification of LLCs
The IRS will classify the LLC as a disregarded entity, partnership, S-Corporation, or C-Corporation based on the election and number of members.
- Default Tax Classification
- An LLC with a single member is regarded as a “disregarded entity” by the IRS for the purposes of federal income tax, but it is treated as a separate entity for employment tax and certain excise taxes.
- A multi-member LLC is treated as a partnership for federal income tax purposes.
- Alternative Tax Classification
- S-Corporation. File Form 2553 to elect this tax classification. Foreign persons are not eligible to elect this tax classification.
- C-Corporation. Use Form 8832 to elect this classification.
Overview of LLC Taxation
LLCs are generally classified as “pass-through” entities for federal income tax purposes, in which income, gains, losses, deductions, and credits are passed through to the members, who must report such items on their tax returns. LLCs pay no federal tax on business income, but members pay on their allocable share. LLCs may also be subject to state and local taxes. An LLC’s tax classification determines the applicable tax rates and filing requirements.
Overview of Foreign-Owned Entities Taxation
Foreign-owned Corporations
Foreign-owned corporations are taxed at 21% on their worldwide income and state tax, which may range from 0% to 11.5%. Tax treaties between the US and a foreign country are irrelevant for state tax purposes.
Foreign-Owned Corporations’ Tax Filing Requirements
Foreign-owned corporations, in general, must file Form 1120 (U.S. Corporation Income Tax Return) on the 15th of the 4th month following the end of the tax year. Visit our blog to learn more about Form 1120.
If a tax return needs to be amended, Form 1120X must be filed within three years of the original Form 1120. Other forms that may be required include but are not limited to Forms 1120-W, 7004, 5472, 941, 1042, and Form 1042-S.
Foreign-Owned Single-Member Disregarded Entity LLC
A single-member LLC is considered a disregarded entity (DE) unless a C-corporation tax classification is elected. A domestic DE wholly owned by a foreign entity is referred to as a foreign-owned disregarded entity. A foreign-owned DE is a separate entity from the owner, but the IRC disregards this distinction for federal tax purposes and treats it as a single entity with the owner. Thus, the business’s income, losses, credits, and deductions “pass through” to the owner’s personal income tax return. It is not required to pay federal income tax; however, it must report “reportable transactions” with related parties.
FODE Tax Filing Requirements
Generally, a foreign-owned DE must file pro forma Form 1120 (only items B and E must be filled out) and Form 5472 by April 15, after the end of its tax year. Write “Foreign-owned U.S. DE” across the top of Form 1120. To obtain a six-month extension, file Form 7004 by the tax return’s due date. To learn more, visit our blog on foreign-owned disregarded entities.
Foreign-Owned Multi-Member LLC Filing as a Partnership
A foreign-owned LLC is an entity in which a foreign person owns an interest, either directly or indirectly. Individuals, partnerships, corporations, other LLCs, and foreign persons may be members of multi-member LLCs. As pass-through entities, foreign-owned MMLCs are not required to pay federal income tax at the entity level. Partnership income, loss, deductions, gains, and credits “pass through” to its partners. They report their distributive share of the partnership tax items on their tax returns and pay any taxes due, even if no distribution is made.
Withholding Tax on Foreign Partners’ Share of ECI
A partnership that has an effective connection (ECI) with a US trade or business is required by IRC Section 1446 to withhold tax on the taxable income that is allocable to its foreign partners. The withholding tax rates are:
- Individual foreign partners: 37%
- Corporate foreign partners: 21%
Withholding Tax on Payments of US-Source Income to Foreign Persons
Under IRC 1441 to 1443, a partnership must withhold tax on payments of US source income to foreign persons. Unless a tax treaty or IRC provides a lower rate, the US taxes foreign persons at 30% on most US source income, such as FDAP.
Foreign-Owned Multi-Member LLC Tax Filing Requirements
Foreign-owned MMLLCs doing business in the US must file Form 1065 by March 15 if reporting based on a calendar year or the 15th day of the third month after its fiscal tax year ends.
If it is using the fiscal year, you do not have to file a US tax return if you have no income, expenses, deductions, or credits to claim. Other forms that may be required include Schedules K1, K2, and K3, Form 8804, and Form 8805.
Foreign-owned Multi-Member LLC taxed as a C-Corporation
A foreign-owned multi-member LLC that elects to be taxed as a C-corporation must comply with the same taxes and filing requirements as a foreign-owned corporation.
Overview of Foreign Entities Taxation
Foreign Partnerships
A foreign partnership is any partnership not formed or organized in the US or under the laws of the US or any of its states. Foreign partnerships, like domestic partnerships, are not subject to federal tax. Any income payments from non-effectively connected US source income to foreign partnerships are subject to a 30% withholding tax.
Filing Requirements of Foreign Partnerships
Generally, any foreign partnership with ECI or US source income must file Form 1065 on the 15th day of the third month after its tax year, regardless of whether its principal place of business is outside the US or all its partners are foreign. There are two exceptions to this rule. A foreign partnership with ECI allocable to a foreign partner must report and pay a withholding tax to the IRS even if no distribution has been made.
Controlled Foreign Partnership
When one or more US shareholders own 10% or more of a foreign partnership and hold more than 50% of its interests collectively on any given day during the partnership’s tax year, the foreign partnership is classified as a controlled foreign partnership (CFP). When a US person controls a foreign partnership, the IRC requires comprehensive reporting of the partnership’s activities and income. Form 8865 must be filed by US persons holding a minimum of 10% interest in a foreign partnership along with their tax returns to report information concerning certain transactions between them and the partnership, such as acquisitions, dispositions, and changes in foreign partnership interests. The schedules that have to be completed by a US shareholder depend on his category.
Foreign Corporations
The IRS defines a foreign corporation as a legal entity not created or organized in the US or in accordance with US law. Foreign corporations can do business in the US in several ways.
Form of Organization of US Operation
A foreign corporation’s US operation can be set up as a representative office, branch, or subsidiary.
- Representative Office
A representative office does not have its own legal identity. Its activities are extremely limited in scope, which does not result in the payment of federal income tax.
- Branch of a Foreign Corporation
Creating a distinct legal entity to open a branch office is unnecessary. However, a foreign corporation doing business in the US through a branch must pay a 21% federal tax on any income effectively connected with its US trade or business. It may also be subject to the 30% branch profit tax (BPT) on branch profit effectively connected to a US trade or business deemed remitted overseas (subject to tax treaty rate reductions or exemptions). No BPT will be imposed if the branch profit in the US is reinvested in US business interests or is not sent back to the owners in their home country.
- US Subsidiary of a Foreign Corporation
A subsidiary is a distinct legal entity that its parent company owns or controls. Subsidiaries are typically formed as corporations or LLCs, following the same formation procedures as any other new company in the US. Setting up a US subsidiary requires several steps that vary depending on the state and circumstances. The process is time-consuming and intricate, making it difficult to navigate. If you need assistance, feel free to contact us.
Key Benefits of Setting up a US Subsidiary
Tax planning is just as important as gaining access to a larger market when deciding whether or not to form a subsidiary. Many states in the United States provide tax breaks and other benefits to businesses that establish subsidiaries in their jurisdiction. Several states have no or very low corporate income tax rates. Wyoming and South Dakota, for example, have no corporate income or gross receipts tax, whereas Nevada exempts corporate income and dividends from taxation.
However, unlike other states, Delaware has straightforward business registration procedures and does not impose sales, inventory, or value-added taxes. In contrast, franchise tax is based on authorized shares rather than income. Many foreign companies prefer to establish subsidiaries rather than branches in the United States because subsidiaries are exempt from the 30% BPT that branches must pay in addition to federal income tax.
Read our blog: Tax Advantages: A Guide to Delaware Incorporation
Overview of US Subsidiary Taxation
A US subsidiary of a foreign corporation is subject to a 21% federal income tax on income that is effectively connected to the US business as well as state and local tax.
Overview of Foreign Corporations Taxation
Foreign corporations are only taxed on US-sourced income; the tax rate depends on their income type.
- Effectively Connected Income (ECI): When it engages in business in the United States, either directly, through a branch, subsidiary, or investment, the net ECI is subject to a federal income tax rate of 21%
- fixed or determinable annual or periodical (FDAP) FDAP income such as dividends, interests, and royalties derived by a foreign corporation from U.S. sources but not technically ECI are taxed under Section 881 on a gross basis at 30% or a reduced rate provided in a tax treaty with the US.
- BPT: 30% or the applicable treaty rate on deemed dividend
- Filing Requirements of Foreign Corporations. Every foreign corporation engaged in trade or business in the US or has US-sourced income is required to file a return using Form 1120-F, even if it has no ECI or US-sourced income during the tax year or its income is exempt from income tax under a tax convention or any provision of the tax law.
- Form 1120-F is typically due on the fifteenth day of the fourth month following the end of the tax year.
- The deadline for filing for a corporation whose fiscal year ends on June 30 is the 15th day of the third month following the end of the tax year.
- If it is not engaged in trade or business in the US, it is not required to file a return if its income tax liability is fully satisfied by withholding tax at source. However, this rule does not apply if it claims a refund or is subject to accumulated earnings tax.
Form 7004 must be filed to obtain an automatic extension to file its tax return. Other forms that may be required are Form 8886 and Form 5472.
Principal Anti-Deferral Regimes
The IRC has two principal “anti-deferral regimes” that apply to foreign corporations.
- Controlled Foreign Corporation (CFC)
According to Section 957(a), a foreign corporation becomes a CFC when US shareholders directly, indirectly, or constructively own more than 50% of the corporation’s total voting power or value on any given day during the foreign corporation’s taxable year. The provisions of Subpart F apply only to US shareholders who own at least 10% of the company. Subpart F eliminates the deferral of US tax on some categories of foreign income by requiring U.S. shareholders of CFCs to report and pay U.S. tax on their proportionate share of certain categories of the foreign corporation’s earnings and profits (E&P) in the year such income is earned, whether or not the CFC makes a distribution.
- Passive Foreign Investment Company (PFIC)
A foreign corporation is considered PFIC if passive income accounts for at least 75% of its gross income or if the average fair market value (FMV) of the assets it held during the tax year produced or were held to produce passive income was at least 50%. When a US shareholder of a PFIC sells their interest in the company’s stock or receives an “excess distribution” as defined by Section 1291, they are liable to additional tax and interest charges. For each year that they own a share of PFIC, individuals in the US who hold such shares are required to file Form 8621 with their tax return.
Staying Compliant with Cleer Tax’s Support
Foreign founders are allowed to invest in US companies or establish business entities (except S-corporations) in the US since both citizenship and residency are not required. Foreign founders’ tax obligations and filing requirements depend on the alien’s tax residency status, type of business structure established, types of income, and tax treaties between the US and their home countries.
Want to be assured of 100% compliance with legal and tax requirements applicable to your business entity right from the start? If you need assistance navigating the very complex multi-tiered income tax system of the US, book a consultation, or feel free to contact us and let our team of tax professionals take care of your tax needs.
Foreign Founders Tax Guide: Frequently Asked Questions
How does the US tax foreign persons?
Foreign persons are only taxed on US-source income. Nonresident aliens are taxed on their net ECI at the same progressive rates applicable to US citizens. FDAP income of foreign persons is subject to 30% or a reduced treaty rate.
What is the difference between the taxation of ECI and income not effectively connected with trade or business in the US?
The income tax rate is applied to the net ECI, while the 30% tax rate is applied to the gross FDAP income foreign persons receive, as netting is not allowed.
How would a foreign investor determine residency status?
A non-US citizen is classified as a nonresident alien for tax purposes if he fails to meet the green card or the substantial presence test.
Can a foreign investor have both resident and non-resident alien status in the same tax year for tax purposes?
Yes, a foreign investor can be a resident and a nonresident alien in the same tax year for tax purposes. This usually happens in the year of arrival or departure from the US.
What are the key tax differences between resident aliens and nonresident aliens?
Nonresident aliens are only subject to tax on income from US sources, while resident aliens are taxed on their worldwide income at the same rates as US citizens. Resident aliens’ ECI and FDAP income are subject to graduated tax rates like US citizens. In contrast, only the ECI is taxed using the graduated income rates for nonresident aliens.
When are foreign LLC taxes not applicable?
A foreign-owned LLC, whether single-member or multi-member, will not be subject to US LLC taxes if it is a member of an Affiliated Group that includes at least one US LLC.
When is a foreign partnership required to file a U.S. partnership return?
Generally speaking, if a foreign partnership has income from a US source or income substantially related to a US trade or business, it must file a US partnership return.
How can I determine if my foreign subsidiary is a Controlled Foreign Corporation (CFC)?
If US shareholders own more than 50% of the total combined voting power of all voting stock or the total value of the company’s stock, or both, they must also own at least 10% of the total combined voting power or value of shares of all classes of stock for a foreign subsidiary to qualify as a CFC in the US.
When do foreign founders need a US visa?
If a foreign founder wants to work in the US, they must have a US visa. Otherwise, a founder can be paid as an independent contractor working outside the country, but the US subsidiary needs to keep a W-8BEN on file. In addition, the non-US founder—or any other founder—must maintain documentation of all labor completed and receive “reasonable compensation” for those tasks; otherwise, the payments may be subject to dividend taxation.
