Anchin’s U.S. Expansion Playbook: Tax Considerations and Compliance Aspects When Forming a U.S. Entity

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When a foreign business decides to establish a U.S. entity, there are several key considerations to be aware of. The most important consideration is the selection of a business entity type, as it can significantly impact the operational efficiency, tax liabilities, and compliance requirements, both in the U.S. and in the foreign entity’s country of organization. There are four different entity types—C-Corporation, Partnership, Limited Liability Company (“LLC”), and S-Corporation—that a foreign business should be aware of when setting up its U.S. subsidiary. Understanding the differences among these entity types is crucial for foreign businesses, as the choice can have lasting legal and financial implications.

C Corporation

A C Corporation is a type of business entity that is legally considered separate from its owners. This separation provides the owners (shareholders) with strong liability protection, as they are typically not personally responsible for the business’s debts and liabilities.

From a tax perspective, a C Corporation is subject to what is commonly known as “double taxation.” This means that the corporation’s profits are taxed at the corporate level on its net profit and then taxed again at the shareholder level when profits are distributed as dividends. This double taxation can be a drawback for some businesses. However, the lower corporate tax rate can sometimes offset this disadvantage.

In the case of a foreign business owning a C Corporation, there are some important considerations. The foreign business does not need to file a U.S. tax return solely because it owns a U.S. subsidiary (the C Corporation). However, the C Corporation itself is a U.S. taxpayer and is required to file a U.S. Corporation Income Tax Return (Form 1120) annually. If more than 25% of the C Corporation is foreign-owned, which is common in this context, an information return (Form 5472) must also be filed. Form 5472 is an important reporting requirement for foreign businesses operating in the U.S., as it reports all inter-company transactions to the IRS. Failure to file gives rise to a substantial penalty of $25,000 per inaccurate or non-filed form. It is also important to note that payments from the U.S. subsidiary to the foreign parent, such as dividends, interest, rents, and royalties, may be subject to withholding tax under U.S. law, which requires careful management to avoid unexpected tax liabilities.

This withholding regime will be further analyzed in a separate article, along with how certain tax treaties can mitigate or reduce the withholding taxes due, and the important compliance filings that need to be made because of such payments.

A C Corporation is by far the most common type of entity used by foreign businesses looking to expand their operations into the U.S.

LLC

An LLC is a flexible type of business entity that combines elements of both corporations and partnerships and is relatively unique to the U.S. tax system. Owners, known as members, enjoy limited liability like shareholders in a C Corporation, while having the benefit of pass-through taxation, similar to a partnership. In essence, an LLC is considered a disregarded entity under U.S. taxation under its default classification.

When a foreign corporation owns an LLC, the foreign corporation (not the LLC) will be considered the taxable entity for U.S. tax purposes and have its own U.S. tax filing requirements. The foreign corporation conducting business in the U.S. must file a U.S. Income Tax Return of a Foreign Corporation (Form 1120-F). Additionally, if the LLC has any reportable transactions, it must file a pro-forma Form 1120 with an attached Form 5472 with the IRS each year.

Given that the above compliance requirements are both similar, but more onerous than those of a C Corporation, utilizing an LLC does not alleviate any compliance obligations in comparison to a C Corporation.

Furthermore, the same double layer of taxation that C corporation is subject to also applies in this context, except that the double layer of taxation will now apply to the foreign owner of the U.S. business as opposed to the U.S. business itself. Although the IRS does not have jurisdiction over the foreign corporation to apply withholding on dividends paid to its shareholders, they do apply a Branch Profits Tax (BPT). BPT is applied to any reduction in the foreign corporations U.S. Net Equity, a tax concept, which essentially replicates the impact of dividends paid out to the foreign corporation’s shareholders, thereby creating the double layer of taxation that applies to domestic corporations.

Therefore, the assumed tax benefits under U.S. domestic law of utilizing an LLC to alleviate the double layer of taxation are rarely available when using an LLC to expand a foreign company’s U.S. operations. One other item to note with regard to the use of an LLC is that it is still possible to operate in the LLC as if it were a corporation for U.S. tax purposes, thereby replicating the C Corporation taxation. This can be done by making an entity classification election on the LLC within 75 days of incorporation date.

Partnership

A partnership – General Partnership (GP), Limited Partnership (LP), Limited Liability Partnership (LLP), Limited Liability Limited Partnership (LLLP) – is a type of business entity formed by two or more individuals or entities who share ownership. Each partner contributes to all elements of the business, including money, property, labor, or skill, and in return, shares in its profits and losses.

Partnerships are subject to pass-through taxation. This means the partnership does not pay income tax, and instead, profits or losses are divided among the partners and reported on their respective tax returns.

Since there can be multiple owners in a partnership, it can lead to issues regarding decision-making and operational efficiency. To limit this issue, it is wise to have a small number of shareholders, and one or two owners deeply involved in the partnership.

U.S. partnerships need to file a U.S. Return of Partnership Income (Form 1065). It is also important to note that if the partnership earns income effectively connected with a U.S. trade or business, it may be required to withhold tax on the income allocable to the foreign partners.

Given that foreign businesses expanding to the U.S. ordinarily operate through a wholly owned subsidiary, a partnership vehicle is rarely used, other than in a JV with two overseas operating entities, or for investment structures.

S Corporation

An S Corporation is a type of corporation that elects to be taxed under Subchapter S of the Internal Revenue Code, allowing it to avoid the double taxation typically associated with C Corporations. Instead of the corporation itself paying federal taxes, the company’s profits or losses are passed directly to its shareholders and are reported on their individual income tax returns. This mechanism of pass-through taxation is similar to how LLCs are taxed, ensuring income is taxed only once at the shareholder or member level, rather than at both the corporate and individual levels.

However, there are restrictions on ownership for S Corporations. S Corporations are restricted to no more than 100 shareholders, and all shareholders must be U.S. citizens or residents. If a foreign corporation were to inadvertently own shares in an S Corporation, violating the set criteria, the S Corporation’s special tax status would be nullified. Consequently, the entity would default to being taxed as a C Corporation, and therefore, S Corporations are never used when foreign businesses are expanding their operations to the U.S.

State Selection

In addition to entity type, foreign businesses need to consider which U.S. state to establish operations in. Since there is no federal company law, the formation, operation, and dissolution of business entities are governed by state law. Accordingly, foreign businesses must determine which state they wish to use for formation and incorporation when establishing a U.S. entity.

As many may know, Delaware has become a common home for both domestic and foreign businesses to utilize for incorporation purposes.

For more information on the basic tax considerations and compliance elements of foreign businesses forming an entity in the U.S., please reach out to Kevin Brown or Gwayne Lai of Anchin’s International Tax Group or your Anchin Relationship Partner.

In the next installment of our U.S. Expansion Playbook series, we will discuss sales and income tax obligations for foreign businesses in the U.S.