US Tax — Startup Guide
The increasing globalization means that foreign citizens and companies are increasingly pursuing business in the USA. This type of transatlantic activity is usually carried out in one of two ways: directly by a foreign entity or a separate legal entity created for that purpose on the territory of the USA. Regardless of the chosen strategy, one of the most important issues and simultaneously the most frequently asked questions concern the moment of creation, scope and amount of tax obligation created in the territory of the USA.
Our experience shows that the complexity of the matter and the lack of accessible studies result in misunderstandings that sometimes lead to unfavorable decisions by foreign entrepreneurs. We undertake, therefore, to highlight nodal tax issues that should be taken into account when deciding to operate in the USA or to take up shares in an American company. This article does not constitute legal advice and each case should be analyzed individually, depending on the situation of a given entrepreneur, and the subject matter of tax law is too extensive to be described in one article. Having all the necessary objections, let’s move to the merits:
The matter of double taxation is usually governed by double taxation treaties between the USA and the foreign country. For example, Poland and the USA is regulated by the “Agreement on avoidance of double taxation and prevention of tax evasion with respect to income tax” since 1974 (hereinafter: “Agreement”). We will use the Agreement as an example of various tax issues between Polish founders doing business in the USA. In 2013, Poland and the United States entered into a treaty to replace the Agreement, but until today it has not been ratified by the Senate and the President of the United States (“Non-ratified Agreement”), and therefore the Agreement remains in force.
Additionally, in order to fully understand the complexity of taxing a Polish entity operating in the US, it is necessary to look at US tax law, especially the IRC Code (Internal Revenue Code — IRC), as many of its provisions regarding US citizens will in certain circumstances also applicable to Polish entrepreneurs. In connection with the above, at the end of this article, we also provide tables with the current tax rates for individuals and corporations in the USA.
Direct activity in the USA; the concept of permanent establishment
According to art. 8 of the Agreement, contracts derived from the US profits of a Polish natural or legal person are in principle subject to taxation only in Poland, unless it carries out a business activity by a permanent establishment in the United States. It follows that determining the existence of a permanent establishment is crucial, because it means a tax obligation in the United States.
The definition of a permanent tax plant is included in art. 6 of the Agreement. A permanent establishment means a permanent place where business activity is wholly or partly carried out. It means in particular: a branch, office, factory, workshop, and also includes the regular performance of a power of attorney to enter into contracts on behalf of the enterprise on the territory of a given country. In practice, this means that the permanent presence in the USA of a natural person who signs contracts for the benefit of a Polish entrepreneur will be considered a case of a company within the meaning of art. 6 of the Agreement. According to the Agreement, an establishment will not be considered a permanent establishment if used solely for storing, displaying or issuing goods or merchandise of the enterprise, stocks of goods or goods held for storage or disposal, or for processing or processing, or a fixed place maintained for advertising purposes, for the purchase of goods or goods or providing or obtaining information. A permanent establishment is also not one that perform the activities of the enterprise by a broker or other representative operating as part of its ordinary commercial activities and the mere fact of controlling another company having its registered office or operating in the USA does not make it permanent establishment.
It should be remembered that the above list is not exhaustive, and tax authorities have an interest in classifying economic entities in a way that results in a tax obligation in their jurisdiction. In connection with the above, a particular emphasis should be placed on individual examination of each case in order to determine whether the activity of a Polish entrepreneur in the USA has reached the status of a permanent establishment. We suggest considering the above issues while still at the planning stage in the US.
Running a permanent establishment results in an obligation to submit a tax declaration on Form 1040 or 1120 - F to the Internal Revenue Service (“IRS”), and the effective tax rate will depend on the income earned and reported (see Tables 1 and 2 below), depending on whether the enterprise is run by a natural person as sole proprietorship or through a legal entity.
It should be remembered that entrepreneurs operating in the US may have certain obligations, regardless of whether their activity is classified as a permanent establishment, e.g. paying state sales taxes or issuing forms W-2 to employees.
Income subject to tax obligation
If it is determined that a Polish entrepreneur is subject to tax in the United States, the next step is to determine how much of his income is taxed in the US. Art. 8 of the Agreement provides that profits may be taxed in the USA only in the amount falling within a tax facility operated in the US. This, unfortunately, means that it is necessary to determine which profits fall within the scope of operations of the given establishment.
Running a business by a legal entity; the basics regarding US companies: joint stock and limited liability.
A significant number of Polish entrepreneurs choose to conduct business in the United States in an approximate form to a domestic joint-stock company (“C Corporation” or “C Corp.”) or a related entity of a Polish limited liability company (“LLC”). Under corporate law, LLC is treated as a C Corporation, which means that it is a separate legal entity. Depending on the choice of its member(s), on the tax basis it can be treated as a full-fledged company or a transparent company. In the latter case, this mechanism is commonly referred to as "pass through", in which case no corporation tax is charged. In contrast to the LLC, the C Corp. is additionally taxed at the level of the company itself, thus the appropriate tax is imposed on the company when it makes profit, as well as on the shareholders themselves, when the income is paid in the form of a dividend.
A natural person as the only partner in the LLC
If LLC is a sole proprietor (the sole partner is a natural person), it is treated as non-existent in the tax field, in accordance with the "pass through" mechanism. Therefore, the shareholder of such a company will be treated as if he were self-employed in the United States and will be taxed in the United States on income earned from operations, according to the regulations of US tax law to the extent that it can be linked to a permanent establishment. As in the case of a business conducted by a natural person who qualifies as a permanent establishment, the profit attributable to LLC should be reported as part of the tax return on form 1040, and the effective tax rate will depend on the income earned and reported (see Table 2 below).
Even if a sole proprietor of an LLC has no profits that can be linked to a permanent establishment, he may be required to report financial participation under FBAR (Foreign Bank and Financial Accounts) regulations.
Legal person as the sole partner in the LLC
The existence of an LLC in which the sole partner is a legal person is allowed. The LLC as a sole proprietorship will probably be treated as a branch of a Polish company in the USA (pursuant to the 26 Code of Federal Regulations § 301.7701-2). The presence of the branch is tantamount to the existence of a tax establishment, in connection with art. 6 of the Agreement. This means that the profit of the Polish enterprise will be taxed to the extent that it can be assigned to the undertaking. In this case, you must submit form 1120-F, which concerns the refund of income tax on foreign corporations, and the same tax rates will apply to US companies, as shown in Table 1 below.
In addition, due to the one-man nature of the LLC, the foreign partner of LLC may be considered, under US tax regulations, as the parent and LLC as its branch. According to the regulations, any payment of profit from the branch to a foreign parent company will be taxed at a rate of 30%. (IRC §884 (a)), unless the United States has entered into a double taxation agreement with the relevant country under which it will be possible to reduce the tax due (IRC §884 (e)). This tax includes interest, dividends, rents and license fees.
It is crucial for Polish entrepreneurs that the IRC provision §884 (a) imposing a branch tax has been enacted in the Tax Reform Act in 1986 and, as indicated by the IRS, the branch tax is still nil for several double taxation avoidance agreements which have not been renegotiated since January 1987. In view of the above, since the Agreement entered into force in 1974, and its successor since 2013 has not yet been ratified - Polish legal entities operating in the US through the establishment of an LLC sole proprietorship will not be subject to this tax.
LLC with several partners
If an LLC has several partners, then, as a rule, it is taxed by the IRS as a partnership, unless the LLC fills in Form 8832 and decides that it wants to be taxed as a joint-stock company. In the event that such decision is not taken but decides instead to complete Form 1065, which includes information about the income received, this type of LLC does not pay corporate tax. Instead, the tax is paid by the individual partners of the company by submitting their own individual or corporate tax returns. This means that each partner will be taxed as described above in the sole proprietorship LLC, depending on whether he is a natural or legal person.
Joint Stock Company (Corporation)
There are two major differences between LLC and C Corporation for tax purposes. First, instead of being a passive tax company, the C corporation is taxed twice: at the corporate level, and then again, when paying dividends. Dividends from US joint-stock companies to Polish shareholders will be subject to a reduced rate of 15% or 5% if shareholders hold over 10% shares of the company, pursuant to art. 11 of the Agreement.
Second, C Corporations are not taxed on the basis of profits related to their activities in the US, but on their global income. A company established in the US with foreign capital is taxed in the same way as a domestic American company, so the tax obligation covers all its income, according to the tax rate indicated in Table 1.
Importantly, apart from the standard corporate document (form 1120), an American company in which there is more than 25% foreign capital is obliged to also submit form 5472 if there are any transactions subject to notification (such as sales, rents, license fees, foreign interest, excluding dividends) between a corporation and a foreign shareholder holding 25% share.
Running a business without the founding of LLC or C Corporation certainly has one advantage: as long as the activity in the USA is not treated as a bet, the Polish person is not obliged to settle his IRS income. On the other hand, the lack of an American entity does not allow for the possibility of limiting liability, which is covered by American companies. Additionally, due to operational and investment reasons, it is often necessary to have a company in the USA. In general, it should be assumed that the larger and more complex the structure of the enterprise and shareholders, the more likely a corporate structure is necessary.
Each type of company has its advantages and disadvantages. Running a business through LLC is a good solution for a Polish shareholder, in certain circumstances. On the one hand, it avoids double taxation and allows you to omit branch taxes. On the other hand, it is necessary to fill and submit appropriate forms, calculate the profit attributable to a permanent establishment, submit a separate tax return and pay an adequate tax. If C Corporation is selected as an organizational and legal form, US law subjects the payment of dividends to double taxation, and this type of company is obliged to pay US taxes on its global income. However, in practice, dividends are just one of the methods of distributing profit from companies, and this tax burden can be mitigated by, for example, concluding specific service contracts and correct transfer prices. In addition, people who prefer anonymity and are not interested in reporting their own individual income to the IRS, should choose the form of C Corporation instead of sole proprietorship.
For a broader understanding, below we present the federal corporate tax rates and personal income tax rates in 2018: