US Corporation Tax Tips for Foreign Founders

CRYSTAL STRANGER , EA, INTERNATIONAL TAX DIRECTOR , GBS TAX & BOOKKEEPING

31 Jan 2022

There are a lot of advantages to having a US corporation as an international founder. Some companies do this to have banking services in US dollars to make payments to international suppliers, or to receive payments using US credit card processing services. Other companies do this in order to open their companies to the US market and to sell their goods or services in North America. And yet other companies choose this for tax and financial planning purposes, to diversify holdings outside of their home country and sometimes find some tax advantages in a US company.

At GBS I have many consultation calls every week with founders in these situations. I dispel myths and misunderstandings, as well as helping these business owners understand what steps they need to take to stay in compliance within the US. Even better, I am able to help them find opportunities to save and become more tax efficient, to grow their business faster. Here are some of the common tax types and issues that I discuss in these consultations.

Income Tax

Income tax is the most easily understood tax, as it is similar to how most people are taxed personally in their home countries, so I like to start here. The US taxes companies on the net income, meaning what is left after all business expenses are paid out. Corporations must file an income tax return every year, regardless of if there is income. Thus even if $0 of income or expenses in a year, there is still a filing requirement typically by mid-April of each year, and high penalties could result if this is inadvertently missed.

There is no tax in the US on the gross turnover of a company, just on the profits. Those profits are taxed at a 21% flat-rate, although that can be lowered if all sales are made to customers outside the US, in that case the Foreign Derived Intangible Income discount can apply, bringing the effective tax rate down to 13.125%.

Expenses are generally pretty straightforward, in IRS-speak they must be “ordinary and necessary” for operating the business in order to be deductible. The area where it can be especially tricky for foreign founders is on paying compensation to shareholders and payments between companies.

Compensation of Shareholders

The default IRS treatment of payment to a foreign shareholder is to treat the income as “FDAP” income (fixed, determinable, annual, and periodic). Or, in other words, to have the income all be a dividend that is both taxable earnings to the company at 21%, and taxed a second time when paid to the shareholder. The default rate is 30% on the dividend withholding amount, but can be as low as 5% in tax treaty countries depending on the ownership structure, holding period, and country.

Compensation for services provided outside the US is treated much more favorably tax-wise though. This compensation is only taxable in the country where services are provided, and not in the US, and it is a deduction for tax purposes from the income of the company. With a big tax difference between compensation and dividends it should come as no surprise that this is an area where some people are taking advantage of the tax rules to have tax-free income. And in the long run this will create a massive risk for foreign-owned companies.

Wages to foreign employees aren’t clearly defined by statutes, so a flat wage amount paid each month is always a little risky as it must later be supported to show this was in fact for services, and not a dividend. Thus unless you use a PEO service in your home country to pay yourself on payroll, I usually recommend that shareholder compensation be paid on a variable rate based on the work actually performed, and supported by several documents:

• A contract defining the parties and what work the shareholder will do.
• Regular invoices from the shareholder to the company outlining what was done.
• Form W8-BEN on file proving the shareholder is not a US person.

Documenting these types of expenses like this doesn’t 100% guarantee that your taxes are audit proof, but it goes a long way to supporting this if it ever is questioned. Plus the question goes from “if the income is wages OR dividends” to “how much is the fair amount of wages and dividends,” which is a far more beneficial position to negotiate from.

Related Party Payments

The biggest penalty risk for most foreign-owned companies is the $25,000 tax penalty for missing form 5472. This is a form that must be filed with the income tax return to report payments between a foreign owner and a US company, or between another company with similar ownership structure and the US company.

If there is a sister company or subsidiary structure and profits are moved between the companies you will want to carefully set the fee structure of this relationship, and have these documents with an Intercompany Services Agreement and invoices. This usually is enough documentation at early stages, as long as it is set based on reasonable values, but once the company has reached the $5M in revenue range you should look at getting a formal transfer pricing study done.

Subsidiaries have additional issues. If the US company owns a foreign subsidiary then you have to file form 5471 every year. This is a complex tax return for the foreign company, set inside the US company’s return. There are also a lot of complex financial calculations that must be done to make sure the books are reported on GAAP and reported both in US dollars and the foreign currency. Furthermore, typically there will be ownership of bank accounts at least through attribution, that will then require filing of FBAR reports and Form 8938 to meet FATCA requirements. All of these forms carry hefty $10,000+ per year penalties, so this shouldn’t be overlooked. And as there is a lot of complexity to filing these forms correctly you should both budget additional time and substantial funds to the filing of this each year.

Franchise Tax

The first tax deadline of the year for many of our clients is Delaware Franchise Tax. Internationally-owned companies are often formed in Delaware because this is an all-online state that is popular with venture capitalists because of the long court precedent of Delaware protecting investors from liability. Many founders think the proliferation of Delaware companies is because of tax reasons, but this is not the case as there are more tax-friendly states such as Wyoming, Nevada, and Texas. Delaware has an income tax that applies for sales made within the state, and a Franchise Tax that is owed every year, regardless of if there is business or not.

The Delaware Franchise Tax (DEFT) is calculated based on a fraction of the authorized shares divided by the issued shares, multiplied by assets in the bank at year end. The best way to stay out of DEFT trouble is to issue at least 50% of your shares right away after forming your company. Sometimes with vesting arrangements and aggressive fundraising we have seen legitimately high DEFT balances. More often though, taxpayers just play with the numbers to get the $400 minimum tax to show, then after a couple years of filing that way, will result in a ‘Demand for Payment’ letter for over $85,000. We have cleaned a lot of these situations up for panicked clients over the years I’ve been at GBS.

State Taxes

There is a complex web of state tax regulations that are constantly changing. Each state is able to set the rules of who has to pay tax in their state, and under what conditions. In the past there were more limitations federally on how states could tax companies located outside their state, but the Wayfair v. South Dakota supreme court case a few years ago threw many decades of court precedence out the window and opened up a Pandora’s box of state tax regulations.

Most states have an income tax as well as a sales tax, and some states have minimum franchise taxes similar to Delaware that also apply if you are doing business in that state. Although “doing business” is a very loose term, as every state defines this differently. In general though, there are three ways that this is triggered:

• Physical presence in the state through an independent contractor, employee, or warehouse (beware of dropshipping!)
• Meeting an economic nexus trigger by having a certain amount of sales in the state.
• Having a certain number of sales in the state, or a percentage of sales or operations occurring in the state.

Please note that these triggers are always different for income and franchise tax than for sales tax. So you may have a requirement to file sales tax but not income tax, or vice versa.

The equivalent of VAT in the US is Sales Taxes. These are administered by each state, and most startups don’t hit the thresholds at early stages of business to need to pay sales taxes based on economic and sales triggers. But as with everything in tax, there are exceptions. Most states now have a Marketplace Facilitator tax law, so if your business is creating a website that allows other people to sell a service or goods, then you may have sales tax obligations to collect and remit right away. SaaS companies also often fall into an early compliance position, and they can end up with requirements to comply on very small amounts of income when the sales triggers are met.

Compliance Help

If you don’t want to learn all this yourself, I don’t blame you. It has taken me almost 20 years to understand all I do in the industry, and we spend months training every new accountant who joins our team to help our clients with all this, even with extensive accounting backgrounds. At GBS we can help you with this with consultations to understand better, tax filing services, and all-inclusive tax and bookkeeping packages to just get it all done for you. With our partnership with Gust we offer excellent discounts, especially aimed at helping early-stage clients get it all done correctly. Please reach out to see how we can help you.

GBS Tax & Bookkeeping

At GBS, we combine world-class tax expertise with cutting-edge accounting tech to provide next-level results for your startup. Our proven process enables us to deliver accurate, affordable, and efficient bookkeeping and tax services for US businesses and subsidiaries of all sizes. Gust Launch Accelerate and Raise customers get a discount on tax filing and bookkeeping services.

Best of all, we give you the financial insight and tax savings you need to extend your runway, secure your next round of funding, and scale your business.

Gust Launch can set your startup right so its investment ready.

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