As a foreigner who wants to conduct business in the United States, you have a lot of decisions to make. One of your very first decisions is how you want your business to be classified by the Internal Revenue Service (IRS). This choice is important to your overall business strategy because it could impact:
- The amount you pay in U.S. taxes
- The amount you pay in taxes to your home country
- When you pay your taxes
- Whether the taxes may be deferred
- Tax compliance and reporting obligations
U.S. Taxation of Foreign Businesses
Generally, there are two situations where a foreign entity may be impacted by United States tax law. A foreign entity may be subject to U.S. taxes if:
- It has income or activities within the United States that rise to the level of a U.S. trade or business according to U.S. tax rules; or
- It has a U.S. owner, member, or partner, and that ownership makes U.S. tax rules applicable.
General Tax Classification Options
It is important to note that the laws in your home country don’t dictate your business entity’s classification for U.S. tax purposes. Instead, the U.S. follows a specific set of rules for determining a foreign entity’s tax classification. When you create a company, you may be able to elect how it will be treated from a tax perspective:
- Taxed at the owner level. The income and losses of the business flow through to the business owners, who are taxed regardless of whether money is actually distributed to them. This type of business is known as a flow-through or tax-transparent. A partnership is an example of a business that is taxed this way.
- Taxed at the business level and the owner level. The business is subject to income tax at the entity level. Then, when money is distributed to the owners, they must pay taxes on their personal dividend earnings. Corporations are taxed this way.
The ability to choose the tax classification offers foreign business entity owners the flexibility to structure foreign investment and business operations in the U.S. in a tax efficient manner.
Choosing a U.S. Tax Classification
Not every foreign business can choose its tax entity classification. Business entities that are formed pursuant to U.S. federal or state corporate statutes as well as foreign entities are automatically classified as corporations.
Other foreign businesses, however, have quite a bit of flexibility in how to structure investment and business operations in the United States. Specifically, they may elect to be treated as a corporation, partnership, or disregarded entity (DRE).
Default Entity Classifications
If a foreign business fails to make an election, the IRS will use a default classification depending on the number of owners and whether the owners have limited or unlimited liability. The default U.S. tax classifications for foreign entities are as follows:
- Corporation. All of the owners have limited liability.
- Partnership. The business has two or more members and at least one member has unlimited liability.
- Disregarded entity (DRE). The foreign business has one owner, and the owner has unlimited liability.
Hybrid or Reverse Hybrid Entities May Result From Entity Classification Elections
Sometimes, the entity classification results in a hybrid (or reverse hybrid) entity, meaning the foreign business is taxed one way in its home country and another way in the United States. For example, an entity could be considered a flow-through entity for U.S. tax purposes and a corporation for foreign tax purposes, which could result in additional tax liability. The U.S. and foreign tax rules must be carefully navigated to prevent double taxation or other outcomes that result in a company paying more taxes than are necessary.
We Will Help You Make the Right Entity Classification Choice
Choosing the wrong entity classification can be very costly, so the best time to make an entity classification decision is before you start a business in the United States. Although an entity election can sometimes be undone after the fact, it is always simpler and cheaper to consider all of your options up front. We can help you understand how U.S. tax law works with the tax laws in your country of origin and recommend the best entity classification to minimize your tax exposure and achieve your overall objectives. Call us today, and let us help you make the right decisions for your business.