International small business owners starting operations in the United States face unbelievable tax laws. Many items allowed in the U.K. and Europe is “illegal” in the U.S. By the word “illegal” I do not mean that you will go to jail because you naively break the tax laws. However, you will get hit with a large tax penalty.
So, I want to list the international tax transactions that are not allowed.
- Thin Capitalization. The funding of your business is where the foreign investor makes his (or her but for this blog, I will use “his”) mistake. Corporations must be funded with $1 of capital for every $3 of shareholder debt. For example, Samfunds his U.S. corporation with a $1,000. $10 is for the common stock and $990 is a loan.The loan is documented with a promissory note and director minutes.The corporation makes a profit and repays the loan. U.S. tax law classifies that loan as capital and the repayment is taxable to Sam as dividend income. The interest paid the on the loan is not deductible. The interest is also taxable to Sam as a dividend.
- Management Fee. Sam, aware of the double taxation issue of a corporation, decides to remit the profits to his U.K. company as a management fee. U.S. tax law looks at the both the form (a management agreement) and the economics. The IRS audits the corporation and asks proof of the management services provided by the U.K. company. Sam has a story but he has no proof. He is taxed two times. The corporate taxable income is increased by the management fee.Next, the payment of the management fee is treated as a dividend. Sam is taxed on the dividend income. Both the corporation and Sam are charged a large tax penalty. Additionally, the state where he is operating also taxes the corporation.
- Salary. Sam does not take a salary from the corporation. He is paid by his U.K. company. He spends one third of the year in the U.S. One third of his U.K salary is taxable to both the IRS and to the state where the business is located. Sam is not a U.S. tax resident. He owes U.S. income taxes because he was in the U.S. and for no other reason.
- Tax Treaties. The French, the Netherlands and the U.K. tax treaty provides a tax advantage by eliminating double taxation To take advantage of the tax treaty, you must reside in the country and use a company formed in the tax treaty country. The operation in the U.S. is considered a branch. The U.S. has a law called “branch profits tax”.This law is designed to prevent double tax the profits. However, the treaties don’t prevent the branch profits tax.The treaties prevent double taxation of the income tax. The treaties provide that your home country will allow an offset of your home country tax for the income taxes your corporation paid to the U.S.