I recently had a client come to me to ask about the appropriate business entity for a startup with foreign investors.
This is one of those questions where if we eliminate what’s impossible and what’s not a good idea, what we are left with is the best choice.
First, according to the tax code, non-US residents cannot own shares of an s-corporation. Having a foreign investor is grounds for automatic dissolution of s-corporation status, so we can go ahead and eliminate that option.
Next, let’s consider the LLC. The majority of US businesses start as LLCs and choose the default option to tax that business as a “disregarded entity.” A disregarded entity is a business that is ignored for tax purposes and all income passes directly to the owners of the business. Instead of filing a separate tax return for the LLC, each owner puts his or her share of the LLC’s gains or losses on their personal tax returns for the year.
This begs the question: What happens if you have a foreign owner of the business, who wouldn’t normally pay taxes in the United States? The tax code says that if a foreign partner has business activities, offices, or employees within the United States, his or her distributive share of partnership income is deemed to be “effectively connected” with trade or business conducted within the United States. That means your foreign owner is now going to have to file K-1s and 1040s in the US, in addition to whatever tax returns he or she is obligated to file in his or her own country. Most often, the investor’s home country will also consider the income received from the LLC a taxable event there, as well. That means an investor in a disregarded entity in the United States will likely have to pay taxes on top of taxes for all income received from his or her ownership stake in the LLC.
This goes for all disregarded entities, so the same would hold true for partnerships, sole proprietorships, and limited liability partnerships.
This effectively leaves us with the c-corporation. Unlike with an s-corporation or an LLC, the earnings of the business do not flow directly through to the owners. Generally, shareholders pay for shares of the company to become owners. The US tax code does not normally require foreign shareholders to pay taxes on capital gains or dividends for US c-corporations unless that has a more direct connection with the United States.
So there you have it. If you’re starting a business with foreign investors, the c-corporation is almost always your best option.