Incorporating in the US: Tax and Regulatory Considerations

Wilson Sonsini Goodrich & Rosati and leading UK VC firm Notion Capital have teamed up on a blog to offer their perspectives on transatlantic VC investment and considerations for UK and other non-US companies looking to raise VC funding from US investors. Check out the full series here.

Non-US entrepreneurs often ask us about navigating the hodgepodge of local, state and federal laws, and regulations comprising the US tax and regulatory regime. The interplay among these various rules is very different from the systems with which most non-US companies we meet are familiar. Operating through a US company typically carries with it significant tax and compliance responsibilities, and non-US entrepreneurs should understand the relevant considerations before deciding to set up in the US.

Compliance does not necessarily need to be expensive; many compliance obligations are addressed as part of discounted start-up packages offered by tax accounting firms, law firms and other advisors. But it pays to understand upfront what those US compliance obligations actually are.

To be absolutely clear: gaining access to the world’s largest commercial market is well worth the entry costs, and those costs need not be significant. However, the strict US tax and regulatory environment can significantly increase costs if proper care isn’t taken.

Taxation

The US tax environment is complex. Corporate income tax is imposed at both the federal (national) and state levels, and a corporation may be subject to state corporate income tax in multiple different states in which it has customers, employs people or generally conducts business. Sales tax is imposed at both the state and local levels, and in some states (including, for example, New York) extends beyond goods to SaaS services. Depending on the nature of the business, still more taxes may apply.

Non-US emerging companies must also contend with US tax laws as they pertain to securities. Potential investors will often inquire about the tax treatment for a company’s securities as part of their due diligence, as certain US tax laws grant preferential treatment to shares and the holders of such shares in qualified businesses, depending on the context of a transaction.

Non-US entrepreneurs may also need to familiarize themselves with tax issues attendant with providing employees share compensation, a key form of compensation increasingly employed by emerging growth companies in the U.S. For instance, individuals subject to US tax receiving shares or options subject to vesting over time – the shares many companies issue to their employees – generally have only 30 days after receiving such stock to make certain key beneficial tax filings. Even in instances such as these where a company is not legally obligated to act, the practical reality is that a non-US company needs to be aware of these considerations, as disgruntled employees upset over losing tax benefits may lead to increased operational costs.

To avoid penalties and unnecessary costs, we consistently recommend to non-US emerging companies that they work with a startup-friendly US tax accounting firm to ensure they correctly set up US tax compliance and establish appropriate arms-length arrangements between the parent company (“topco”) and subsidiary. This does not need to be excessively expensive when handled by a tax accounting firm motivated to work with early-stage companies on a low fixed-fee or discounted basis.

In particular, non-US entrepreneurs should get tax advice before setting up in, or “flipping” into, a US topco. Establishing in the US through a US topco – rather than a US subsidiary – potentially subjects global corporate profits to US tax. Not only is managing US international tax compliance beyond the internal capabilities of most non-US start-ups, but corporate income tax rates in the United States are among the world’s highest. Combined federal and state rates of 40% are typical, compared with 20% (soon declining to 17%) in the UK and 12.5% in Ireland. Accordingly, subjecting global revenues to the US tax system may not make sense.

Further, because moving either a company or its intangible assets such as IP out of the US typically will result in significant US tax consequences, we often encounter early-stage companies experiencing “buyer’s remorse” after establishing a US topco when it made little long-term sense for their business. Beyond the downsides of any negative tax treatment, the US tax scheme with respect to IP transfers can also complicate an eventual exit by dissuading potential non-US based entities from pursuing an acquisition.

As a result, although we are US-qualified lawyers, we often recommend that non-US entrepreneurs seriously consider setting up through a UK or Irish topco and enter the US market through a Delaware subsidiary. The UK and Irish tax rates are lower, compliance is easier, and treatment of non-local source income is more favorable. Also, a non-US topco operating a successful US business through a US subsidiary may be a more attractive acquisition target to US multinationals seeking to put to good use their offshore “trapped cash” profits.

Finally, it is very important to understand the interaction between the tax systems of your home country and the US, as it affects the company and its founders, shareholders and employees. This is influenced by a variety of factors, including the home country’s domestic tax legislation, US domestic tax legislation, and the home country’s tax treaties with the US.

Regulation and Compliance

The US is a highly regulated environment for businesses, often with regulations at the federal, state and local level. Non-US companies entering the US market need to understand what applies and how to comply, especially in heavily regulated industries such as financial services and healthcare.

To provide just one mundane example, every non-US person establishing a Delaware corporation or other US business must file a foreign investment report with the US Department of Commerce within 45 days of setting up the company. An exemption should be available if the investment is under $3 million, but an application for exemption needs to be filed.  The mechanics of this aren’t difficult and can be handled online, but the form is confusing and we often find companies request assistance to complete it correctly.

In addition, non-US entrepreneurs and non-US companies must be acutely aware of immigration laws and regulations as they pertain to their work force. Visa requirements and related reporting obligations can be complex and time consuming; we regularly recommend to non-US entrepreneurs that their next US expansion meeting after speaking to us should be with a startup-friendly US-qualified immigration lawyer.

Liability

The US is a high-risk environment from a liability standpoint. The US litigation system is expensive, and in contrast to many other countries, in the US each party to a lawsuit bears its own costs (even if it wins). Consequently, commercial counterparties, discharged employees and others may use the threat or initiation of US litigation as leverage to negotiate a business settlement.

Use of a US topco subjects a company’s global business – not just its US business – to these risks.  However, even non-US companies entering the US market through a Delaware subsidiary need to respect the subsidiary’s corporate formalities (e.g., board meetings and shareholder meetings) to reduce the risk that a US litigation plaintiff can successfully “pierce the corporate veil” and subject the non-US topco to claims against the US subsidiary. This corporate housekeeping should start from the very beginning – mere incorporation of the subsidiary is not enough.

Don’t lose sight of the fact that the benefits of establishing US operations and having access to US financial systems and commercial markets usually far outweigh these risks. However, the US liability landscape rewards those that take appropriate precautions.  In particular, non-US emerging companies conducting business in the US should (1) procure appropriate US insurance coverage, including employment insurance, (2) pay attention to the terms of the US contracts they sign, and (3) establish controls to comply with their contractual undertakings.

The need to navigate a web of tax, regulatory and compliance issues should not deter non-US entrepreneurs from entering the US market. Companies and entrepreneurs embracing for the first time the opportunities of the US market simply need to ensure they understand and proactively address the US market’s challenges and responsibilities.

Article produced in partnership with Daniel Glazer and Collins Belton at Wilson Sonsini Goodrich & Rosati.
Compliments of Wilson Sonsini Goodrich & Rosati