Establishing a U.S.-Based Business? Know the Federal Tax System

A complete guide to help businesses navigate the U.S. tax system

While a government is technically not a business, it still needs income to do its job. And in a country with the 3rd-largest population in the world, you can imagine the emphasis placed on collecting taxes. This makes the U.S. federal tax system a critical lifeline for every aspect of the government’s operations.

If you own a business based in the United States, you have federal tax obligations even if you aren’t a resident here. To understand those obligations, it’s essential that you learn the basics of the federal tax system.

The U.S tax system is set up on 2 levels: federal and state. The federal tax system covers all taxpayers operating in its jurisdiction. The state system applies only to taxpayers having “nexus” (tax connection) in that state.

The federal government doesn’t have the right to interfere with state taxation, and each state has its own tax laws separate from the other states. Within the state, there may be several jurisdictions that also charge taxes, for example, counties or cities.

Additionally, there are several different types of taxes. In essence, taxpayers may be subject to taxes on:

• What they earn (income taxes)
• What they buy (sales taxes)
• What they own (property taxes)

There are also taxes related to having employees, such as FICA and unemployment taxes.

The U.S. tax system is complex and can be a challenge to navigate, especially when entering the U.S. market from overseas. This article aims to familiarize you with the federal tax system.

Federal income tax

Income tax is probably one of the most well-known forms of taxation. Every taxpayer with income from U.S. sources is subject to income tax. The amount of income subject to tax is generally calculated as revenues less deductions allowable under the tax code (ordinary and necessary business expenses).

On the federal level, taxpayers are divided into 2 categories: corporate and individual. The tax rules and rates for those 2 groups are entirely different and create various planning opportunities for setting up a tax structure for your enterprise.

Corporate Tax

Currently, U.S. corporations are subject to a flat tax rate of 21%. This is a change from historical practice, which involved a series of increasing percentages based on the amount of company earnings. The higher your business income, the higher the percentage used to determine your corporate federal tax obligation.

The Tax Cuts and Jobs Act (TCJA) of 2018 replaced these federal tax brackets with the 21% rate. It also made the change permanent—meaning there’s no “sunset” provision allowing the rate to expire after a set number of years. (That said, new laws can always be made. It’s important to watch for legislation that can change the flat rate percentage or even reinstate graduated brackets.)

Because corporations are treated as separate taxpayers from their owners, the corporate tax system creates so-called “double taxation.” Corporate profits distributed to shareholders are subject to individual income taxes in the hands of shareholders. Individual shareholders are subject to progressive tax rates up to 37%, which may result in a painful tax bill if proper tax planning is not considered.

There are several additional taxes that should be considered in corporate taxation matters. They include the following.

Accumulated earnings tax

Smaller corporations will sometimes refrain from distributing profits to owners in order to avoid double taxation. Corporations accumulating earnings and profits for the purpose of avoiding shareholder individual income tax are subject to a penalty tax in addition to any other tax that may be applicable. This is called the accumulated earnings tax, and it equals 20% of accumulated taxable income.

Generally, accumulated taxable income is the excess of taxable income with certain adjustments (including a deduction for regular income taxes) over the dividends paid deduction and the accumulated earnings credit. Corporations that accumulate earnings to cover ordinary working capital needs are not subject to accumulated earnings tax.

Personal holding company tax

U.S. corporations and certain foreign corporations that receive substantial passive income and are closely held may be subject to personal holding company tax. This 20% tax on undistributed personal holding company income was established to avoid growing generational wealth within a corporation and avoiding death taxes.

Passive income includes:

• Dividends
• Interest
• Rents
• Royalties
• Stock sale gains

A corporation is considered closely held if it has no more than 5 shareholders or for which all shares are held by your family members.

Employer taxes

Companies with employees in the U.S. are subject to payroll taxes that fund federal programs. These include:

• Social Security tax
• Medicare/additional Medicare tax
• The Federal Unemployment Tax (or FUTA)

Similar payroll taxes may also be assessed at the state level, but not all states assess them.

It’s your responsibility as an employer to withhold the employees’ share of these taxes (as applicable) from their paychecks. These funds, along with your matching contributions, must be remitted regularly to the federal government.

Occasionally, the presence of these taxes and similar ones in other nations can result in double taxation. The U.S. has worked to alleviate this situation by establishing totalization agreements with many countries. These agreements can exempt wages for services performed in the U.S. from FICA taxes if the employee doesn’t reside there permanently.

Individual tax

Tax assessed on individuals (also referred to as personal tax) is a progressive tax whose rates increase as the taxpayer’s income increases. The levels range from 10% to 37% of personal income. This rate also depends on the individual’s marital or family status.

The income ranges for which these rates apply are called tax brackets. All income that falls within each bracket is taxed at the corresponding rate.

Individual taxpayers may also qualify for various deductions that reduce their taxable income, such as deductions for:

• Medical expenses
• Qualified business activities
• Real estate taxes

Some taxpayers are also eligible for tax credits that directly reduce the amount of their tax due. The most common tax credits are:

• The earned income tax credit
• The child tax credit
• Education credits

As with payroll taxes, you’re responsible for withholding income taxes from employees’ wages and remitting them to the federal government.

In general, income tax must be prepaid throughout the year in 4 equal estimated payments and fully paid by the due date. For calendar-year corporations, the due date is March 15 of the following year, and the 4 estimated payments are due by the 15th days of April, June, September and December.

Individuals can also face other tax-related situations, including the following.

Capital gains taxes

Individual taxpayers are assessed separate tax rates for gains on the sale or disposal of capital assets. These are often higher-value items such as stocks, bonds, homes, cars, jewelry and art.

Whenever one of those assets increases in value (e.g., when the price of a stock you own goes up), the result is called a capital gain. Depending on income levels, capital gains are subject to 0%, 10%, 15%, 20% or 23.8% tax rates.

Passthrough entities

Businesses in the U.S. broadly fall into 2 categories: C corporations (described above) and passthrough business entities. These are partnerships, S corporations and sole proprietorships that pass their income through to their owner’s income tax returns and pay the individual income tax.

Passthrough entities offer a lot of flexibility and are not subject to double taxation that C corporations face. They also benefit from a 20% deduction on qualified business income.

Businesses should evaluate the pros and cons of corporate vs. passthrough structure when choosing the appropriate entity for their venture. Entities with owners who are not U.S. persons should also consider far-reaching tax consequences of tax structures, such as tax treaty benefit maximization and reduced exposure to estate tax described below.

Check-the-box election

Many businesses are formed as LLCs, which can be taxed as corporations, partnerships or disregarded entities. There is no federal tax law for LLCs; they are legal entities that need to elect their tax status.

An LLC with 2 or more owners can be taxed as a partnership or a corporation. Partnership is a default structure that can be changed by filing form 8832, known as the “check-the-box” election form.

Estate (death) tax

Individual taxpayers are subject to a federal estate tax if the value of their assets at death exceeds certain thresholds. Non-U.S. persons with assets situated in the U.S. are also subject to the estate tax.

Most non-U.S. estates are subject to the tax if the assets are above $60,000. The tax rate is gradual, with the maximum rate being 40%. Estate tax must be taken into consideration when setting up business structures in the U.S.

Sales tax

The United States is one of the few countries that does not impose a federal sales tax, value-added tax (VAT) or federal goods and services tax (GST). Instead, sales tax is governed by local jurisdictions.

States generally impose a sales tax collection and remission liability on a seller once a minimum threshold is met. This threshold is based on either the number of sales transactions or the dollar amount of sales into (or within) a state.

Excise taxes

The U.S. government imposes excise taxes (including retail excise taxes) on a wide range of goods and activities. Excise taxes are in addition to income and sales taxes.

Items and services subject to excise taxes include:

• Air transportation of people and property
• Gasoline and diesel fuel used for transportation
• Wagering
• Foreign insurance
• Manufacturing of specified goods (e.g., certain sporting goods, firearms and ammunition, vaccines, alcohol and tobacco)
• Retail sales of other specific goods (e.g., heavy trucks and trailers)

Excise tax rates are as varied as the goods and activities on which they are levied. For example, a federal excise tax of 7.5% is levied on domestic, commercial air passenger transportation.

Meanwhile, the federal excise tax imposed on motor fuel generally is 18.3 cents per gallon of gasoline and 24.3 cents per gallon of diesel fuel. Many states and cities also impose their own excise taxes on certain goods and activities.

Get help from a tax professional

We know—it’s a lot to think about when you simply want to do business in the world’s largest economy. That’s why it’s crucial to have an experienced international tax CPA on your team. At James Moore, our knowledge helps you stay compliant with boundless federal tax laws—so you can seize the boundless opportunities the U.S. has to offer.

Contact us to help you with your foreign tax needs today, and watch your business grow.