Choice of Business Vehicle

When starting or growing a business, the choice of vehicle is very important since there are commercial and tax differences between each. It is therefore advisable to consider these differences before choosing which vehicle should be used for setting up a new business venture.

Sole trader vs partnership vs Limited Company

The three main business vehicles are sole trader, partnership and Limited Company and a brief description of each is: 

• A sole tradership is where an individual runs a business on their own account, having sole responsibility for the business and sole liability for its debts.
• A partnership is where two or more individuals run a business jointly, sharing responsibility for the business and liability for its debts. The profits (and losses) are split between the partners.
• A Limited Company is where a separate legal entity is set up to run a business, financially separate from the owners. The company is divided into shares which are held by the owners while directors are appointed to run the business (though in smaller companies the shareholders and directors are often the same). The directors have responsibility for the business while liability for its debts is broadly limited to the capital introduced.

Commercial Advantages and Disadvantages of Each Vehicle

Sole Trader

The key commercial advantages of operating as a sole trader are:

• Control over the business
• No sharing of profits
• Privacy of business data

The key commercial disadvantages are:

• Unlimited liability for business debts
• Funding the business, especially in the early stages

Partnership

The key commercial advantages of operating as a partnership are:

• Sharing of responsibilities and a wider range of skills increase the opportunity to profit
• Possibility of benefiting from economies of scale
• More options for funding the business
• Privacy of business data (except for a Limited Liability Partnership)

The key commercial disadvantages are:

• Unlimited liability for business debts (though a Limited or Limited Liability Partnership can address this issue)
• Less control over the business
• Sharing profits
• Potential disputes between partners

Limited Company

The key commercial advantages of operating as a Limited Company are:

• Limited liability
• Pooling of resources and increased funding options
• Easier to involve family and facilitate succession planning
• Opportunities to incentivise employees through share incentive plans

The key commercial disadvantages are:

• The need for information to be made public, including filing statutory accounts and directors’ details with Companies House, with penalties for non-compliance including fines and even striking-off
• Increased administration requirements, including financial record keeping and potential audit requirements for larger companies, and increased costs

Tax Advantages and Disadvantages of Each Vehicle

Sole Trader

The key tax advantages of operating as a sole trader are:

• Flexibility over using losses including against other taxable income of the same or previous tax years (especially relevant in the earlier years of business)
• No additional tax for drawing funds from the business

The key tax disadvantage is:

• All profits are immediately assessable to income tax (at rates of up to 45%) and national insurance (at rates of up to 9%)

Partnership

The key tax advantages of operating as a partnership are the same as for sole traders.

The key tax disadvantages is the same as for sole traders plus:

• Increased tax filing requirements, especially the need for a partnership tax return
• No annual investment allowance if the partnership has a corporate partner

Limited Company

The key tax advantages of operating as a Limited Company are:

• Profits are initially taxed at lower rates of corporation tax (currently a flat rate of 19% but from 2023 the rate will be between 19% (the rate where profits are up to £50,000) and 23% (the rate where profits are £250,000 or more). This cash flow advantage can enable higher reinvestment.
• While additional tax will apply on drawing profits from the company, using a combination of salary and dividends can mean that careful tax planning can result in a lower overall tax burden and some of the overall tax being deferred.
• Company pension contributions can also be made which can result in greater tax relief compared to those made by a sole trader or partner.
• Involving family either as employees or shareholders can enable profits to be drawn at lower tax rates provided payments are reasonable and commensurate 

The key tax disadvantages are:

• A double layer of tax on capital gains (corporation tax is paid on gains and personal taxes are paid on drawing gains from the company).
• Increased tax filing requirements, especially the need for a corporation tax return
• Use of company assets results in benefits in kind and additional tax compliance requirements

Structuring

Types of Partnerships

There are three types of partnerships, each with different benefits:

• General Partnerships are not separate entities from the partners themselves and so the partners have unlimited liability.
• Limited Partnerships are most often used as a fund investment vehicle. Again, these are not separate entities from the partners. The partners consist of one general partner and limited partners. Only the general partner has unlimited liability but is usually a company to limit their liability. The limited partners have limited liability. A limited partner is unable to agree documents or arrangements on behalf of the wider limited partnership.
• Limited Liability Partnerships are considered to be a separate entity from the partners and all partners have limited liability (limitation is to their capital contribution although there are exceptions such as in the event of negligence).  

Company Shares

In a Limited Company there are different types of shares with different ownership, conditions and rights which include:

• Ordinary Shares typically give the shareholder participation in company dividends as well as entitlement to voting rights. In addition, should the company be wound up the proceeds are divided equally between the ordinary shareholders after creditors and preference shareholders have been paid.
• Non-voting Shares are often issued to employees or family of the main shareholders for tax efficiency. They carry no voting rights but otherwise are the same as ordinary shares. 

• Preference Shares give the shareholder preferential rights over ordinary shareholders with regard to dividends and capital on a winding up. They usually carry no voting rights.
• Redeemable Shares entitles the company to redeem the shares in the future, often at their issued price. Redemption can either at a fixed time or at the company’s discretion. 

Tax Reliefs

CGT Business Asset Disposal Relief

Business Asset Disposal Relief (BADR) (previously Entrepreneurs’ Relief) can be claimed on  disposals or gifts of business assets which relate to trading activities. For details on this relief please go to the CGT page here.

CGT Holdover Relief for Gifts

Holdover Relief can be claimed to defer CGT on gifts or sales at undervalue of business assets which relate to trading activities and many gifts into or distributions out of trusts. For details on this relief please go to the CGT page here.

CGT Rollover Relief

Rollover Relief can be claimed on disposals of certain assets of a trade where the disposal proceeds are reinvested in assets for the trade. For details on this relief please go to the CGT page here.

CGT Investors’ Relief

Investors’ Relief can be claimed on qualifying disposals of shares in unquoted trading companies where certain conditions are met throughout the period of ownership.  Other than being unquoted trading company shares, the key conditions are:

• The shares are ordinary shares
• The shares are subscribed for in cash and fully paid up when issued
• The shareholder is not an employee of the company nor connected with an employee
• The shares are owned for at least three years

The key features of Investors’ Relief are:

• Where it applies the CGT rate is a flat rate of 10%
• There is a £10m lifetime limit on gains that can qualify

Investors’ Relief can be useful for:

• Those who cannot qualify for BADR or have exceeded their lifetime BADR threshold of £1m
• Attracting investment into unquoted companies where SEIS or EIS is not available
• Investors whose shares were originally valid under SEIS or EIS but now no longer qualify

IHT Business Property Relief

Business Property Relief at a rate of either 50% or 100% is available on interests in wholly or mainly trading businesses, including shares in trading companies.  Relief is available for gifts as well as on death. For more details on this relief please go to the IHT page here. 

Business Investment Relief

Business Investment Relief (BIR) is a tax relief for non-UK domiciliaries who claim the Remittance Basis. For more details on the Remittance Basis please go to the Domicile page here.

BIR enables non-UK domiciliaries to remit foreign income or gains into the UK without a tax charge where they invest the remittance in a qualifying company.

A qualifying company is broadly any private limited which is either a:

• trading company (or preparing to trade within five years); or
• stakeholder company investing in trading companies; or
• hybrid trading / stakeholder company; or
• holding company of trading group.

A trading company is one which carries out one or more commercial trades or lets out commercial and residential properties.  A stakeholder company is one that exists for the purpose of investing in trading companies and has made at least one such investment.

There are situations where BIR could be withdrawn resulting in the funds used for the investment becoming a taxable remittance. This could be because:

• A relevant person (including the investor, spouse or minor child) receives a benefit attributable to the investment which is not on commercial terms e.g. private use of a company asset. Ordinary dividends will not be caught.
• The investment is sold (in part or wholly).
• The company ceases to be a qualifying company. 
• The company was preparing to trade within five years but does not do so. 

It is possible to avoid a taxable remittance where relief has been withdrawn by selling the investment within 90 days of the withdrawal event and then taking with proceeds offshore within 45 days.

Before making an investment for the purpose of claiming BIR, it is often advisable to  ask HMRC for an advance assurance that the investment will qualify for relief.

Raising Business Finance

Sole traders and partnerships

A sole trader or a partnership can raise business finance either by borrowing or bringing in partners (which in the case of a sole trader would involve going into partnership). Interest paid on such loans is a tax deductible expense.

In addition, in certain circumstances a partner can obtain income tax relief for interest paid on a loan taken out to invest in their trading partnership.

Limited Company

There are two main ways for a Limited Company to raise business finance; issuing company shares or borrowing.

Issuing company shares

Issuing shares can be one of the effective means of raising finance, since the shareholders only receive a return on their investment if the company makes a profit while the capital invested is generally not repaid unless the company is wound up. There are also a number of tax advantaged investment schemes (SEIS and EIS – see below) for smaller trading companies which make the issue of shares tax efficient for the investor.

One disadvantage of raising money in this way is dilution of shareholdings for the existing shareholders.

Seed Enterprise Investment Scheme

The Seed Enterprise Investment Scheme (SEIS) offers the investor scope for income tax relief, CGT exemption for the shares and a CGT exemption for half of any gains reinvested in qualifying SEIS shares. It is only for new and very small trading companies, though, since a SEIS company has to be trading for less than two years with fewer than 25 employees and gross assets of no more than £200,000. For more details on SEIS please go to the CGT page here.  

Enterprise Investment Scheme

The Enterprise Investment Scheme (EIS) offers the investor scope for income tax relief, CGT exemption for the shares and CGT deferral for gains reinvested in qualifying EIS shares. It is only for small trading companies, though, since an EIS company must have gross assets of no more than £15,000,000 before the share issue and not more than £16,000,000 after. For more details on EIS please go to the CGT page here.

Loans

Whilst loans are often seen as a simpler option than issuing shares, consideration needs to be given to not only the amount borrowed needing to be repaid but also the payment of interest. However, the interest cost will normally be tax deductible though  there can be restrictions in the case of shareholder loans in certain circumstances where the loan is not in line with the terms on which a third party will lend. The shareholder themselves would be taxable on the interest received.

In addition, in certain circumstances a shareholder can obtain income tax relief for interest paid on a loan taken out to invest in their trading company.

Incorporation of Sole Trader / Partnership

Your business may have reached a stage where it makes financial sense to change from being a Sole Trader or a Partnership business to running the business through a Limited Company. This process is called Incorporation.

Advantages and Disadvantages

There can be various commercial and tax advantages and disadvantages with changing from a Sole Trader or Partnership to a Limited Company. For more details on the differences between each please go to the Choice of Business Vehicle section at the top of this page.

Method of Incorporation

The Incorporation itself though has its own considerations. The process will require a number of administration steps including:

• The company being incorporated at Companies House.
• Transferring business assets and liabilities to the company, evidenced by a business transfer agreement if appropriate.
• HMRC being informed about the change including registration of the company for corporation tax and perhaps PAYE and VAT.
• A company bank account being opened.

Succession Planning and Exit Strategy

It is important to have a business succession and exit strategy; not only will it make the process smoother but also enable an exit in the most tax efficient way. 

Use of Trusts

Trusts are often used in succession and exit planning. Often a business owner might not yet know who the business should pass to but wants some arrangements in place, even if only temporary, for unforeseen circumstances. Trusts can offer those temporary arrangements. Not only can they provide asset protection for business assets but also a trusted adviser to take over in the short-term while the longer term position is decided upon. Discretionary trust powers, alongside a letter of wishes, are typically given to the adviser to give flexibility over succession. They could also be used as a lifetime exit strategy to manage income distribution and capital growth following the owner’s exit with a gradual passing on of the business. For more details, please go to the Trusts page here.  

Employee Benefits Trust

For an exit where there is no market for the company shares, or there are no shareholders willing to buy the shares, then an Employee Benefits Trust (EBT) can be used as a buyer or to warehouse the shares while allowing the existing shareholders to receive value for their shares.

The EBT is set up by the company with employees (including perhaps ex-employees) as the beneficiaries. They can also be used as a means of incentivising and rewarding staff.

When used as part of a succession and exit strategy, an EBT will typically hold shares (purchased from the owners) or cash (for purchasing more shares). Shares held can either be distributed to the beneficiaries or sold with the proceeds being distributed instead. Any such distributions will be assessed to Income Tax and perhaps National Insurance.

Any contributions made to the EBT are normally eligible for Corporation Tax Relief but not necessarily immediately.

The EBT itself will broadly be taxed in the same way as any other trust. For more details, please go to the Trusts page here.

An employee share ownership trust is a tax advantaged type of employee trust which is aimed at promoting employee ownership.

Employee Share Schemes

There are a number of Employee Share Schemes which can be tax efficient for your limited companies. These include:

• Enterprise Management Incentive (EMI) Schemes – under EMIs certain qualifying companies can offer share options to key employees in an Income Tax and National Insurance advantaged manner.  A limit applies to the market value of shares an employee can be given options over.
• Approved Share Incentive Plans (SIPs) – these share schemes also provide Income Tax and National Insurance advantages.
• Unapproved (or non-tax-advantaged) Share Option Scheme – under these schemes options can be granted to an individual allowing them to purchase a specified number of shares at a fixed price. Since these schemes are not HMRC approved they can be more flexible than approved schemes. However, they are not tax advantaged so Income Tax will be payable on exercise as well as possibly National Insurance. Income Tax or National Insurance is only payable on exercise, not on grant of the options.

The above covers the Income Tax and National Insurance position but CGT also needs to be considered on a future sale of the resulting shares. Any CGT depends on the difference between the disposal proceeds and the total of:

• The price paid for the option (if anything)
• The price paid for the shares on exercise
• The amount assessed to Income Tax on exercise

Sale of Business

When you sell your business, you are subject to 10% or 20% CGT on the proceeds.

The 10% rate will apply in particular where the disposal qualifies for BADR. This relief applies up to a lifetime threshold of £1m for disposals of interests in trading businesses or shares in trading companies. For details on this relief please go to the CGT page here.

A sale could be structured as an earn-out where the buyer and seller decide on the price to be paid for the business with part of the proceeds being paid up-front and the balance being deferred (called an earn-out). How the tax is calculated on an earn-out depends on whether it is ascertainable or unascertainable.

• Ascertainable – if the amount payable under the earn-out is fixed at the outset it is considered to be ascertainable and so the full amount of the earn-out will be taxed upfront without any discount for the delay in receipt (though relief is given if it subsequently turns out to be irrecoverable).
• Unascertainable – if the amount payable under the earn-out cannot be calculated at the outset, e.g. because it is dependent on future results of the business, it is considered to be unascertainable. The seller is required to estimate the right to the earn-out and include this in their CGT calculation. The estimated value of the earn-out is then compared to actual receipts in future with a further capital gains or loss arising.

With an unascertainable earn-out HMRC may argue some or all of it could be taxed as income if there is continued involvement in the business e.g. as a consultant to aid transition. 

US Considerations for Entrepreneurs

US connected persons resident in the UK should take special care when starting a business venture through a UK vehicle. US persons will need to take more than the UK commercial and tax implications into account. They will also need to consider the US tax and reporting impact of doing business in the UK. The tax considerations of owning a non-US business are complex and can lead to double taxation and punitive taxing regimes. Therefore, it is advised to take advice, customized to your circumstances, prior to setting up a UK business operation. 

Choice of Business Vehicle

The commercial considerations for choosing a UK vehicle discussed previously are broadly similar for a US person in the UK. However, from a tax perspective, a US person must also consider the US tax and reporting implications alongside the UK.

US Tax Implications of UK Business Vehicles

Sole Trader in the UK

For US tax purposes, operating as a self-employed person has similar tax advantages and disadvantages to those outlined above.  A US person will pay tax in the UK and claim a foreign tax credit against their US tax liability. However, due to the mismatch of the UK and US tax years, the timing of the payments must be monitored. This will ensure that sufficient credits are available in the correct US calendar year and minimize double taxation.

UK Partnership

A US person who is a partner in a UK partnership will be taxable on partnership profits. The profits will need to be adjusted for US tax purposes in accordance with US tax rules.  As such, the UK profit amount may not necessarily match the profit for US tax purposes. UK taxes paid on the partnership profits can be claimed a foreign tax credit against the US tax liability. However, due to the mismatch of the UK and US tax years, the timing of the payments must be monitored. This will ensure that sufficient credits are available in the correct US calendar year and minimize double taxation.

There may be a further reporting requirement on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. This may apply in years where the partnership interest was acquired or disposed, or contributions were made to the partnership. It will also apply when the US person owned directly, indirectly, or constructively, more than 50% of the partnership interest. Alternatively, it may instead be reportable on Form 8938, Statement of Specified Foreign Financial Assets.

UK Limited Liability Partnership (‘LLP’)

A UK limited liability partnership which is a partnership for UK tax purposes will be classified as a corporation for US tax purposes. Therefore, a US person who is a partner in a UK LLP will be taxable on distributions rather than profits. The LLP can choose to make a US tax election to be treated as a partnership for US tax purposes. It will require the consent of all partners and should be made within 75 days of formation. An election made after this period may have additional US tax implications.  In certain circumstances, a late election may be allowed.

A US person will pay tax in the UK on their share of the partnership profit. They will then claim a foreign tax credit against their US tax liability. However, due to the mismatch of the UK and US tax years, the timing of the payments must be monitored. This will ensure that sufficient credits are available in the correct US calendar year and minimize double taxation.

There may be further reporting requirements in years where the LLP interest was acquired or disposed. It may also apply if certain ownership or contribution thresholds are met. The LLP interest may also be reportable on Form 8938.

UK Investment Company

A UK investment company is a tax-efficient investment vehicle in the UK and widely used for UK tax planning purposes. The company is invested in real estate or passive investments. However, for US persons, the use of such vehicle may subject them to a punitive taxing regime in the US. There may be options to mitigate the US tax impact by making a tax election for US tax purposes. Advice should be sought prior to setting up such a vehicle or if one has already been put into place.

UK Limited Company

The UK limited company is generally the most common vehicle when setting up a business in the UK. The company will be taxed as a separate legal entity in the UK. The owner will be taxed upon distribution, through salary or dividends. A US person will pay tax in the UK on their salary and/or dividends from the UK limited company. Upon sale, the owner may qualify for tax reliefs in the UK.

There may be a further reporting requirement on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. This may apply in years where the company interest was acquired or disposed, or contributions were made to the company. It will also apply when the US person owned directly, indirectly, or constructively, more than 50% of the partnership interest. Alternatively, it may instead be reportable on Form 8938, Statement of Specified Foreign Financial Assets.

Sale of UK Business Interest

The UK tax reliefs available upon sale of a UK business are outlined earlier on this page. As a US person with a UK business, consideration will also need to be given to the US tax implications. Therefore, it is recommended to seek advice from a specialist if you are considering a sale of a UK business.

Potential Pitfalls: Punitive US Taxing Regimes

A US person with certain interests in a non-US corporate entity may become subject to unfavourable taxing regimes. For ownership purposes, direct and indirect interests, or through certain family members are also included.

Controlled Foreign Corporation (‘CFC’)

A controlled foreign corporation is a non-US corporation in which US persons, each owning 10% or more, have control. A controlling interest constitutes more than 50% of the voting stock. A US individual is deemed to own the interest of their spouse, children, grandchildren, and parents under the attribution rules.  A non-US related person’s interest will not be attributable for CFC purposes. A CFC is subject to the Subpart F and Global Low-Taxed Income (GILTI) taxing regimes, outlined further below.

Global Intangible Low-Taxed Income (GILTI)

Prior to the GILTI regulations, a US shareholder of an actively trading CFC was taxed upon receipt of a distribution. However, the GILIT regime changed the timing of taxation to a current basis. US individuals are generally taxed on their share of the CFC’s profits at their ordinary tax rates up to 37%. US individuals do not have the benefit of foreign tax credit relief and may result in double taxation.

The amounts taxed under GILTI will not be subject to taxation upon distribution as a dividend. However, it may still be subject to the Net Investment Income Tax (NIIT) at 3.8%. It may also result in a foreign exchange gain, taxable at ordinary rates.

Subpart F

Under the Subpart F regime, the deferral of certain types of income is disallowed. It broadly includes investment income such as rents, interest, dividends, royalties, and capital gains. It can also include income from personal service companies and deemed dividends in the form of shareholder loans.  Income deemed as Subpart F will be treated as a current year distribution on the shareholder’s individual income tax return.   It is taxable at the individual’s ordinary tax rate. This may result in double taxation due to the mismatch of the taxing events in the US and the foreign country.

US Persons Owning Less than 50% of a Non-US Corporate Entity

A non-US corporation which is not a CFC may still be subject to a punitive tax regime. If the company is deemed a passive foreign investment company (‘PFIC’), defined below, it will fall under the PFIC regime.

Passive foreign investment company (‘PFIC’)

A PFIC is a foreign corporation that falls under one of the tests below:

• Income Test: at least 75% of the company’s gross income is passive
• Asset Test: at least 50% of the company’s gross assets generate passive income or are held to produce passive income

For the purposes of this test, cash is considered a passive asset. Passive income generally consists of investment income including interest, dividends, rents, and capital gains. PFICs can also include foreign pooled investments such as mutual funds and unit trusts.

PFICs are reportable on Form 8621 with the filing of the individual tax return and are taxed unfavorably. They often result in punitive tax rates and interest charges on income and gains that have accumulated in prior years.

Tax Elections Available to Minimize the Impact of Punitive Taxing Regimes

Certain tax elections, outlined below, are available to mitigate the potential for double taxation. However, each requires careful consideration of the facts and circumstances. Therefore, it is advised to take advice prior to making an election.

High-Tax Elections

CFCs that operate in certain taxing jurisdiction with high corporate tax rates may qualify for a high tax exemption.  The tax rate must be at least 90% of the US corporation tax rate, currently 21%. This equates to a corporate tax rate of 18.9%. The high tax election provides an exemption from either the GILTI and/or Subpart F provisions.  The election is made on annual basis and will apply to all the taxpayer’s CFC interests, including subsidiaries. Therefore, if operating in multiple jurisdictions, it is important to consider the overall benefit prior to making the election.  Also, it will apply to all of the CFC’s US shareholders, therefore, US shareholders should be notified and consulted prior.

Section 962 Election

The Section 962 election allows a US individual taxpayer to be treated as a US corporation. The benefits are a flat rate of tax at 21% and a 50% deduction on the taxpayer’s GILTI inclusion. A foreign tax credit of 80% of the corporation income taxes paid is also available. Although the current taxable income is reduced, dividends received in the future will be taxable.

This election is made on an annual basis and will apply to all the taxpayer’s CFC interests. Therefore, CFC interests in multiple foreign jurisdictions will require further consideration before making this election. The election will require additional disclosures and attachments to the tax return, which may result in increased compliance costs.   

Check the Box Election

An election may be available to change the entity classification for US tax purposes. If made on a timely basis, the company may avoid the GILTI, Subpart F and/or PFIC taxing regimes.  We recommend that advice is taken prior to making the election to ensure the entity qualifies. Otherwise, it may result in a deemed disposal for US tax purposes and trigger an undesired taxing event.

US Business Operations

For business owners whose dealings may require a base of operations in the US, there are further considerations. The US operates on a Federal and State level and therefore the business may become subject to multiple taxing jurisdictions.  The choice of business vehicles can extend beyond the options in the UK and careful consideration is needed. Therefore, it is advised to take advice, customized to your circumstances, prior to setting up a US business operation.

US Business Vehicles

Below are the three most common US business vehicles and the related US tax implications:

US Corporation

A US corporation is a separate legal entity formed in the US under state law. It is widely used by overseas businesses who are looking to set up a presence in the US. A US corporation has similar benefits to a UK limited company with liability protection and greater flexibility to attract outside investors. A corporation also allows the transfer of ownership to be facilitated with greater ease. It also allows flexibility to provide employee benefits such as a health plan, pension, and deferred compensation plans. These benefits may be deductible as business expenses by the company.

The US corporation will have separate reporting and tax filing requirements for Federal and State purposes. The US company will be subject to Federal income tax at the corporate level, currently 21%. State corporate income tax rates vary. They can range from zero to 11.5% depending on the state and local jurisdiction. Certain locales such as New York City will also assess their own local tax to businesses.

In addition to income tax, the company may also have payroll tax reporting and filing obligations for Federal and State tax purposes. Payments to US contractors may also require additional tax reporting.

The individual shareholders will also be subject to US tax on any salary or dividends received from the US company. The salary will be subject to Federal tax at graduated rates up to 37%. Dividends will be taxed at rates of up to 23.8% or a treaty rate, where applicable. Income may also be subject to state tax, based on certain circumstances.

As such, the corporation is subject to a double layer of taxation. First at the corporate level, and then at the shareholder level upon distribution.

US Partnership

A partnership is formed under state law by two or more people who agree to engage in business together. Each partner contributes money, labour, or assets such as property to the partnership. The partnership is not deemed to be separate from its owners and is a pass-through entity for US tax purposes.  This allows the partnership to avoid the double layer of taxation as compared to a corporation.

The partners share in the profits and losses of the business which is reported on their personal income tax return. The partners can then draw distributions from the partnership tax-free, up to the amount previously taxed or contributed.

Partners can also be paid for their services through a guaranteed payment which is the equivalent of a salary. It is a fixed annual amount determined by the partnership that is guaranteed irrespective of partnership profits.  The partnership can deduct the guaranteed payments, but it is added back as income to the partners receiving the payment.

A partnership files an annual information return reporting its business operations but is not taxable at the entity level. Partners are provided with a copy of Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc, by the partnership. A partnership may also be subject to US tax withholding requirements for foreign partners. This will apply to items of income or gains that are effectively connected to the US.

US Limited Liability Company

The US LLC is a popular vehicle in the US due to its flexibility and relatively simple set-up. Whilst it is a corporate entity for legal purposes, it is taxed as a transparent entity in the US. A single member LLC by default is taxed as a disregarded entity and a multi-member LLC is taxed as a partnership. If beneficial, an election can be made to treat the LLC as a corporation.

An LLC has minimal initial and annual filing fees compared to incorporation and avoids the double layer of taxation. The income of the LLC is passed through to its owner(s) annually and is reported on their personal tax return(s). The LLC owners can then draw distributions from the LLC tax-free, up to the amount previously taxed or contributed. LLC Members can also receive guaranteed payments.

The LLC files an annual information return reporting its business operations but is not taxable at the entity level. LLC members are provided with a copy of Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc, by the partnership. An LLC may also be subject to US tax withholding requirements for foreign members on effectively connected income.

US S-Corporation

The S-corporation is a hybrid entity that is often utilized by small business owners in the US. It is a corporate entity for legal purposes but makes an ‘S election’ to be taxed as a transparent entity, like an LLC. The income passes through to its owner(s) annually, thereby avoiding the double layer of taxation. The owners can then draw distributions from the S-corporation tax-free, generally up to the amount previously taxed or contributed.

The S-corporation can afford greater tax savings in the way of employment taxes in comparison to an LLC or corporation. However, there are greater restrictions. It must pay out a reasonable salary to its owner and shareholders must meet certain requirements. For example, non-US persons and corporate entities are ineligible and result in an immediate termination of the S-corporation, if admitted. This can lead to unintended tax consequences.

The S-corporation files an annual information return reporting its business operations but is not taxable at the entity level. It may be taxable in certain states such as California.

State Tax Considerations

Another key area to consider when setting up a US business operation is state tax. Each state has different rules to determine if you are transacting business (creating nexus) in the state. This can result in additional registration, filing and tax implications, despite having no physical presence in that state.

The two general areas of consideration from a state tax perspective are:

• Income tax
• Sales tax

State and Local Income Tax Nexus/Economic Nexus

The first consideration for state and local tax is nexus for income tax purposes. Each state has their own set of criteria and/or revenue thresholds. Certain local jurisdictions such as New York City and the City of San Francisco also have separate thresholds. These thresholds apply to the following:

• Performing/providing services to clients located and deriving benefit of the services within the state or local jurisdiction
• Sale of physical or digital products to customers located and deriving benefit within the state or local jurisdiction

Initially, where you live and/or perform your services may trigger business state registration and filing for income tax purposes. Depending on the state and type of business entity, sales can be sourced to a state based on either:

• Customer location
• Where the services are performed

Certain states such as Massachusetts and New York have revenue thresholds which will trigger economic nexus for income tax purposes. The current thresholds in Massachusetts and New York are:

• Massachusetts – annual sales (on a calendar year basis) greater than $500K.
• New York – annual sales (on a calendar year basis) greater than $1,138,000.

Not all states operate based on annual revenue thresholds. Income tax nexus can instead be based upon having employees, property, or an office in the state. State corporate income tax rates vary. They can range from zero to 11.5% depending on the state and local jurisdiction. Certain locales such as New York City assess their own local tax to businesses.

State and Local Sales Tax Nexus

Sales tax is a separate class of tax similar to VAT. It can be assessed at a state or local level on certain types of sales and services. The threshold to trigger sales tax can vary but is generally $100K of sales. Once nexus is established, it will require company registration and collection of sales tax from customers. The tax collected is remitted to the state and applicable local jurisdictions by filing sales tax returns.

States are closely monitoring companies that sell or provide services into their state and assessing harsh penalties for non-compliance. Therefore, it is important to review the rules to determine if your business will trigger nexus for sales tax purposes.

Potential Pitfall:  Non-US Business Operating in the US

Operating in the US through a non-US business may result in creating a permanent establishment in the US. Permanent establishment can include a fixed place of business in the US through which the company conducts business. This may subject the business to the US taxing regime. A US tax return filing may be required along with state tax returns.  A non-US partnership may also be subject to US tax withholding requirements for non-US partners on effectively connected income.

Depending on the nature of the business operations, it may be beneficial to set up a US subsidiary. Consideration will need to be given regarding intercompany transactions and transfer pricing policies.  There may be certain exceptions or treaty positions available to minimize the company’s tax exposure. Therefore, it is advised to take advice prior to conducting business in the US through a non-US business entity.

Potential Pitfall:  UK Residents with US Business Interests

UK residents with US business interests need to consider the UK tax impact of their US business interests. Further consideration is also required for US persons moving to the UK with an existing US business.  Highlighted below are two US entities which may result in double taxation in the UK.

US Limited Liability Corporation (LLC) or S-Corporation

The US LLC and S-corporation as discussed above may be tax efficient whilst resident in the US. However, for a UK resident owner, they can potentially lead to double taxation. The UK will tax the owner upon distribution as it views these entities as opaque, corporate bodies. As such, no corresponding credit for taxes previously paid in the US will be allowed in the UK. It is recommended to take advice prior to moving to the UK with a US business.  This will ensure any potential exposure to adverse or double taxation is minimized.

US Tax Reliefs

Qualified Small Business Stock (‘QSBS’)

QSBS may be available to non-corporate shareholders of qualified small businesses where shares have been held longer than five years. Upon sale or exchange, a shareholder can exclude a substantial portion of the gains.  The exclusion allowable is the greater of $10M or 10 times the adjusted cost basis. In certain circumstances, there is a potential to exclude 50-100% of the Federal income tax owed on the gain.

To qualify, the company must meet the following requirements:

• It is an active US corporation (S-corporations and holding companies do not qualify).
• It is within a qualified industry such as technology, retail, or manufacturing. (Industries such as personal services, banking and investing do not qualify.)
• Assets do not exceed $50M either prior to or after the stock issuance.
• Stock must be issued directly in exchange for cash or property; or as compensation through options, RSUs or convertible securities.
  • Acquisition from another party or secondary market will not qualify.
  • In certain circumstances, QSBS may be gifted.

There are many benefits for companies that qualify for QSBS including attracting investors and aiding in recruiting and retaining talent. It can also draw in additional funding from individual investors and encourage longer-term ownership.  Qualifying small businesses should be aware that buying back too many shares can invalidate their QSBS eligibility.

Section 199A Deduction

Certain small business owners and real estate investors may qualify for the Section 199A deduction. It will shield income that is passed through from a partnership or LLC on qualified US sourced income. The business must be in the US and will not apply to corporations. Certain types of businesses that provide personal or professional services may be excluded.

The deduction is based on the taxpayer’s qualified business income (QBI) and can result in a deduction up to 20%. Taxpayers with multiple qualifying businesses must net all income and losses to determine their QBI.  The deduction is limited within certain individual income thresholds and phased out for higher earning individuals.

Considerations on Sale of a US Business Interest

Asset Sale vs Share Sale

The sale of a US business can be structured as an asset sale or stock sale. This can be a complex negotiation between the buyer and seller as the parties may desire the opposite structure.  Buyers may generally prefer an asset sale, whereas sellers may prefer a stock sale. There are many factors during negotiation, but the main points may focus on potential liabilities and tax implications. In the sale of a partnership, LLC or sole proprietorship, parties may consider a sale of the partner’s/member’s interest rather than a stock sale.

Asset sale

In an asset sale, the buyer will purchase individual assets of the company such as a license, goodwill, or inventory.  The seller will generally retain legal ownership and liability obligations, minimizing the risk of potential future obligations for the buyer. A buyer can also receive a step-up in certain assets which can result in additional tax savings.  However, not all assets such as intellectual property or contracts may be easily transferable. They may require additional legal steps to transfer ownership and cause delay in the sale process.

From a seller’s perspective, an asset sale can result in increased taxes. Items such as inventory can be subject to tax at ordinary rates rather than the lower capital gains rate. A corporate seller will also be subject to a double layer of taxation. The corporation will be taxed upon the sale and the shareholders will be taxed upon receipt of the proceeds.

Stock Sale

In a stock sale, the buyer will directly purchase the seller’s stock and acquire legal ownership of the company.  The buyer will inherit the basis of the assets at the time of the sale. This may result in higher taxes as compared to an asset sale. The buyer also assumes all risk of future litigation, contingencies, and regulatory obligations. This can be mitigated by indemnifications or warranties in the purchase agreement. A stock sale can be more beneficial to a buyer in certain circumstances. For example, when there is a large number of intangible assets or contracts which are not readily assignable or transferrable.

From a seller’s perspective, a stock sale has numerous benefits. It can relieve the seller from future obligations. Shareholders can also take advantage of the lower capital gains tax rate and double taxation can be avoided.

As each transaction has its own set of unique facts and circumstances, it is always recommended to seek advice beforehand. This will ensure there are no surprises, and the deal can be structured to deliver the desired outcome.

Sale of Partnership Interest by Non-US Persons

The sale of a partnership interest by a non-US person may result in US effectively connected income to the transferor. The transferee will be required to withhold 10% of the sales price if certain exceptions are not met.  The withholding tax will be due within 20 days of the closing date. The filing of a US tax return may be required to report the sale and associated tax on the gain. The tax will be assessable on the underlying gain that is effectively connected with a US trade or business. The withholding will be applied to the calculated tax with any overpayment refundable upon the filing of the tax return. It is also worthwhile to note that distributions received from a US partnership in excess of basis can trigger withholding. It is subject to certain exceptions and treaty relief may be available in certain circumstances.