A European technology company sets up a Delaware LLC (a limited liability company formed under Delaware state law) to access US markets. Twelve months later, its founders receive an IRS notice asserting that one of them has become a US tax resident. No one anticipated this outcome. The consequences – back taxes, penalties, and interest accumulating over multiple years – are severe. Tax residency in the United States is one of the most consequential legal determinations an international business or individual can face. Getting it wrong is costly.
Tax residency in the United States is determined by separate tests for individuals and entities, and neither test is optional or discretionary. For individuals, the primary mechanisms are the Green Card Test and the Substantial Presence Test, both grounded in federal tax legislation. For companies, residency turns on place of incorporation and, in some cases, the location of effective management. Understanding which test applies – and how to document compliance – is the first obligation for any foreign party operating in the US market.
This guide covers the procedural steps, documentary requirements, common errors made by international clients, applicable cost ranges, and a decision framework for different business scenarios. It addresses both individual and corporate tax residency, with attention to tax treaty interaction and the risk of unintended permanent establishment.
How individual tax residency is determined in the United States
Under US federal tax legislation, an individual is treated as a US tax resident if they satisfy either the Green Card Test or the Substantial Presence Test. These are distinct tests. Satisfying either one triggers full US tax obligations on worldwide income.
The Green Card Test is straightforward. Any individual who holds a lawful permanent resident status – regardless of how many days they spent in the United States – is a US tax resident for the entire calendar year. Residency under this test begins on the date the green card is issued and ends only when the card is formally abandoned or revoked.
The Substantial Presence Test is more nuanced. It counts physical days across a rolling three-year period using a weighted formula. Days in the current year count in full. Days in the first prior year are weighted at one-third. Days in the second prior year count at one-sixth. If the weighted total meets the statutory threshold. and the individual was present for at least a minimum number of days in the current year – US tax residency is established for that calendar year.
Certain categories of days are excluded from the count. Days spent in the United States as a diplomat, a student on an exempt visa, or a professional athlete competing in a charity event do not count toward the threshold. This exclusion is frequently misunderstood. Many foreign professionals assume that business visa status automatically protects them. It does not. Only the specific exempt categories defined in federal tax legislation apply.
A person who crosses the Substantial Presence threshold can, in limited circumstances, avoid US resident status by demonstrating a closer connection to a foreign country. This requires filing a specific disclosure with the IRS within the prescribed deadline – typically the due date of the US tax return. Missing that deadline eliminates the closer-connection exception entirely. Practitioners frequently encounter cases where the filing window was missed because the individual did not realise the threshold had been triggered until months later.
The first-year election is a separate mechanism. An individual who does not meet the Substantial Presence Test in the current year but who expects to meet it in the following year may elect to be treated as a US resident from a specific date in the current year. This election can be advantageous when the individual has significant US-source income that would otherwise be taxed at higher withholding tax rates applicable to non-residents.
For individuals who are nationals of countries that have concluded a tax treaty with the United States, treaty tiebreaker provisions can override the domestic residency tests. However, claiming treaty benefits requires a formal election filed with the IRS. The election carries its own disclosure obligations. Failing to file those disclosures can result in penalties even when the substantive tax position is correct.
Corporate tax residency and the permanent establishment risk
Under US tax legislation, a corporation is a US tax resident if it is incorporated under the laws of any US state or the District of Columbia. This is the place-of-incorporation test. It is categorical. A corporation formed in Delaware, Nevada, or Wyoming is a US resident regardless of where its management sits or where its business is conducted.
Foreign corporations are generally not US tax residents. They are subject to US corporate income tax only on income that is effectively connected with a US trade or business, or on certain categories of US-source income subject to withholding tax. The distinction matters enormously. Effectively connected income is taxed at the regular corporate rate on a net basis. Passive US-source income is taxed at flat withholding tax rates, which can be reduced under an applicable tax treaty.
The permanent establishment concept is the primary mechanism by which a foreign corporation becomes subject to US tax on business profits. A permanent establishment is created when a foreign entity has a fixed place of business in the United States. such as an office, a warehouse. Alternatively. A construction site. or when a dependent agent in the United States habitually concludes contracts on the foreign entity's behalf. Once a permanent establishment exists, the profits attributable to it are subject to US corporate income tax.
The Delaware LLC presents a specific challenge for international structures. A Delaware LLC with foreign members is transparent for US tax purposes by default. The foreign members are treated as directly earning US-source income. Depending on the nature of that income, withholding tax obligations may arise at the entity level. Many foreign investors choose a Delaware LLC for its legal flexibility without appreciating that the tax treatment flows through to them personally.
A common scenario involves a European holding company that appoints a US-based manager to oversee its US operations. If that manager has authority to conclude contracts in the United States, a permanent establishment may be created – even if the holding company has no physical US office. US courts and the IRS have taken a broad view of what constitutes a dependent agent. The risk is not theoretical.
For a practical breakdown of the corporate structuring options available to foreign businesses entering the US market, the corporate law advisory service for the United States addresses entity selection, governance, and compliance requirements in detail.
To explore how tax treaty positions interact with your US corporate structure, contact us at info@ferrazwhitmore.com for a tailored assessment of your exposure.
Step-by-step procedural guide: establishing and documenting tax status
The following steps apply to both individuals and corporate entities. They represent the minimum procedural sequence for anyone seeking to clarify, establish, or contest their US tax residency position.
Step 1 – Day count and presence audit. The first action for any individual is a precise count of days physically present in the United States during the current and two prior calendar years. Travel records, passport stamps, boarding passes, and hotel receipts are the primary evidence. This audit should be completed before any other step.
Step 2 – Entity structure review. For corporate clients, the review examines the place of incorporation of each entity in the group. The location of directors and officers who exercise management functions. Additionally, whether any contracts are habitually negotiated or concluded in the United States. This review identifies potential permanent establishment exposure before the IRS does.
Step 3 – Treaty analysis. Where the individual or entity is connected to a country that has a tax treaty with the United States, the treaty's residency and tiebreaker provisions must be reviewed. Treaty benefits must be actively claimed. They are not applied automatically by the IRS.
Step 4 – Identification number application. Individuals who are not eligible for a Social Security Number must apply for an Individual Taxpayer Identification Number (ITIN). Corporations and other entities obtain an Employer Identification Number (EIN). Both applications require specific documentary evidence. Processing typically takes six to twelve weeks, though expedited procedures exist in certain circumstances.
Step 5 – Filing obligations assessment. Once residency status is determined, the relevant annual filing obligations must be identified. US residents file on worldwide income. Non-residents file on US-source income only. Additional disclosure forms – covering foreign bank accounts, foreign corporations, and foreign trusts – apply where threshold values are exceeded. Missing these disclosures carries penalties that are disproportionate to the underlying tax at stake.
Step 6 – Withholding tax registration. Foreign individuals and entities receiving certain categories of US-source income – interest, dividends, royalties, and real property gains – are subject to withholding tax deducted at source. The withholding agent has independent obligations. Both the payee and the payer need to understand the applicable withholding tax rate, and whether a treaty reduces or eliminates it.
Step 7 – Ongoing compliance calendar. US tax compliance is not a one-time event. Annual filing deadlines, estimated tax payment dates, and disclosure thresholds must be tracked. For non-resident individuals who cross the Substantial Presence threshold during a given year, the filing obligation arises even if they were unaware of it. Establishing a compliance calendar at the outset avoids the most common penalty scenarios.
Legal fees for the full residency analysis and initial compliance set-up vary. For individuals, fees typically start in the range of several thousand dollars. For corporate groups with multiple entities and treaty considerations, the cost is proportionally higher. Government filing fees for ITIN and EIN applications are minimal. The greater cost is always in the penalty exposure that accumulates when compliance is delayed.
Common errors by foreign clients and how to avoid them
International clients entering the United States consistently make a specific set of errors. Each one is avoidable. Each one has a cost.
The first error is assuming that operating through a non-US entity eliminates US tax exposure. It does not. A foreign corporation that places employees or agents in the United States, or that uses a Delaware LLC as an operating vehicle, may be fully subject to US tax on the income generated. The entity form does not determine the tax result. The substance of the activities does.
The second error is ignoring the Substantial Presence Test until it is too late. Many foreign executives spend extended periods in the United States without tracking their day count. By the time they consult a lawyer, the threshold has already been crossed for the prior year. The back-filing obligation and associated penalties are then unavoidable.
The third error is treating withholding tax as the final tax. Withholding tax is a prepayment mechanism. It does not extinguish the underlying US tax obligation. A foreign investor who receives US rental income subject to withholding tax may still have an obligation to file a US non-resident return and pay additional tax if the withholding was insufficient. or may be entitled to a refund if it was excessive. Neither outcome is resolved automatically.
The fourth error involves the Delaware LLC structure specifically. Foreign investors frequently form a Delaware LLC believing it to be a tax-neutral vehicle. In the absence of a specific tax election, the LLC is transparent. The foreign members are treated as directly holding a US investment. Depending on the nature of the income, this can create both withholding tax and filing obligations that the members did not anticipate.
The fifth error is failing to claim treaty benefits within the required timeframe. The United States has concluded tax treaties with a substantial number of countries. Those treaties can reduce withholding tax rates and, in some cases, exempt certain business profits from US tax entirely. But treaty benefits require a formal claim. The IRS does not apply them automatically. A foreign investor who waits too long to assert a treaty position may find that the statute of limitations has closed the window for a refund.
For businesses with parallel operations in Latin America. A comparison with the approach described in our guide to tax residency in Brazil illustrates how differently civil law and common law systems handle the same underlying question of corporate fiscal presence.
Decision framework: which approach suits your scenario
The correct approach to US tax residency depends on the specific business scenario. The following framework identifies the key decision points.
Scenario A – Foreign individual with limited US presence. If the individual spends fewer than the minimum threshold of days in the United States in any given year and holds no green card. US tax residency does not arise under the domestic tests. The priority is documentation: maintain travel records that demonstrate the day count, and review treaty tiebreaker provisions if there is any ambiguity. No US filing obligation arises unless US-source income is received.
Scenario B – Foreign individual approaching the Substantial Presence threshold. If the weighted three-year day count is approaching the statutory limit, active management of US presence is required. Options include restructuring travel patterns, documenting a closer connection to a foreign jurisdiction, or – if residency is strategically desirable – filing the first-year election to establish residency from a chosen date. The decision must be made before the tax year closes.
Scenario C – Foreign corporation with US activities. The analysis focuses on whether a permanent establishment has been created. If US employees, agents, or fixed premises are involved, the assumption should be that a permanent establishment exists until the analysis demonstrates otherwise. The corporation must then determine whether a tax treaty reduces or eliminates the resulting US corporate income tax liability, and whether withholding tax applies to profit repatriation.
Scenario D – Delaware LLC used as a US operating vehicle. The foreign members must determine whether the LLC should retain its default transparent status or make a tax election to be treated as a corporation. Each choice has different consequences for withholding tax, information reporting, and treaty access. The decision depends on the nature of the income, the members' home jurisdiction, and the applicable tax treaty position. This analysis should be completed before the LLC begins generating income.
Scenario E – International group with US and non-US entities. The group-level analysis examines transfer pricing between US and non-US entities. The risk of permanent establishment in the United States through affiliated parties. Additionally, the treatment of intercompany payments under US withholding tax rules. The US tax law advisory service covers the full spectrum of group tax structuring considerations for international businesses.
This framework is applicable if the client has at least one of the following: a physical presence in the United States, US-source income. A US entity in the group structure. Alternatively, an individual who travels to the United States regularly for business. Before initiating any filing or structuring decision, verify that the day count audit is complete, the entity structure is documented, and any applicable tax treaty has been identified.
For a preliminary review of your US tax residency position, email info@ferrazwhitmore.com with a summary of your current structure and US activities.
Frequently asked questions
Q: How long does it take for a foreign individual to establish tax residency in the United States?
A: The timeline depends on the residency test used. Under the Substantial Presence Test, residency is established once a specific day-count threshold is met across a rolling three-year period. Under the Green Card Test, residency begins on the day the card is issued. Obtaining an ITIN or filing the first US tax return typically takes between six and twelve weeks after documentation is submitted.
Q: Does a Delaware LLC automatically create US tax residency for its foreign owners?
A: No. A Delaware LLC is a pass-through entity by default. Its foreign owners are not automatically US tax residents. However, the LLC itself may create a permanent establishment or filing obligation depending on where and how it conducts business. Foreign owners must separately analyse their individual tax status and any applicable tax treaty benefits.
Q: Can a tax treaty reduce or eliminate US tax obligations for non-residents?
A: A tax treaty between the United States and a foreign country can reduce withholding tax rates on certain types of income and may provide exemptions from US corporate income tax in limited circumstances. Treaty benefits are not automatic. The taxpayer must actively claim them on the appropriate US tax filing, and the IRS may scrutinise claims where business substance in the treaty country is unclear.
About Ferraz & Whitmore
Ferraz & Whitmore is an international law firm based in Lisbon, advising business clients across 46 jurisdictions. Our practice covers US tax residency analysis, permanent establishment assessments, withholding tax structuring, and tax treaty claims for international businesses and individuals operating in the United States. Engaging a lawyer in the United States context – particularly one with cross-border experience across both common law and civil law systems – is essential when the stakes include multi-year back-tax exposure and IRS penalties. As an international law firm advising clients on law firm United States mandates, we combine Portuguese civil law expertise with English common law tradition to deliver practical, cross-border legal solutions. Our attorneys have advised on corporate income tax structuring, withholding tax compliance, and permanent establishment disputes before US District Court and in JAMS and AAA arbitration proceedings involving tax-related contractual claims. The firm's Lisbon base provides direct access to EU and transatlantic regulatory environments, while our common law expertise supports enforcement and dispute resolution strategies in US jurisdictions. To discuss your US tax residency situation, contact us at info@ferrazwhitmore.com.
Disclaimer: This publication is provided for informational purposes only and does not constitute legal advice. The information herein should not be relied upon as a substitute for professional legal counsel tailored to your specific circumstances. Ferraz & Whitmore assumes no liability for actions taken or not taken based on the contents of this material. For advice regarding your particular situation, please contact info@ferrazwhitmore.com.