Launching an AI or Software Business in the U.S.

Dilendorf Law Firm advises technology companies from abroad that are entering the American market. Software raises tax questions that physical products do not. The intellectual property can sit in one country, the servers in another and the customers in fifty states.

An example

Three founders outside the United States own a holding company that holds their AI models and code. They plan to form a U.S. subsidiary to sell subscriptions, usage-based API access, a downloadable application and implementation services. They will hire sales staff in New York and engineers in California, Texas and Washington.

Their adviser at home suggests licensing the IP to the U.S. company for 80 percent of revenue. The royalty would be deducted in the United States and taxed at home. The example is illustrative, but the plan is one we see often.

What are you selling?

Final regulations effective January 14, 2025 govern “transactions involving computer programs, including by applying the rules to transfers of digital content,” and add rules for cloud transactions [1].

A digital content transaction is treated as one of four things: “a transfer of a copyright right,” “a transfer of a copy of the digital content (a copyrighted article),” development services, or know-how [2].

Cloud access is different. A cloud transaction is “on-demand network access to computer hardware, digital content, or other similar resources,” and it “is classified as the provision of services” [3].

So the subscription and the API are services, while the downloadable application may be a copyrighted article. Each category has its own source rule, and source drives everything that follows.

The license from abroad

Royalties paid by a U.S. company to a foreign owner are “fixed or determinable, annual, or periodical” income. A 30 percent tax “applies to the gross amount” of such U.S.-source income unless a treaty lowers the rate [4]. The IRS publishes the treaty rates on royalties by country, and a payee “must meet all of the treaty requirements” before a reduced rate applies [5].

A holding company in a low-tax jurisdiction without a treaty pays the full 30 percent. The foreign payee documents its status on Form W-8BEN-E, and the U.S. company reports the payment and the withholding on Form 1042-S [6] [7].

The rate of the royalty is also tested. The standard “in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer” [8]. The IRS may adjust income between commonly controlled companies to reflect what unrelated parties would have agreed [9].

An 80 percent royalty with no study behind it invites that adjustment.

Every payment to the parent is a reportable related-party transaction on Form 5472, and the penalty for not filing is $25,000 [10].

The entity

Investors usually expect a corporation, and for foreign founders the tax rules point the same way. A corporation pays 21 percent on its profits [23]. An LLC with two or more members is a partnership by default, and a partnership “must pay a withholding tax” on U.S. business income allocable to foreign partners, currently 37 percent for individuals [24].

Each foreign partner then files a U.S. return. Most technology founders prefer to avoid that.

Where to build

Since 2025, “a deduction is allowed for any domestic research or experimental expenditures” in the year paid. Foreign research “continue[s] to be amortized ratably over a 15-year period” [11].

For an AI company, that gap changes where model training should happen. Domestic research may also qualify for the research credit [12].

State income tax

Federal law bars a state from taxing a company whose only in-state activity is “the solicitation of orders … for sales of tangible personal property” [13]. Software subscriptions and services are not tangible personal property, so the protection does not apply.

States then tax on presence or on sales. New York taxes a corporation that derives $1,283,000 or more of receipts from the state [14]. California treats a company as doing business when its California sales exceed $757,070 or when payroll or property there exceeds $75,707 [15].

Texas imposes a franchise tax on “each taxable entity formed or organized in Texas or doing business in Texas,” with no tax due below $2,650,000 of revenue [16].

New York adds one more rule for our example. A taxpayer “must add back royalty payments” made to a related member, to the extent deducted federally, unless it proves an exception “by clear and convincing evidence” [17]. The offshore license that works for federal purposes may be disallowed in New York.

State sales tax

Here the states split. In New York, prewritten software “is taxable whether sold on a disk or other physical medium; by electronic transmission; or by remote access” [18]. Texas treats “sellers of software as a service” as data processing providers, with “twenty percent of the charge” exempt and the rest taxable [19].

California goes the other way. A prewritten program “is not a taxable transaction if the program is transferred by remote telecommunications” and the buyer receives no physical media [20]. Washington taxes “all digital products, regardless of how they are accessed,” including digital automated services and remote access software [21].

A company with no U.S. office can still be required to collect. New York’s registration presumption applies once sales of tangible personal property delivered into the state exceed $500,000 and 100 transactions [22]. Because New York treats prewritten software as tangible personal property, software sales count.

Problems we see most often

1. A royalty with no support. A rate set to move profit, with no arm’s-length analysis, no withholding and no Form 5472.
2. Treaty benefits assumed. A holding company in a jurisdiction with no treaty, or one that fails the treaty’s ownership tests.
3. “Software is not taxable.” Years of untaxed subscriptions sold into New York, Texas and Washington.
4. Income tax nexus from remote hires. One engineer in California creating a filing obligation nobody tracked.
5. IP in the wrong place at funding. Investors who require the IP in the U.S. company, forcing a transfer under time pressure.

This article is for general informational purposes only and does not constitute legal or tax advice. Outcomes depend on the facts of each matter and no result is guaranteed. The example is illustrative and does not describe any client. Thresholds and rates are those published by the agencies as of the date of writing and change periodically. Reading it does not create an attorney-client relationship with Dilendorf Law Firm. Prior results do not guarantee a similar outcome. Attorney Advertising.