Foreign Investors Should be Cautious When Using U.S. LLCs
When determining what type of an entity should be used by foreign investors starting a business in the United States, an often-suggested structure is a U.S. limited liability company (U.S. LLC). This simple structure may be great for some foreign investors and disastrous for others.
- A U.S. LLC is a disregarded entity for U.S. tax purposes. This means that its income is taxed at the foreign owner level, even if income is not distributed.
- However, the home country of the foreign investor may treat the U.S. LLC as a corporation for its income tax purposes. This means that the U.S. LLC income is taxed at the entity level (not at the owner level).
- This results in a mismatch (or hybrid) in how a U.S. LLC is treated for US and foreign country tax purposes.
- This mismatch may severely impact a foreign investor’s ability to claim tax treaty benefits to reduce or eliminate U.S. income taxes.
- The reason for this, is that only residents of a treaty country can qualify for treaty benefits – and there is a mismatch between who is the relevant resident, the individual investor or the legal entity.
- Most modern treaties (for example: Belgium, Bulgaria, Denmark, Finland, Germany, Malta, Netherlands, New Zealand, South Africa, Sri Lanka, Sweden, and United Kingdom) recognize that a partnership or a disregarded LLC is ignored for income tax purposes and thus, focus on whether the partners/members themselves qualify as residents.
- For example, U.S.-source income received by a U.S. LLC, which is (i) treated as a corporation under foreign country tax law and (ii) owned by a foreign person residing in such country, is not considered derived by the foreign member of that entity even if, under the U.S. tax law, the U.S. LLC is ignored.
- Therefore, the foreign owner of a U.S. LLC may not be able to claim a benefit under the treaty for income received by the U.S. LLC.
The solution may be to use a more conventional partnership (general or limited) because a partnership is typically ignored for both U.S. and foreign country income tax purposes. This would allow foreign investors to claim treaty benefits for income received by the US partnership.
Before committing to a tax planning strategy, be aware of potential pitfalls that may change any foreseen advantages into disasters.