Are you a foreign investor or entrepreneur who owns a stake in a U.S.-based limited liability company (LLC)? If so, you might be wondering how the U.S. tax system applies to your business income and what are your reporting and compliance obligations. In this article, we will provide an overview of the tax implications for foreign-owned LLCs and some of the key factors to consider.
What is a Multiple Member LLC?
According to the IRS, an LLC is created by state law and is not recognized as a separate tax entity by the federal government. Therefore, an LLC must adopt a federal tax classification that determines how it will be taxed for federal income tax purposes.
An LLC can have one or more members, who can be individuals or entities, domestic or foreign. A Multiple Member LLC is a type of business entity that combines the features of a corporation and a partnership. It offers limited liability protection to its owners, who are called members, and allows them to choose how they want to be taxed
How are LLCs taxed?
LLCs are relatively flexible in terms of tax classification. According to Treas. Reg. § 301.7701–3(b)(1), an LLC with multiple members is considered a partnership for tax purposes unless the members opt to designate it as a corporation. A partnership is a pass-through entity, which means that it does not pay federal income taxes itself. Instead, the income and expenses of the partnership are passed through to the individual members, who then report them on their personal tax returns.
An LLC with only one member is considered a disregarded entity for tax purposes unless the member elects to treat it as a corporation. A disregarded entity is treated as a sole proprietorship if the member is an individual, or as a branch or division of the parent entity if the member is an entity.
The choice of tax classification can have significant implications for how the business’s income and deductions are treated on the members’ personal tax returns. For example, if an LLC is classified as a corporation, it will be subject to double taxation: once at the corporate level and again at the individual level when dividends are distributed to shareholders. On the other hand, if an LLC is classified as a partnership, it will avoid double taxation and benefit from certain tax advantages, such as the ability to deduct losses and expenses at the individual level.
How are foreign-owned U.S LLCs taxed?
The tax treatment of foreign-owned LLCs depends on several factors, such as:
- The tax classification of the LLC (partnership, corporation, or disregarded entity)
- The source and character of the income earned by the LLC
- The status and residency of the foreign members
- The level of involvement of the LLC in a U.S. trade or business
Types of Income Subject to U.S. Taxation for Foreign LLC Members
Generally speaking, foreign members of an LLC are subject to U.S. taxes on two types of income:
- U.S. source fixed or determinable, annual or periodic (FDAP) income, such as interest, dividends, and rents. This income is subject to a flat 30% withholding tax (or lower treaty rate) at the source, unless it is effectively connected with a U.S. trade or business.
- Income that is effectively connected with a U.S. trade or business (ECI). This income is taxed at the same rates as U.S. persons and requires the filing of a U.S. tax return.
Consequences of ECI Taxation for Foreign LLC Members
The source and character of the income earned by an LLC are determined at the partnership level and retain their character as they pass through to the individual members. Therefore, if an LLC earns foreign source income, it will not be taxable to its foreign members in the U.S., unless it is effectively connected with a U.S. trade or business.
The determination of whether an LLC is engaged in a U.S. trade or business depends on the facts and circumstances of each case. However, according to IRS regulations (Treas. Reg. § 1.875-1), if a partnership is deemed to be conducting business in the U.S., its foreign partners are also considered to be engaged in a U.S. trade or business by virtue of their ownership interest in the partnership (I.R.C. § 875). In simpler terms, these foreign partners would be treated as if they’re directly involved in a U.S. business.
This determination can have significant consequences for foreign partners, as they would be subject to U.S. taxes on their share of ECI from the partnership (I.R.C §§ 871 & 872). Moreover, they would also be required to file Form 1040-NR (U.S. Nonresident Alien Income Tax Return) and report their U.S ECI to the IRS, even if they qualify for an exemption or a treaty benefit.
Taxation of Foreign LLC Members on Personal Services Income
One of the factors that can affect this determination is whether the partnership’s income is derived from personal services or from other sources. According to the IRS, the source of personal services income is where those services were rendered, regardless of the location of payment or place of contracting (I.R.C. § 862(a)(3)). Therefore, if an LLC provides personal services outside the U.S., its income from those services will be considered foreign source income and will not be taxable to its foreign members in the U.S., unless it is effectively connected with a U.S. trade or business.
However, if an LLC provides personal services in the U.S. – whether through a U.S office, physical location, its employees, exclusive independent agent or other dependent agents, its income from those services will be considered U.S. sourced Effectively Connected income and will be taxable to its foreign members in the U.S., regardless of the tax classification of the LLC. This is because the foreign members are deemed to be engaged in a U.S. trade or business by virtue of their ownership interest in the partnership that provides personal services in the U.S. through a U.S office, physical location, its employees, exclusive independent agent or other dependent agents (Treas. Reg. § 1.864-4(c)(5)).
This principle was affirmed by the Supreme Court in United States v. Basye, 410 U.S. 441 (1973), where the Court held that a foreign partner’s distributive share of a U.S. domestic partnership’s income was exempted from taxation only if it represented his proportionate share of the firm’s income from non-U.S. sources. The Court also asserted that partnerships serve as channels, or conduits, through which the obligation to pay taxes is passed to individual partners (the conduit principle). Essentially, the partnership itself isn’t the taxpaying entity; its members are.
What are the reporting and compliance requirements for foreign-owned LLCs?
Foreign-owned LLCs and their members have various reporting and compliance obligations depending on their tax classification and income sources. Some of these include:
- Filing Form 1065 (U.S. Return of Partnership Income) and issuing Schedule K-1, K-2 and K-3 (Partner’s Share of Income, Deductions, Credits, etc.) to each member if the LLC is classified as a partnership. This form details the partnership’s income, deductions, and credits, and each partner’s share of these items. Depending on the type and source of income and deduction, the partners may be subsequently required to include this information on their individual tax returns.
- Filing Form 1120 (U.S. Corporation Income Tax Return) if the LLC is classified as a corporation. This form reports the corporation’s income, deductions, credits, and taxes. The corporation must also pay taxes on its taxable income at the corporate level and distribute dividends to its shareholders, who must report them on their individual tax returns.
- Filing Proforma 1120 and Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business) if the LLC is classified as a disregarded entity owned by a foreign entity. This form provides information about the transactions between the LLC and its foreign owner or other foreign related parties. The LLC must also attach Form 5472 to its pro forma Form 1120 (a dummy tax return that shows no income or deductions) and file it with the IRS.
- Filing Form 1040-NR (U.S. Nonresident Alien Income Tax Return) if the foreign member has ECI or other FDAP income that was not properly withheld at source. This form reports the foreign member’s income, deductions, credits, and taxes. The foreign members must also pay taxes on their taxable income at the individual level.
- Filing Form 8804 (Annual Return for Partnership Withholding Tax), Form 8805 (Foreign Partner’s Information Statement of Section 1446 Withholding Tax), and Form 8813 (Partnership Withholding Tax Payment Voucher) if the LLC has ECI allocable to its foreign partners and is required to withhold tax under IRC Section 1446. This section imposes a withholding tax obligation on a partnership (whether foreign or domestic) that earns income effectively connected with a U.S. trade or business, or income treated as such. The partnership must withhold tax on the effectively connected taxable income allocable to its foreign partners at the rate of 37% for individuals and 21% for corporations, unless a lower treaty rate applies. The partnership must also remit the withheld taxes to the IRS and report them to the foreign partners using the forms mentioned above.
- Obtaining an Employer Identification Number (EIN) for the LLC and an Individual Taxpayer Identification Number (ITIN) for each foreign member who does not have a Social Security Number (SSN). These numbers are used by the IRS to identify taxpayers and track their tax accounts. The LLC can apply for an EIN online, by fax, by mail, or by phone. The foreign members can apply for an ITIN by submitting Form W-7 (Application for IRS Individual Taxpayer Identification Number) along with their tax return and other proof of identity and foreign status.
- Registering for an Electronic Federal Tax Payment System (EFTPS) account to remit the withheld taxes to the IRS and report them to the foreign partners using the forms mentioned above.
Corporate Transparency Act (CTA) Reporting Requirements
Complying with the Corporate Transparency Act (CTA), The CTA mandates consistent beneficial ownership reporting for specific corporations, LLCs, and related entities in the U.S. FinCEN gathers this information and can share it with authorized government and financial bodies, ensuring proper checks and balances. This act aids in thwarting illicit financial activities in the U.S. by criminals, terrorists, and corrupt oligarchs. The CTA is a segment of the Anti-Money Laundering Act of 2020.
- Companies established or registered before January 1, 2024, must submit their initial ownership report by January 1, 2025.
- Companies formed or registered from January 1, 2024, have 30 days to submit their initial report once notified of their effective registration – starting January 1, 2024.
Complying with State Tax Regulations
This article focuses exclusively on federal tax issues. Be aware that each of the 50 U.S. states has its own tax regulations, including obligations related to sales tax, state franchise tax, and income tax. Your business activities within a specific state may necessitate compliance with these regulations. For comprehensive guidance on both state and federal tax obligations, consult a qualified tax advisor.
How can we help?
The U.S. tax system can be complex and challenging for foreign-owned LLCs and their members. That is why it is advisable to consult a competent tax advisor who can help you navigate the tax implications and compliance requirements for your specific situation. At O&G Accounting, we have the expertise and experience to assist you with your U.S. tax needs. Whether you need help with tax planning, filing, withholding, or reporting, we are here to provide you with professional and personalized service. Contact us today to book a paid consultation with one of our qualified tax advisors. We look forward to hearing from you!