When foreign entrepreneurs earn royalty income from U.S.-based platforms such as Amazon or Audible, understanding U.S. federal tax obligations is essential. Lucia (Spain) and Marco (Italy) are two such entrepreneurs planning to form a U.S.-based Multiple Member LLC (MMLLC) to manage their royalty income from creative works. This article will help them and other foreign owners of MMLLCs understand key U.S. tax concepts, including FDAP, withholding taxes, and how international tax treaties impact their obligations. It also provides step-by-step guidance for staying compliant with IRS requirements.
Introduction
Lucia and Marco, both non-U.S. residents, are looking to establish a U.S.-based MMLLC to manage their royalties from platforms like Amazon. Their key concerns include:
- Whether royalties are classified as “effectively connected income” (ECI).
- Understanding FDAP (Fixed, Determinable, Annual, or Periodical income) and how it applies to their situation.
- Understanding U.S. withholding tax rates and how tax treaties between their countries of residence and the U.S. can lower their tax burden.
- Ensuring compliance with U.S. federal tax regulations.
This article explores U.S. tax obligations for foreign-owned LLCs, focusing on royalty income, tax treaties, and practical steps for IRS compliance.
FDAP Income vs. Effectively Connected Income (ECI)
The IRS categorizes income earned by foreign individuals into two main types:
- Effectively Connected Income (ECI): This is income tied to conducting business or trade in the U.S., such as providing services or selling goods. ECI is taxed on a net income basis, meaning that foreign persons can deduct business expenses.
- Fixed, Determinable, Annual, or Periodical (FDAP) Income: FDAP income is passive and includes royalties, interest, dividends, and rent. FDAP is subject to a U.S. withholding tax of 30%, though this rate can be reduced by applicable tax treaties. FDAP is taxed on a gross basis, without deductions for expenses.
For Lucia and Marco, their royalty income from Amazon falls under FDAP income, as it is passive income derived from copyrighted content used in the U.S.
Withholding Tax and Tax Treaties
The standard U.S. withholding tax on FDAP income is 30%, but tax treaties between countries can lower this rate for certain types of income. For example:
- Spain (Lucia’s residence): The U.S.-Spain tax treaty reduces the withholding rate on royalties to 5%.
- Italy (Marco’s residence): The U.S.-Italy tax treaty reduces the withholding on copyright royalties to 0%. However, if Marco’s royalties come from Industrial Equipment, Know-How, Other Industrial Royalties, Patents, Film & TV, the withholding rate is 8%, according to Article 12(2) of the treaty.
This means that the type of royalty income Marco earns will affect the withholding rate applied to his earnings.
Using an MMLLC for Efficient Tax Management
Lucia and Marco plan to form a Multiple Member LLC (MMLLC) to handle their royalty income. For U.S. tax purposes, an MMLLC is treated as a partnership, meaning the LLC itself doesn’t pay federal taxes. Instead, the income flows through to each partner, and the MMLLC acts as a withholding agent for its foreign members, ensuring that the appropriate tax is withheld from their FDAP income.
- Lucia’s royalty income will be subject to a 5% withholding rate, based on the U.S.-Spain tax treaty.
- Marco’s royalty income will be subject to 0% withholding for copyright royalties or 8% withholding for royalties from industrial or other specific sectors, per the U.S.-Italy tax treaty.
Step-by-Step Tax Process for Foreign-Owned MMLLCs
- Forming the MMLLC and Applying for an EIN
The first step for Lucia and Marco is to form their MMLLC, which can be done through online platforms or with professional assistance. After the LLC is established, they must apply for an Employer Identification Number (EIN) from the IRS, which is required for tax and information filings and payments. - Registering for EFTPS and Making Quarterly Payments
Once the LLC is formed, Lucia and Marco need to register with the Electronic Federal Tax Payment System (EFTPS) to make quarterly estimated tax payments of the FDAP withholding. The MMLLC, as the withholding agent, is responsible for withholding and paying taxes on the FDAP income for its members:- Lucia’s royalties will be withheld at 5%, based on the U.S.-Spain tax treaty.
- Marco’s royalties will either be withheld at 0% for copyright royalties or 8% for industrial-related royalties, depending on the nature of his earnings, according to the U.S.-Italy tax treaty.
Payments are required to be made quarterly to avoid penalties.
Filing Form 1065 (Partnership Tax Return)
At the end of each tax year, the MMLLC must file Form 1065, the U.S. Return of Partnership Income. This form reports the LLC’s income, expenses, and distributions to its members. Additionally, each member receives the following forms:
- Schedule K-1: Summarizes each member’s share of income, deductions, and credits.
- Schedule K-2: Provides details on foreign income and tax credits.
- Schedule K-3: Breaks down international tax reporting, helping foreign members understand their U.S. tax obligations.
Filing Forms 1042 and 1042-S
The MMLLC is also responsible for filing Form 1042 and Form 1042-S to report withholding taxes on foreign members’ FDAP income. For example:
- Lucia will receive a Form 1042-S showing the 5% withholding applied to her royalty income.
- Marco will receive a Form 1042-S showing the 0% withholding for copyright royalties or 8% withholding for royalties related to industrial sectors, depending on the nature of his income.
Solutions and Recommendations
- Leverage Tax Treaties: Lucia and Marco can reduce their tax burden significantly by taking advantage of their countries’ tax treaties with the U.S. Lucia benefits from a reduced 5% withholding rate, while Marco’s royalties may either be fully exempt or subject to the 8% rate depending on the type of royalty income he earns.
- Properly Manage Withholding: The MMLLC must act as a withholding agent and ensure all taxes are withheld and paid to the IRS. Registering with EFTPS ensures timely payments and helps the LLC avoid penalties.
- Stay Compliant with Filing Requirements: The MMLLC must file Form 1065 annually and issue Schedules K-1, K-2, and K-3 to its members. Additionally, the LLC must file Forms 1042 and 1042-S to report withholding on U.S source FDAP income.
- Focus on U.S.-Sourced Income Only: U.S. withholding taxes apply only to royalties and income sourced from the U.S. If Lucia and Marco earn royalties from outside the U.S., such income is not subject to U.S. withholding taxes.
Additional Considerations: BOIR Compliance
Foreign-owned U.S. LLCs must comply with the Corporate Transparency Act (CTA), which mandates reporting beneficial ownership information to FinCEN. Filing deadlines vary depending on when the LLC was created:
- Existing Entities (before January 1, 2024): Must file by January 1, 2025
- New Entities (on or after January 1, 2024): Must file within 90 days of the LLC’s creation.
At O&G Tax and Accounting, we offer full assistance with CTA filing to ensure compliance.
Forming an MMLLC and understanding U.S. tax obligations for FDAP income allows foreign entrepreneurs like Lucia and Marco to better manage their royalty income from U.S.-based platforms. By leveraging tax treaties, ensuring proper withholding, and staying compliant with IRS filing requirements, they can optimize their tax obligations and ensure their business operates smoothly.
If you need assistance forming an LLC, managing withholding taxes, or complying with the Corporate Transparency Act, O&G Tax and Accounting Services is here to help. Contact us today to schedule a consultation and begin the process of ensuring compliance with U.S. federal tax laws. Schedule a consultation here.
