The Tax Cuts and Jobs Acts of 2017 TCJA is still impacting business decisions investors and entrepreneurs are making, with many considering the benefits and consequences of converting their business entity type to achieve more beneficial tax positions. As the first filing season under tax reform is well gone and since most taxpayers have now seen the full impact of those changes on their 2018 returns, we will revisit the tax pros and cons for foreign investors and entrepreneurs structuring investments thru C Corporations (C Corp) vs limited liability companies (“LLC”) taxed as partnerships.
America is the land of opportunity. However, opportunity can mean additional tax considerations, especially for foreign individuals setting up a business on U.S. soil. It is imperative to structure the business appropriately from the beginning so as not to trigger any unintended U.S. tax consequences down the road. Below is a brief comparison of the most popular entity structures to consider.
Investment in US real estate or a business should be properlty structured to provide privacy, asset protection and minimisation of US taxation. Due to the US taxing on worldwide income, tax structuring is often a driving force behind a transaction.
Ownership structures for foreign investors
The use of U.S. limited liability companies (LLCs) as investment holding vehicles or operational business entities has become increasingly popular among U.S. taxpayers. Along with a remarkably flexible charter, U.S. LLCs offer the opportunity to shield owners from unlimited liability while retaining flowthrough treatment for tax purposes. A U.S. LLC that has not made an election for corporate treatment—a “transparent” U.S. LLC—is effectively disregarded as an entity separate from its owner or, in the case of multiple owners, treated as a partnership for federal income tax purposes.
However, when it comes to cross-border structuring, transparent U.S. LLCs should be used with great caution. This article explores some common issues encountered by foreign taxpayers adopting transparent U.S. LLCs to invest or operate in the United States. Unless otherwise noted, any reference to an LLC is to a U.S. LLC that has not elected to be treated as a corporation for U.S. tax purposes.
For a foreign national looking to set up a business in the US, the choices of business entity to use look very confusing. Most of the available information about US companies is designed for US residents, and does not take into account the needs of non-residents.
The brief entity comparisons in this post paint a simple picture of a much more complicated decision. Whether an LLC or a C Corporation is right will depend on each taxpayer’s individual goals and set of circumstances. But one thing remains constant: it pays to conduct due diligence up front to ensure you are starting your new opportunity knowing all of the tax consequences.
In general, however, the choice of entity for a non-resident follows simple, general guidelines:
- If the company will be doing business in the US, then a corporation is the better choice.
- If the company will be used strictly outside the US, and there will be no US resident owners, then a limited liability company (LLC) will be much better.
Why do these choices work? First, the easy part: If you use a US company to carry on business outside the US, and have no US-resident owners, then very likely your LLC is not subject to US income tax or reporting. As a single-member LLC, your company is automatically considered to be a “disregarded entity,” meaning that it does not exist for income tax purposes. If the owner is not subject to US tax, and the LLC is not doing anything that would trigger US tax obligations, then it does not have a US tax or reporting obligation. A US corporation, no matter which state it is incorporate in, is taxable on its worldwide income, and must file a corporation tax return each year.
On the other hand, if your company will be doing business in the US, by leasing office space, hiring employees, or otherwise setting up a “permanent establishment,” then a corporation makes more sense for most people. This is because, while a corporation is considered to be a separate legal and tax entity from its owners and pays ordinary income rates whether owned by a resident or non-resident, an LLC’s situation is more complicated. The LLC default tax status is flow-through, either as a disregarded entity or a partnership.
Flow-through tax is a mixed blessing for a non-resident, since it means that the non-resident must obtain a US tax number and file a non-resident US income tax return. LLC default tax status may cause foreign owners to encounter a number of unanticipated U.S. tax consequences. U.S. partnerships that have foreign partners are required to withhold U.S. tax on their distributive share of partnership income. This withholding occurs quarterly and must be made at the highest graduated rate for the particular type of income (currently 21% for corporations and 37% for ordinary income earned by individuals). – which is sent straight to the IRS as a withholding tax. When the non-resident files his/her/its tax return with the actual tax amount due, the IRS may then issue a refund (by check) to the taxpayer for the excess of the withheld amount over the actual due. If it sounds complicated, well, it is complicated. As part of this process, the LLC must designate a tax withholding agent to calculate the amount due and send it to the IRS before releasing the rest of the money. There are also various information that are prepared and sent to the IRS at the end of the year.
A foreign-controlled LLC is also subject to the Branch Profits Tax, an onerous tax and accounting procedure meant to prevent foreign-owned companies from circumventing capital gains taxes. US corporations are not subject to the Branch Profits Tax. Another problematic issue is the classification of an LLC by the tax laws of the foreign owner country of residence. The crux of the issue is the potential mismatch in how an LLC is classified under U.S. tax law and the laws of a foreign jurisdiction. In many instances, the transparent treatment accorded under federal law is not relevant in determining how the LLC is classified for the tax purposes of another country. If the LLC is regarded as a nontransparent entity by the jurisdiction of its foreign owner, a mismatch will arise as to the identity and residency of the taxpayer who recognizes revenues and expenses, as well as the timing of income recognition. If an LLC is effectively treated as a hybrid entity foreign taxpayers should also be concerned about the potential loss of treaty benefits with respect to U.S.-source income earned by the LLC.
The only benefit that an LLC would have is that non-US source income that is not considered earned from the activities of the LLC (a complicated concept in practice) are not taxed. Because of all these complications, using a corporation to transact only US business (and using a different, non-US entity for non-US business) is considered the best practice.
The use of a C Corporation structure is often very attractive to foreign business owners. Because C Corporation profits and losses do not flow through to its owners, foreign owners will not need to file U.S. personal income tax returns. Even if the U.S. business is organized as a partnership, it could make sense for foreign persons to own their LLC interest indirectly through a corporate entity. Furthermore, the “double tax” consequence of C corporations may not be a concern for some foreign individuals if their home country treats U.S. dividends in a favorable manner.
Properly structuring foreign investment in the US takes into account corporate law, liability protection, privacy and tax planning. The structure is primarily driven by tax considerations, and an incorrect structure can have catastrophic tax results. In addition to the federal tax consequences discussed above, there may also be state income tax issues among others, which are beyond the scope of this article. Every investor, and their professional advisers, are strongly encouraged to seek local counsel in the US for structuring and tax advice.
It is important to note that all of the federal corporate tax changes mentioned above are permanent while the federal individual changes are temporary in nature for now. It is clear there are many factors to consider for any business that is considering a change in entity-type or a new business that is looking to choose what suits their needs. For more information about what entity type might be right for you and your business please contact Cuevas & Cuevas Tax Advisors.
This is just one article within our 2019 Year-End Tax Guide. For more great insights, check out our 2019 Year-End Tax Guide or attend our individual or business year-end planning webinars.
THIS INFORMATION IS PROVIDED AS A COURTESY – NOT AS LEGAL ADVICE.
Please know that we are raising the above issues as a courtesy and for informational purposes only. It is not intended as a substitute for legal advice concerning a particular situation that may be affecting your business.
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