Popularity of LLC’s in the U.S.
In recent years, it is has become increasingly convenient for online entrepreneurs who are non-U.S. citizens or residents to form a U.S. limited liability company (“LLC”) virtually through popular platforms such as Stripe Atlas and StartPack. The formation of the LLC provides for the foreign entrepreneur the ability to obtain a U.S. bank account and do business in the U.S.
If it is the case that the LLC is 100%-owned by a non-U.S. owner, there could be hidden tax traps and risks that the non-U.S. entrepreneur may not be aware of.
Trap #1 – LLC owner’s U.S. tax obligations
An LLC 100% owned by a single member is by default treated as a flow-through entity and not subject to tax. Even if the LLC itself does not have a U.S. federal income tax return filing requirement (nor pay federal income tax since it is not a taxable entity), the LLC’s owner will be taxed on the income of the LLC. If such income is derived from a U.S. trade or business conducted by the LLC, the owner generally will need to file a U.S. income tax return and pay U.S. tax on the LLC’s profits allocated to the owner. Non-U.S. owners of single-member LLC’s are often unaware of their U.S. income tax obligations as they believe they already pay personal tax in their country of residence. If unrectified, the U.S. tax exposure can quickly add up, especially considering the 37% federal income tax rate for individuals and the 21% federal income tax rate for corporations (as well as the U.S. branch profits tax of up to 30%).
Trap #2 – Double tax
From the perspective of the tax law of the non-U.S. owner’s home country of residence, the U.S. LLC is likely still considered a taxable corporate entity (ie, its flow-through nature for U.S. purposes is not respected in the home country). This means that when the non-U.S. owner takes out distributions from the U.S. LLC (i.e., when the LLC makes a distribution payment), that item of income could be taxable again to the owner in his home country, creating an unfortunate scenario where the same income could be double taxed (first taxed in the U.S. as discussed above, and then taxed in the non-U.S. owner’s country of residence when the LLC makes a distribution payment).
Trap #3 – Foreign reporting obligations
Although a flow-through LLC itself is not required to file a U.S. income tax return, a change in tax law in 2017 requires such entities that are foreign-owned to annually file “Form 5472 information return with respect to reportable transactions between the entity and its foreign owner or other foreign related parties”. Non-compliance of each Form 5472 as required per year will result in a penalty of $25,000 per occurrence.
What are the alternatives?
“Check-the-box” election
A single-member LLC can make an election to be taxable as a corporation. This means that the LLC’s files a tax return and pay tax on its profits instead of the non-U.S. owner. As long as the non-U.S. owner is not itself carrying on a U.S. trade or business, the activities of an LLC treated as a taxable corporation in and of itself should not subject its non-U.S. owner to U.S. tax. Since the LLC is treated as taxable corporations in both the U.S. and the tax jurisdiction of the non-U.S. owner, the alignment of tax treatment of the LLC should mitigate the risk of double tax for the non-US entrepreneur.
Do business in the U.S. through a “C-Corporation”
Instead of setting up an LLC, the foreign owner can consider forming a C-Corporation which by default will be treated as a taxable entity in the U.S. This would achieve the same result as the “Check-the-box” election made by a single-member LLC as described above.
Do business in the U.S. through a foreign corporation
The non-U.S. entrepreneur can incorporate a corporation resident in his or her home country. This could be beneficial if the foreign corporation is resident in a country with which the U.S. has a double tax treaty. If the level of US business activity conducted by the foreign corporation does not reach the threshold of “taxable presence” (or, “permanent establishment”) under in a double tax treaty, then that foreign corporation may be able to be exempt from U.S. federal income tax on its business profits altogether. Additional considerations will need to be given towards the applicability of state income tax and state sales & use tax.
There are many more cross-border tax tips and advantages you can apply, here are some reasons you should hire a cross-border tax accountant.