What Is a LLC and How Is It Taxed and Reported in the US?
Quite possibly the most common and well-known business structure is the limited liability company, or LLC. Business founders love the flexibility, low-cost, and ease of setup that an LLC offers. Additionally, with many service providers available to set up an LLC, it is no surprise that the first type of business structure that many businesspeople consider is an LLC.
However, although it may be easier and cheaper to set up an LLC than an S Corporation or C Corporation, this does not mean one should be careless when settings things up. It is important to note that an LLC is a business structure that exists on the state level, which means, when organizing an LLC, you do so by registering it in a given state, such as Delaware, California, Wyoming, and so forth. Owners of an LLC are called members, and there is tremendous flexibility in that members may include individuals, corporations, or even foreign entities.
In terms of the default tax treatment of LLCs, a single-member LLC with one owner is disregarded for U.S. income tax purposes. What does this mean? This means all the income and expenses of the LLC flow through to one’s personal tax return, on Schedule C of Form 1040. It also means that no separate tax return is needed for the LLC, and that the income from the LLC is considered self-employment income, on which the taxpayer will pay federal income and self-employment tax.
An LLC that has at least two owners is treated as a partnership, and therefore, a separate federal partnership return, Form 1065, will be required. The income and expenses for each member, or partner, in this case, would be reported on a Schedule K-1, which each member would then need to report on their personal tax return, on Schedule E of Form 1040.
A question that may arise is, what about the treatment of a foreign-owned LLC?A foreign-owned U.S. LLC that has a single member must file a Form 5472 to report the ownership of and transactions between the LLC and a foreign entity, as well as a Form 1120 corporation tax return for each calendar year. If the foreign-owned LLC has two or more members, a partnership tax return (Form 1065) would be needed. However, If the LLC has non-U.S. members as partners, there is no Form 5472 filing requirement for the LLC.
Yet another implication for a foreign-owned LLC that is owned by only one member is that it would be treated as a branch of the foreign parent company for U.S. tax purposes. Under U.S. tax laws, the U.S. imposes a 30% branch profits tax on a foreign corporation’s U.S. branch earnings and profits that are effectively connected with a U.S. business, to the extent that the profits are not reinvested into branch assets. A U.S. branch would be taxable at the federal and state level. At the federal level, the branch profits tax at the rate of 30% is levied on the effectively connected earnings and profits of the U.S. branch.
Therefore, the foreign parent company would be treated as engaged in a U.S. trade or business to the extent that the LLC is engaged, and consequently, will report the income and activities of the LLC’s activities on the foreign corporation’s U.S. tax return. The federal tax rate for foreign corporations on income earned in the U.S. is currently 21%. State income tax rates vary.
In this scenario, it might be beneficial for the LLC to elect to be taxed as a corporation for U.S. income tax purposes. This election would create a separate taxable entity in the U.S. and consequently prevent the foreign parent company from having U.S. federal and state income tax filing obligations, which can be burdensome for a foreign corporation as the company continues to grow in the U.S. If the LLC is taxed as a corporation, the foreign parent will avoid U.S. trade or business income tax (though it may still be subject to tax on any dividends it receives from the LLC) and the branch profits tax mentioned above. The LLC, instead of the foreign parent, will pay federal income tax as a corporation at 21%. There would be no branch profits tax.
In addition, we cannot stress enough how important the operating agreement is when organizing an LLC, in particular if the LLC is to be taxed as a partnership. To paraphrase venture capitalist Peter Thiel, a company that is broken at the start will probably not succeed. Part of getting the foundation correct is having a clear operating agreement that spells out the duties of each member.
If you are considering organizing an LLC, or you have already organized an LLC, and need guidance on the tax implications or operating structure, please get in touch with us today to discuss your options going forward. Indeed, one of the biggest strengths of an LLC is its flexibility, but that also means there are plenty of areas where things can go wrong.