Setting Up A US Limited Liability Company (LLC)
The United States is a key market for Australian businesses seeking to expand overseas.
The breadth and depth of economic opportunities will continue to attract Australian entrepreneurs and business owners.
In the world of ecommerce and technology, where the markets for end users of ‘apps’ are global, establishing an American entity can provide a marketing edge that Australian companies cannot provide.
To remain relevant to clients with global aspirations it is important for accountants to be able to guide their clients on overseas expansion.
Often this means explaining the issues to clients and, where appropriate, recommending specialist advice.
Once the decision is made to incorporate in the USA – the threshold question for a client will usually always be whether they should establish an LLC or a Corporation.
An understanding of how both the US and Australian tax systems apply to these entities will be required.
This is an additional layer of planning and complexity for clients who may never have previously set up a business outside Australia.
In Part 1 of this article we specifically examine how United States LLCs are taxed both in the USA and Australia. In Part 2 we discuss the issues that Australian clients should think about if they choose to incorporate a C Corporation instead of an LLC.
We hope that you can assist your client to make a more educated choice before establishing an LLC and not find themselves surprised by tax outcomes and compliance requirements that were not expected.
The accountant’s role in helping the client make an important decision should not be overlooked.
A US Limited Liability Company
A US Limited Liability company (LLC) is a type of owner managed company which provides limited liability to its owners, known as members. As the name implies an LLC is a company, incorporated under the law of a particular US state.
In a key difference to Australian companies, LLCs do not have directors. The responsibility for managing the company falls on the members (i.e shareholders). Provision also usually exists for the members of an LLC to appoint a manager to manage the business.
The State which has become most well known to foreigners establishing an LLC in the USA is Delaware, but clients should definitely take advice as to whether they may be better off incorporating in another state depending on their business plans.
US LLCs usually have ‘operating agreements’ rather than the more familiar ‘Constitutions’ but essentially the operating agreement is the foundation document that provides for the governance of the LLC along with relevant state law.
US Tax Treatment
For US tax purposes, it is usually the case that LLCs are treated as partnerships where the taxable income of the partners are included in the individual tax returns of the members to the extent of their membership interest.
It is possible under the US ‘check the box rules’ for an LLC to elect to be treated as a Corporation but advice should be sought in the US before that approach is taken.
Where the LLC has a sole member, then the LLC is usually considered to be a ‘disregarded entity’ for tax purposes.
This approach to taxing the profits of a company is unfamiliar in the Australian context and may catch the client unawares. The client will be dealing with an entity which is a partnership for tax purposes despite its legal form as a company.
Where the client is the sole member of the LLC they will generally be expected to file a personal tax return (1040-NR) in which the income and expenses of the LLC are included in their individual tax return. In addition, where the sole member is not a US person then the LLC must file a Form 5472. Penalties for incorrect filing or late filing will apply.
If the client is not the sole member, they will still be required to declare their percentage share of the LLC’s profit and of course ensure that the LLC itself lodges a return with the IRS which declares all its income and expenses at the LLC level.
Australian Tax Treatment
Of paramount importance is to understand how the US treatment may differ from the Australian requirements – to avoid the problems that can arise where the treatment is different.
The Australian tax treatment of the LLC, unlike the American treatment, depends on the threshold issue of whether the LLC would be considered a resident of Australia for income tax purposes.
Given that the LLC is a company, it will be a resident of Australia if it carries on a business in Australia and has either its central management and control in Australia or has its voting power controlled by shareholders who are resident of Australia (section 6(1) ITAA 1936).
Despite Government announcements that Australia’s Corporate Residency tests would be changed, the amendments to the law have not occurred and there seems no prospect of changes in the near future.
Hence the principles summarised in the landmark Bywater case still form the basis of advice to clients and the ATO’s Ruling TR 2018/5 and its Practice Compliance Guide should be consulted by practitioners before clients are advised.
In most cases where an Australian resident client has established an LLC in the USA, it should be quite clear whether or not the entity is resident of Australia, residency being a question of fact.
Sometimes the central management and control of the LLC (which is carried on by the members) will clearly be exercised from Australia and that may also mean that its business is carried on in Australia, meaning that at least two of the necessary elements for a foreign company to be resident of Australia are met.
If there is doubt about the place in which CMAC is exercised, that should be discussed with the client, but even then if CMAC is not exercised in Australia, if business is carried on in Australia, then usually the entity would be resident here because the sole member would reside in Australia if the client (or client entity) directly owns the LLC.
Where the LLC is resident of Australia, unless the situation is otherwise addressed, the issue will be that the US tax laws will require the members to be assessed, but Australian law would require a company tax return to be lodged.
The question will be whether the client in being personally assessed in the United States, can claim a credit for Australian tax paid at the entity level, or alternatively, if the US imposes primary taxing rights, the problem would arise in claiming a FITO at the Australian company level for personal US tax paid by the individual. This is a recipe for double taxation depending on the facts notwithstanding the foreign branch profit exemption under Australian law (section 23AH ITAA 1936).
It may be that for some clients the establishment and use of an LLC creates no real problems. That might be in a situation where the LLC has no ‘effectively connected income’ in the USA and the entity is treated as an Australian company.
In that case the tax position would be equivalent to the outcome that would have arisen if an Australian company had been incorporated rather than an LLC – simply that Australian company tax would apply to the taxable income of the entity. This sometimes arises where a US LLC is established but has no office and/or has no permanent establishment in the USA, as that expression is defined in the US-Australia DTA.
On other occasions if the LLC is considered a resident of Australia, real problems might arise. One example might be a US LLC established to acquire US real estate which is a common US approach.
If the LLC is treated as a resident of Australia for tax purposes, capital gains arising on the sale of US real estate would be taxable in Australia at the company tax rate, whereas the gains would be assessed to the individual for US purposes. It is difficult to see how a FITO can be claimed at the company level in Australia, where the US tax has been paid at the shareholder/member level because of the US flow through approach.
Where the Australian client establishes an LLC and opens a US office and employs US based staff it may be possible to show that CMAC is exercised from Australia and that business is not carried on in Australia depending on the facts.
In that case the LLC would not be resident of Australia for tax purposes, a threshold requirement for the application of Division 830 ITAA 1997, in which US LLCs are treated as foreign hybrid companies, not CFCs.
Under Division 830 the Australian client who owns an interest in the LLC would be considered to own an interest in a partnership (even if they are the only member).
The LLC becomes a partnership for Australian tax purposes which lines up the Australian treatment with the US treatment. It would also be possible to apply for a substituted accounting period in Australia so that the US year end could be used for Australian tax purposes.
The Australian member is then required to compute the ‘net income’ of the partnership by applying Australian principles. Effectively what is required is the calculation of partnership ‘net income’ as if the LLC was actually an Australian partnership.
A TFN would need to be applied for an Australian partnership return would need to be lodged unless the only activity of the LLC was the derivation of passive rental income.
In the right situation the symmetry provided by Division 830 has appeal because it permits the flow through of foreign tax credits and can reduce the incidence of double taxation of income.
However it is not an approach that we would suggest for a high growth Australian business which plans to establish a significant US business presence. The structure can lead to much higher capital gains tax outcomes if the US LLC is sold as compared to the alternative structure where a client might instead choose to incorporate a US Corporation in preference to an LLC.
