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How LLC income is taxed under US primary tax law depends on three things.
LLC Income
In this episode Gary Carter of GW Carter in Edina Minnesota will discuss with you when and how LLC income is taxable in the US under US primary tax law, focusing on a single-member LLC. Here is what we learned but please listen in as Gary explains all this much better than we ever could.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
LLC Income
Three factors determine how US primary tax law taxes LLC income – disregarding any treaty position:
1 – Source of Income: US or foreign-sourced?
2 – Business: US Trade or Business or not?
3 – Tax residency of partners: US persons or non-resident alien / foreign corporation?
1 – Source of Income
The source of income depends on two things: 1 – Control of the manufacturing process and 2 – Location of production or sale.
If the entity has control (self-created product) over the manufacturing process, then the place of production determines the source of the income. If it doesn’t have control (third party product), then the location of the consumer and product at the time of sale determines the source.
Self Created Product
You have a self-created product when you produce (manufacture and create) your own unique product for which you hold the trademark (property right). You might have a third-party manufacturer but as long as you control key facets of the manufacturing process.
See Treasury Regulation Section 1.863-1(a)(3) and further explained in Treasury Regulation Section 1.954-3(a)(4), you have a self-created product. (Section 863(b) and Section 864(c)(4)(B)), s861(a)(6), Treasury Regulation Section 1.861-7(a)).
2 – US Business or Trade
Neither the Internal Revenue Code nor Treasury Regulations define when a company has a US Trade or Business (‘USTB’). Hence the courts had to decide and courts tend to give varying outcomes.
Factors that suggest a USTB are:
1 – a profit motive;
2 – considerable, continuous, and regular activities;
3 – a dependent agent acting in the US to further the business.
A 3PL service like FBA (‘Fulfilled by Amazon’) does not count as a dependent agent, but that doesn’t mean that there is no USTB. There is no specific law or court case you can use to defend against an IRS USTB claim.
3a – Tax Residency of LLC
If formed in the US, an LLC is a US person. Even if the LLC is completely disregarded for US federal tax purposes, the LLC is still a US person.
As a US person, the LLC is a US tax resident, even if disregarded for US federal tax purposes.
A resident’s starting position is “All In”. All its income – be it sourced in the US or overseas – is in the US tax net, unless a DTA pulls it out.
In contrast, a non-resident’s starting position is “All Out”. No income is taxable in the US unless primary US tax law pulls it in and as long as a DTA doesn’t pull it out again.
3b – Tax Residency of LLC Partners
The LLC’s single-member assumes the LLC’s tax position. If the single member is a foreign corporation – like an Australian Pty Ltd – the single member of the LLC only pays tax in the US on US-sourced income or effectively connected income (ECI) to a US Trade or Business. If the single member is protected by a Treaty like Australian entities are, then the single member only pays tax in the US on ECI if it has a permanent establishment.
Any Australian company – even if holding an LLC interest – is a foreign corporation as per Section 7701(a)(5) and never a US resident.
Corporate Filing
The LLC has to file a tax return unless it is a US-owned single-member LLC.
A SMLLC without a 8832 election is a disregarded entity under Treasury Regulation Subchapter F Section 301.7701-3(b)(ii) and hence it has no filing obligation with one exception.
If the SMLLC is foreign-owned, it has to disclose its member in a 5472 + pro-forma 1120 under Treasury Regulation Section 1.6038A-1(c) under threat of a USD 25k penalty per Section 6038A(d) but the IRS can waive under Treasury Regulation Section 1.6038A-4(b). The LLC is also disregarded for most state taxes with some exceptions (e.g. California’s sales receipts tax). All other obligations still apply to the SMLLC itself, for example, the obligation to maintain books and records as a separate entity (Treasury Regulation Section 1.6038A-3).
An MMLLC is a domestic partnership irrespective of the tax residency of its members. It has to file a 1065 disclosing its income. And then issue a Schedule K – 1 to each member listing the income they are to include in their tax returns.
US Primary Law
If there is no US-sourced income or ECI derived by a foreign resident
, then there would be no need to look at the treaty. Already under primary US tax law, the business income would not be subject to US tax.
But if there is US income or ECI and hence a US tax liability under US primary tax law, then we need the treaty to get out of this US tax obligation.
Double Tax Agreement
The Australian entity would only be taxable in the US to the extent it had a PE in the US under the US Australian Treaty (1982 Treaty together with its 2001 Protocol).
This PE would require a fixed place of business and / or dependent agents in the US and the exemptions in Article 5 (3) (a) and (b) must not apply.
Fixed Place of Business
The Amazon warehouse does not count as a fixed place of business, since the Pty Ltd has no access to the warehouse.
Dependent Agent
Amazon represents an independent agent under primary tax law due to multiple factors such as acting independently and working as agent for multiple parties (Treasury Regulation Section 1.871-7(d)(3)).
So without a fixed place of business and without a dependent agent, the Pty Ltd has no PE in the US. Any income it derives from having a USTB and ECI is not taxable in the US under the treaty position.
So all the Pty Ltd would have to do is do a protective 1120F filing with an 8833 claiming the treaty position on the return as required by Section 6114.
Protective Filing
The protective filing serves two purposes:
1 – Treasury may fine the Pty Ltd USD 10,000 for using the treaty without filing per Section 6172; and
2 – If the IRS challenged the treaty position, the Pty Ltd would not be able to use prior expenses for reducing gross sales (Treasury Regulation Section 1.882-4(a)(3)(vi)) if the IRS won.
Manufacturing
If the LLC did manufacturing or processing in the US, it is possible for the Australian Pty Ltd to have a PE in the States due to Article 5 (4) (d). Rephrasing the paragraph it says:
(4)(d) “…the Australian Pty Ltd shall be deemed to have a PE in the US if the Australian Pty Ltd owns merchandise that:
(i) it purchased in the US, that had been produced in the US; or
(ii) it produced the merchandise itself in the US or had it produced in the US on its behalf,
and are, after such purchase or production, the LLC or Australian Pty Ltd substantially processes the merchandise in the US and the same persons participate directly or indirectly in the management, control or capital of both the LLC and the Australian Pty Ltd.”
Taking the technical explanation and again inserting ‘Australia’ and ‘US’ for an easier read.
“. . . an Australian entreprise which maintains goods in the US whose goods were either purchased in the US (and not previously processed elsewhere) or produced in the US by it or on its behalf, and are then substantially processed in the US by a related enterprise is deemed to have a PE in the US.”
Australia
The Single Member LLC is a disregarded entity in the US but not in Australia. In Australia, the SMLLC is an Australian resident since its central management and control is in Australia.
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Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 16 December 2022
Tax Talks spoke to Gary Carter - Founder at GW Carter - for more details.
