Updated Jan 15, 2020, by Ross Lustman, JD, CPA, EA
A US-based LLC can have great tax advantages, especially for foreign entrepreneurs abroad. Even for US taxpayers, LLC taxes can be favorable.
An LLC is a pass-through tax entity. What this means is that the LLC is not taxed directly. Instead, the profits and losses of the business pass through to its owners, who report them on their personal tax returns.
Tax-free LLC income for foreign owners of a US LLC
A little known fact is that the US can be one of the biggest tax havens in the world. A US LLC opened by a non-US citizen or nonresident can arguably allow for earnings that are not taxed in the US.
Of course, certain rules apply to avoid LLC taxes.
Effectively, foreigners are only subject to US tax if they are “engaged in a trade or business in the United States” (ETOB). If your business is not ETOB, even if it generates income in the US, the income is not taxed in the US.
However, you are engaged in a trade or business (ETOB) in the US if
(1) you have at least one “dependent agent” in the US, which are employees or companies that work for you almost exclusively, and
(2) this dependent agent does something substantial to further your business in the US, as opposed to something purely administrative, or
(3) you are engaged in “considerable, continuous, and regular” business in the US
More on dependent agents below.
Unfortunately, courts have not provided a clear and definite standard of what constitutes “considerable, continuous, and regular” business.
Furthermore, other circumstances could make you ETOB. The tax code and court rulings are vague about ETOB, which introduces an element of risk here.
Tax treaties also play a role. Some tax treaties include dependent agent exceptions. Therefore, if you reside in a country with an applicable tax treaty with the US, you may not be subject to US tax.
Depending on the treaty, you could claim you operate a “permanent establishment” (e.g., an office or other fixed place of business) in the country where you are a tax resident. In other words, when you live, work and pay tax in your home country, the tax treaty may circumvent the US rights to tax you.
In general, not taxable are:
- Personal services performed from abroad
- Selling digital products
- Web design etc.
- Selling physical products if the shipping point is from outside of the US.
Any business transacted from within the US would be taxable. This potentially includes shipping from Amazon. Personal services performed from within the US are taxable as well.
Potential Risk of LLCs for Foreigners
Be aware that applying this approach to Amazon selling uses a rather aggressive reading of the US tax code and does not come without risks.
To date, we are not aware of any court ruling against this interpretation of the tax code. However, as with any aggressive approach to tax planning, there is always the possibility that the IRS eventually rejects it.
A more cautious approach would be to set up a US C corporation. While it is not tax-free, it can still be quite tax efficient. A C corp must pay tax on the net income after all expenses. Since those expenses include the management fee that the owner pays to themselves, the actual taxable income could be rather small. And because the service is performed by a non-US person outside the US, a lower US tax rate, often zero, applies.
When you are just starting out, a tax-free LLC might be a good choice. For more cautious entrepreneurs or those with an established successful business, we recommend considering the C corp instead to mitigate any risk. Discuss your options with an experienced tax accountant.
What is a Dependent Agent
Let’s explain the “dependent agent” requirement with two examples.
Example 1: Foreign software company without US office or representative
A Mexican software company is performing programming/design work for US clients. It is based in Mexico and has no US office or sales agents. All sales are done over the phone or online.
The company can open an LLC to receive payments in USD in a US bank account. The work is performed in Mexico and the owners are non-US citizens/residents, who are not taxed in US. Therefore, the LLC income is not taxed in the US as there are no offices or dependent agents in the US.
Example 2: Foreign “Fulfillment by Amazon” service provider
A foreign entrepreneur sells products into the US market using Amazon’s “Fulfillment by Amazon” service. All marketing and procurement are managed online by the non-US citizen, who lives in Colombia. Products are ordered and shipped to Amazon’s warehouses, where Amazon employees package the products and ship to customers in the US.
In this case, Amazon is not a dependent agent but an independent agent that has its own business with millions of other clients. Amazon is not uniquely working for this foreign entrepreneur.
Even though Amazon is not a dependent agent, the Amazon seller may still engage in a US trade or business. If the seller doesn’t manufacture the product, then the actual transaction, the transfer of ownership, takes place in the US. This means the seller may have to pay US income tax.
Again, the tax code and courts have been vague if this qualifies as ETOB. To mitigate the risk, setting up a C corporation would be a safer approach.
US LLC tax filing requirements for foreigners
Previously single-member LLCs with foreign owners were not required to file. However, starting 2017, all foreigners who own a US LLC must file a 5472 US tax return with the IRS for disclosure purposes even if they do not owe tax in the US.
In addition, foreign owners should be aware of the LLC tax implications in their local fiscal residence jurisdictions. The income from the US LLC may still be taxed in the country of residence.
LLC taxes for US citizens or residents as owners
For Americans there is no tax haven for LLCs. Still, an LLC offers an easy option to formalize business operations and create partnerships.
As mentioned earlier, the IRS does not treat an LLC as a separate tax entity. Instead, all its income is passed through to the members of the LLC, who must declare it and pay personal income tax.
A single owner of an LLC would include the profit and loss from the LLC on Schedule C of his or her Form 1040. With two or more partners, each owner reports the allocated portion of the profits on their personal tax return.
However, some US states tax LLCs directly. Also, note that an LLC may elect to be taxed as a corporation. In many cases, American taxpayers will also be required to pay self-employment tax in addition to income tax.
To limit this self-employment tax liability and also offer the option to contribute more to a retirement plan, US taxpayers should consider an S Corp. We explore more of these advantages in this comparison of LLC and S Corp.
Photo by Lee Cannon