Friday, January 31, 2014

U.S. taxation of foreign-owned LLCs

This topic causes a lot of confusion, and it's not uncommon to receive conflicting answers from the IRS itself. The following guidelines help determine whether an LLC owned by nonresident alien(s) has to pay US tax and/or file a federal tax return. This blog post only covers LLCs formed in the U.S. by nonresident individuals (not entities).

LLC is a “disregarded entity” for federal income tax purposes. That means that the IRS does not tax the LLC itself, but instead looks at the LLC’s owner(s) for tax status determination. Therefore, rules applicable to nonresident alien individuals apply. Generally speaking, LLCs owned by nonresident aliens do not have to file a federal tax return unless they a) have “U.S. source income” and/or b) “engage in a U.S. trade or business.” Note that the LLC owner will have to file a tax return if the LLC is engaged in a U.S. trade or business, even if that trade or business did not produce any U.S. source income. The IRS uses the following rues to determine the source of income and the location of a trade or business.

U.S. source income

The first step to decide whether a nonresident alien has to file a federal tax return is to determine whether the alien received any U.S. source income.

Type of income
Factor determining source
Business income: personal services
  Where services performed
  Residence of payer
IP royalties (patents, copyrights, etc.)
  Where IP is used
Sale of personal property
Seller's tax home
Sale of real property
  Location of property
For example, if a nonresident alien software developer forms a Delaware LLC to perform services for U.S. clients, payment for such services would not be considered “U.S. source income” if the developer performs the services from a foreign country.


U.S. trade or business

The second step to decide whether a nonresident LLC owner has federal tax filing obligations is to determine whether the LLC is engaged in a U.S. trade or business. Note that even if that LLC generated only foreign source income, nonresident aliens must still file federal tax return 1040NR if they are “engaged in a U.S. trade or business”  (IRS Publication 519, p. 33). Simply registering an LLC is not considered being engaged in a U.S. trade or business unless that LLC has an actual office, manufacturing, storing or other facility in the U.S.

Foreign source income may be considered to be effectively connected with a trade or business in the United States if:

1)      You have an office or other fixed place of business in the United States to which the income can be attributed,
2)      That office or place of business is a material factor in producing the income, and
3)      The income is produced in the ordinary course of the trade or business carried on through that office or other fixed place of business.

An office or other fixed place of business is a material factor if it significantly contributes to, and is an essential economic element in, the earning of the income.


If nonresident alien owners of a U.S. LLC do not maintain an office or other facilities in the U.S. and do not receive U.S. source income, they are not obligated to file a federal tax return. They may still have tax liability to the state where the LLC is formed, however, normally the states follow the above described federal pattern and do not tax income unless the LLC has an actual office in the state or receives income from activities within that state. For example, Delaware has specifically ruled that maintaining a website by a Delaware company does not constitute "doing business in Delaware" for tax purposes, unless the actual server is located in that state. Therefore, a web-based foreign business will not have to pay any income tax to Delaware for maintaining a website registered to a DE company, unless the server is in DE. 

Read next:
IRS Publication 519, U.S. Tax Guide for Aliens
- US companies and US bank accounts (for foreign and domestic clients)
- Регистрация оффшорной компании в Делавэр, США (Registering a Delaware company)