Taxation of Foreign-Owned LLCs

Published: May 12, 2024 • M&A

Introduction

Non-resident aliens (NRAs), meaning individuals who are not U.S. citizens, permanent residents, or tax residents, often choose to form and own a limited liability company (LLC) in the United States to conduct business activities and sell goods or services in the U.S. market. A critical issue that arises for NRAs in this situation is whether their U.S. LLC will be subject to U.S. federal income taxation.

The taxation of a foreign-owned U.S. LLC depends on several key factors, including the type of business activities the LLC engages in, whether those activities constitute being engaged in a U.S. trade or business, and whether the LLC has income effectively connected to a U.S. trade or business. In some cases, a foreign-owned LLC may not owe any U.S. income tax at all, while in other cases, the LLC may have a U.S. tax liability that passes through to its NRA owner.

This guide will cover all the essential aspects of U.S. taxation for LLCs that are wholly owned by one NRA. We’ll start by reviewing some key concepts and definitions, then discuss common scenarios where NRA-owned LLCs are exempt from U.S. taxation. After that, we’ll examine the business activities and situations that do trigger a U.S. tax liability.

A special section will cover the tax implications of an NRA-owned LLC engaging in contracting with the U.S. federal government. Finally, we’ll walk through the process of properly filing U.S. tax returns for a foreign-owned LLC when required.

The goal is to give NRAs who own or are considering forming a U.S. LLC a solid understanding of how their LLC will be taxed, so they can structure their U.S. business activities in the most tax-efficient manner and remain in full compliance with U.S. tax laws.

Key Concepts and Definitions

Before diving into the specific tax situations of foreign-owned LLCs, it’s important to review some key concepts and terminology that apply in this area.

NRA – Nonresident Alien

For U.S. tax purposes, a nonresident alien is an individual who is neither a U.S. citizen nor a U.S. “resident alien.” The resident alien definition is based on two tests:

  1. The green card test – the individual is a lawful permanent resident of the U.S. at any time during the year; or
  2. The substantial presence test – the individual is physically present in the U.S. for at least 31 days during the current year and 183 days during the 3-year period that includes the current year and the 2 preceding years, counting all the days in the current year, 1/3 of the days in the prior year, and 1/6 of the days in the earliest year.

If an individual meets either of these tests, they are a resident alien and subject to U.S. taxation on their worldwide income. An individual who does not meet either test is an NRA and is subject to U.S. taxation only on certain types of U.S.-source income.

LLC – Limited Liability Company

A limited liability company is a business entity created under state law that offers liability protection to its owners, called “members.” For federal tax purposes, an LLC is treated by default as a disregarded entity if it has only one owner (member) or as a partnership if it has two or more members.

A single-member LLC owned by an NRA is known as a “foreign-owned U.S. disregarded entity.” It is disregarded as an entity separate from its owner, meaning the LLC does not file a separate U.S. tax return. Instead, the LLC’s income and expenses pass through to the NRA owner and are reported on the owner’s individual U.S. tax return, if required.

ETOB – Effectively Connected Trade or Business

Whether an NRA is engaged in a U.S. trade or business is a key determination because it establishes if the NRA has a U.S. tax liability. Being engaged in a U.S. trade or business means the NRA is conducting regular, continuous, and substantial business activities in the United States.

Sporadic or isolated business transactions in the U.S. usually do not rise to the level of an effectively connected trade or business. But if an NRA’s U.S. business activities are considerable, regular, and continuous, the NRA likely is conducting an effectively connected U.S. trade or business, even if the activities are only for a short period.

Examples of activities that typically constitute being engaged in a U.S. trade or business include:

  1. Maintaining a physical office or store in the U.S. where the NRA regularly conducts business activities
  2. Having U.S.-based employees who carry out business functions for the NRA
  3. Providing in-person services to clients located in the U.S. on a regular basis
  4. Selling products to U.S. customers through a website or platform, where the NRA holds the sold inventory at a warehouse or fulfillment center in the U.S.
  5. Regularly purchasing inventory or supplies in the U.S. for resale to U.S. customers

In contrast, examples of sporadic or isolated activities that likely would not rise to the level of an effectively connected U.S. trade or business include:

  1. Making a single, isolated purchase of inventory from a U.S. supplier for sale abroad
  2. Attending a U.S. trade show solely to gather information, without engaging in sales or marketing activities
  3. Sending an employee to the U.S. for a few days to receive training or attend an educational seminar
  4. Shipping products to the U.S. on a “landed” basis where title transfers outside the U.S., without further involvement in the U.S. distribution process
  5. Purchasing a small amount of office supplies or equipment from U.S. retailers for use in the NRA’s foreign business

ECI – Effectively Connected Income

Once it is determined that an NRA is engaged in an effectively connected U.S. trade or business, the next step is determining the income that is “effectively connected” to that trade or business. Effectively connected income is the portion of the NRA’s gross income from U.S. sources that is connected to the conduct of the NRA’s U.S. trade or business.

ECI is taxed at the same graduated income tax rates that apply to U.S. citizens and residents. Income that is not effectively connected to a U.S. trade or business is not subject to graduated tax rates and may be taxed at a flat 30% rate or lower treaty rate, or it may be exempt from U.S. tax entirely.

Source of Income Rules

The “source” of income (foreign or U.S.) is important in determining an NRA’s U.S. tax liability because foreign-source income is generally not subject to U.S. taxation, while U.S.-source income often is taxable.

Different sourcing rules apply to each type of income. For example:

  • The source of compensation for services is generally the place where the services are performed.
  • The source of certain types of passive income, like interest and dividends, depends on the residence of the payer.
  • The source of gains from selling inventory property depends on where the sale occurs, based on where title to the property transfers to the buyer.
  • The source of income from selling non-inventory property depends on the residence of the seller.

Special sourcing rules apply in the case of inventory produced in one country and sold in another. These rules are covered later in the context of e-commerce and online selling activities.

Tax-Free Situations for NRA-Owned US LLCs

In many cases, an LLC in the U.S. that is wholly owned by an NRA will not have any U.S. income tax liability at all. This would be the case whenever the LLC is not engaged in an effectively connected U.S. trade or business and does not have effectively connected income. Here are some common scenarios:

Foreign-Based Service Providers

Many NRAs form U.S. LLCs to provide services to U.S.-based clients. These services can include:

  • IT consulting and software development
  • Graphic design and web development
  • Business consulting
  • Financial and investment advice
  • Legal research and contract drafting
  • Bookkeeping and accounting services
  • Language translation and tutoring

As long as all the services are performed by the NRA owner while physically located outside the United States, the income from those services is foreign-sourced and not effectively connected to a U.S. trade or business, therefore not taxable in the U.S.

It’s critical that the NRA owner not travel to the U.S., even briefly, to meet with clients or perform any services. Doing so would likely be considered engaging in a U.S. trade or business and trigger a U.S. tax liability on the services income related to those U.S. activities.

Fulfilment by Amazon (FBA) Sellers – Sometimes

Many NRAs selling products on Amazon use the Fulfilment by Amazon service, where sellers ship their inventory to Amazon warehouses and Amazon handles storage, order processing, shipping, and customer service. Whether an Amazon FBA seller has a U.S. tax liability depends on several factors:

Scenario 1: NRA purchases inventory outside the U.S., has it shipped to an Amazon warehouse in the U.S., and sells it to U.S. customers entirely through Amazon. The NRA has no other U.S. activities.

Result: The NRA likely is engaged in a U.S. trade or business because they have inventory in the U.S. The income from selling that inventory to U.S. customers is U.S.-sourced and effectively connected, therefore taxable in the U.S.

Scenario 2: NRA purchases inventory in the U.S., has it shipped to an Amazon warehouse in the U.S., and sells it to U.S. customers entirely through Amazon. The NRA has no other U.S. activities.

Result: Same as Scenario 1 – the NRA likely has an effectively connected trade or business and effectively connected income, therefore is subject to U.S. taxation on the net income from selling the U.S. inventory.

Scenario 3: NRA produces their own inventory entirely outside the U.S., ships it to an Amazon warehouse in the U.S., and sells it to U.S. customers through Amazon. The NRA has no other U.S. activities.

Result: Although the NRA has inventory in the U.S., the income from selling that inventory is sourced based on where it was produced, which is outside the U.S. That income would be foreign-source income, not effectively connected, and not taxable in the U.S.

Key Point: The location of the inventory doesn’t matter from a tax perspective. What matters is where the inventory was purchased or produced. Inventory purchased or produced in the U.S. and sold to U.S. customers creates ECI, while foreign-produced inventory does not.

E-Commerce Without U.S. Inventory

It’s possible for an NRA to sell products online to U.S. customers without creating a U.S. tax liability in certain circumstances. The key is that the NRA never takes physical possession of the inventory in the U.S.

One way to achieve this is using the dropshipping business model. With dropshipping, the seller accepts orders from customers but has a third party, either the manufacturer or a fulfillment warehouse, ship the products directly to the customer. The seller never handles the products directly.

For an NRA with no other U.S. activities, selling via dropshipping may be considered non-effectively connected and the seller’s income would be foreign-source and not taxable in the U.S. However, this is only if the products are shipped directly from the manufacturer or a third-party fulfillment center and the NRA seller never takes possession of the inventory. If the seller uses Amazon FBA or a similar service where the seller’s inventory is warehoused and shipped from the U.S., the income likely is effectively connected and taxable.

NRAs selling online need to be very careful about their fulfillment process to avoid creating an effectively connected trade or business in the U.S. and becoming subject to U.S. taxation.

Tax Trigger Situations for NRA-Owned LLCs

Now let’s look at some common ways an NRA-owned U.S. LLC can become subject to U.S. income taxation.

U.S. Offices and Fixed Places of Business

If an NRA maintains an office or other fixed place of business in the U.S., they likely are engaged in a U.S. trade or business and have effectively connected income. Some factors that create a U.S. fixed place of business include:

  • Maintaining a physical office in the U.S.
  • Warehousing inventory in the U.S.
  • Providing services to clients at a U.S. location
  • Having employees or dependent agents in the U.S.

It’s important to distinguish between having a physical office versus a mere “mailing address” in the U.S. Many NRAs use a registered agent service to obtain a U.S. mailing address for their LLC. This by itself does not create a fixed place of business as long as no business is actually conducted at that address.

But if the NRA rents physical office space where employees carry out business functions, or if the NRA stores inventory at a U.S. warehouse, an effectively connected trade or business likely exists.

Services Performed in the U.S.

As mentioned earlier, performing services while physically present in the U.S. usually makes that services income effectively connected and taxable. This is true even if the NRA is only in the U.S. for a short period.

Many NRAs want to travel to the U.S. to attend trade shows or conferences related to their business. This activity by itself is generally not an effectively connected trade or business as long as the NRA is not actually soliciting business or performing services for clients during their trip. Attending the conference is considered a “preliminary” activity that by itself does not create a U.S. tax liability.

But if an NRA attends a U.S. trade show and solicits orders for their business, or meets with U.S. clients to provide consulting or other services, the income related to those activities likely is effectively connected and subject to U.S. tax.

NRAs who form a U.S. LLC to provide services need to be very careful about travelling to the U.S. for business purposes. A short trip involving direct client service could create a big tax liability.

Selling U.S. Real Estate

Many NRAs invest in U.S. real estate through an LLC for liability protection and privacy. But selling U.S. real estate will nearly always generate effectively connected income and a U.S. tax filing obligation.

Under the Foreign Investment in Real Property Tax Act (FIRPTA), gain from the sale of a U.S. real property interest is automatically treated as effectively connected income. And rental income from U.S. real estate is subject to a special 30% withholding tax under the FIRPTA regime unless the NRA or their LLC makes a “net election” to treat the rental income as effectively connected income and taxed on a net basis.

NRAs using an LLC to hold U.S. real estate investments need to plan for the U.S. tax consequences and filing requirements that come with that structure.

Contracting with the U.S. Government

Can an NRA-owned U.S. LLC enter into contracts to provide goods or services to the U.S. federal government? In many cases, yes, subject to certain restrictions and tax implications.

There is no blanket prohibition on contracting with the federal government based on foreign ownership of a business. However, certain federal contracts may require U.S. citizenship of the business owners for security clearance or other reasons. It depends on the specific agency and type of contract involved.

Many federal contracts also include a requirement that the majority of the contract work be performed in the United States. An NRA-owned LLC may be able to meet this requirement by subcontracting with a U.S.-based company for a portion of the work.

From a tax perspective, an NRA-owned LLC performing contracts for the U.S. government likely would be considered engaged in an effectively connected U.S. trade or business. The payments received under the government contract would be U.S.-source income, effectively connected to that U.S. trade or business, and therefore subject to U.S. taxation.

The NRA owner would be required to file U.S. tax returns on behalf of the LLC and individually to report the effectively connected income and pay any tax due. The NRA may also be required to make estimated tax payments throughout the year, depending on the amount of effectively connected income generated by the LLC.

Filing Requirements for NRA-Owned LLCs

Now that we’ve covered the various tax situations that can apply to NRA-owned LLCs, let’s review the specific U.S. tax forms and filings that may be required for these entities and their owners.

Form 5472 – Information Return

Regardless of whether an NRA-owned U.S. LLC has any U.S. tax liability or not, it must file IRS Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business.

Form 5472 discloses transactions between the LLC and its foreign owner, such as:

  • Capital contributions by the owner into the LLC
  • Loans between the owner and the LLC
  • Payments from the LLC to the owner, including distributions
  • Provision of services or lease of property between owner and LLC

A separate Form 5472 must be filed for each foreign owner of the LLC. The penalty for failure to file Form 5472 is $25,000 per form, so compliance is critical.

Along with each Form 5472, the LLC also files a “pro forma” Form 1120, U.S. Corporation Income Tax Return. This is a partially completed Form 1120 that includes only basic identifying information for the LLC – most of the form is left blank if the LLC is a disregarded entity with no separate tax liability.

Form 5472 and the pro forma 1120 are due by the 15th day of the 4th month after the LLC’s tax year end – April 15 for calendar year LLCs. If the LLC’s foreign owner has a different tax year, the due date is the 15th day of the 4th month after the owner’s year end.

LLCs that are required to file Form 5472 must obtain an Employer Identification Number (EIN) by filing Form SS-4 with the IRS. The EIN is entered on Form 5472 and the pro forma 1120.

Form 1040-NR – Nonresident Alien Income Tax Return

An LLC that has effectively connected income passes that income through to its NRA owner for U.S. tax reporting purposes. The NRA owner must file Form 1040-NR, U.S. Nonresident Alien Income Tax Return, to report the effectively connected income and pay any tax due.

Form 1040-NR is similar to the Form 1040 used by U.S. citizens and residents, but certain lines and sections apply specifically to NRAs. The LLC’s income and expenses are reported on Schedule C (Form 1040-NR), Profit or Loss from Business, and attached to the Form 1040-NR.

The NRA owner may also need to file the following additional forms as part of their Form 1040-NR, depending on their situation:

  • Form 8833, Treaty-Based Return Position Disclosure: Used to claim a tax treaty exemption or reduced tax rate on certain effectively connected income
  • Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return: Used to request a 6-month extension to file Form 1040-NR
  • Form 8938, Statement of Specified Foreign Financial Assets: Required if the value of the NRA’s foreign financial assets exceeds certain thresholds
  • Form 1116, Foreign Tax Credit: Used to claim a credit for foreign taxes paid on effectively connected income that is also taxed by the NRA’s home country

Like the Form 5472, Form 1040-NR is due by April 15 for NRAs who use a calendar year. If the NRA uses a fiscal year, the due date is the 15th day of the 6th month after their year-end.

Before an NRA can file a Form 1040-NR, they must first obtain an Individual Taxpayer Identification Number (ITIN). This is done by filing Form W-7, Application for IRS Individual Taxpayer Identification Number, with the IRS. The ITIN is used on Form 1040-NR in place of a Social Security Number.

Estimated Tax Payments

NRAs who expect their LLC to generate effectively connected income may need to make quarterly estimated tax payments to avoid underpayment penalties. Estimated tax payments are due April 15, June 15, September 15, and January 15 (of the following year).

Estimated payments should equal the lesser of:

  1. 90% of the current year’s tax liability, or
  2. 100% of the prior year’s tax liability (110% if the NRA’s adjusted gross income exceeded $150,000 in the prior year)

Estimated payments are made using Form 1040-ES (NR), U.S. Estimated Tax for Nonresident Alien Individuals. This form includes vouchers to send with each payment.

NRAs can also have their LLC make estimated payments on their behalf using Form 1120-W, Estimated Tax for Corporations. These payments are then claimed on the NRA’s Form 1040-NR as a credit.

As with all tax filings, it’s important to keep detailed records of all estimated payments made to ensure they are properly accounted for and to prevent any double payments.

State Tax Considerations

In addition to federal income tax, NRA-owned LLCs may also be subject to state income tax in the states where they operate. Most states treat LLCs as pass-through entities and impose income tax on the LLC’s members rather than the LLC itself.

However, some states impose entity-level taxes on LLCs, such as annual franchise taxes or fees based on the LLC’s gross receipts or net income. A few states, like Texas and Tennessee, don’t have a general income tax but do tax LLCs with gross receipts above a certain threshold.

NRA-owned LLCs that are treated as disregarded entities are generally subject to the same state filing requirements as their owners. This means if the LLC has effectively connected income in a state, the NRA owner typically must file a non-resident state income tax return in that state.

Some states have specific registration and filing requirements for disregarded LLCs, such as:

  • California requires all LLCs to pay an annual minimum franchise tax of $800, even disregarded LLCs with no income.
  • Florida requires disregarded LLCs to file an annual report with the Department of State.
  • New York requires foreign-owned single-member LLCs to be treated as corporations and file state corporate tax returns.

The state tax rules for NRA-owned LLCs vary widely and can be quite complex. It’s crucial to research the specific requirements in each state where the LLC operates to ensure full compliance with all state tax laws.

Conclusion

As this guide illustrates, the U.S. tax implications for LLCs owned by nonresident aliens can be complicated. In some cases, the LLC may be tax-free, while in others, it may pass effectively connected income through to its owner and generate a U.S. tax liability.

The key factors in determining an LLC’s tax situation are:

  1. The nature and extent of the LLC’s activities in the U.S.
  2. The source of the LLC’s income under U.S. tax laws
  3. Whether the LLC is engaged in a U.S. trade or business
  4. Whether the LLC has income effectively connected to a U.S. trade or business

In general, NRA-owned LLCs that only have foreign-source income are not subject to U.S. taxation. This includes LLCs that solely provide services from outside the U.S. or sell products online without storing inventory in the U.S.

On the other hand, NRA-owned LLCs engaged in a U.S. business, like selling U.S. real estate, performing services in the U.S., fulfilling contracts with the U.S. government, or selling products stored in a U.S. warehouse, likely have effectively connected income that is taxable in the U.S. This income passes through and is reportable on the NRA owner’s U.S. tax return.

All NRA-owned LLCs, whether they have a U.S. tax liability or not, must file Form 5472 with the IRS to report transactions with their foreign owner. NRA owners with ECI must also file a U.S. tax return and may need to make estimated tax payments during the year.

Given the potential tax consequences involved, NRAs who own or plan to form a U.S. LLC should consult with a qualified tax professional to evaluate their specific situation and ensure they are in compliance with all applicable U.S. tax laws. Proper planning and advice are essential to minimize U.S. tax exposure and prevent costly penalties.

FAQ

How can an NRA-owned LLC avoid paying taxes in the U.S. altogether?

The key to avoiding U.S. taxation for an NRA-owned LLC is to structure the LLC’s activities so that it is not engaged in a U.S. trade or business and does not have any effectively connected income. Some strategies to achieve this include:

  1. Providing services to U.S. clients from outside the U.S. and never traveling to the U.S. to perform services
  2. Selling products online to U.S. customers without storing inventory in the U.S., such as by using a foreign fulfillment center or dropshipping directly from the manufacturer
  3. Limiting U.S. activities to those that are merely “preliminary” or “auxiliary” to the main business, such as market research, purchasing supplies, or attending trade shows without directly soliciting sales
  4. If the LLC licenses intangible property (e.g., software, trademarks) for use in the U.S., making sure the licensing agreement is structured so the royalty income is not effectively connected to a U.S. business

As long as the LLC’s income is from foreign sources and not effectively connected to a U.S. trade or business, it should be tax-free in the U.S.

Can an NRA-owned LLC that only has tax-free foreign income still be required to file a U.S. tax return?

Yes, even if an NRA-owned LLC has no effectively connected income and no U.S. tax liability, it still must file Form 5472 with the IRS to report transactions between the LLC and its foreign owner. This is an informational filing requirement, not an income tax return.

The LLC files Form 5472 as an attachment to a pro forma Form 1120, even though no information is entered on the Form 1120 other than the LLC’s name and address. Failing to file Form 5472 can result in a $25,000 penalty, so it’s important to comply with this requirement.

How does an NRA determine if their U.S. LLC’s income is effectively connected?

The determination of whether an LLC’s income is effectively connected to a U.S. trade or business depends on the facts and circumstances of each case. Some factors that tend to indicate income is effectively connected include:

  • The LLC maintains a fixed place of business in the U.S.
  • The LLC has employees or dependent agents conducting business activities in the U.S.
  • The LLC provides services to clients while physically present in the U.S.
  • The LLC sells products that are sourced within the U.S., such as goods purchased or produced in the U.S. and resold to U.S. customers

In some cases, an LLC’s income may be partly effectively connected and partly not. For example, an LLC that manufactures products in China and sells them online to both U.S. and foreign customers would have effectively connected income from the U.S. sales if it stored the inventory in the U.S., but its income from foreign sales would be foreign-source and not effectively connected.

NRAs with complex fact patterns should consult with a U.S. international tax professional to determine the proper treatment of their LLC’s income.

If an NRA-owned LLC has an operating loss, can the NRA owner claim that loss on their individual U.S. tax return?

It depends. If the LLC is engaged in a U.S. trade or business and has effectively connected income, then any net operating loss from that business activity can pass through and potentially be claimed on the NRA owner’s Form 1040-NR.

However, the NRA owner must file a timely U.S. income tax return to claim the loss. They cannot use the loss to offset income in their home country.

Also, if the LLC’s loss creates a net operating loss carryforward, the NRA owner can only use that loss in a future year if they continue to engage in the same U.S. business that generated the loss. Effectively connected losses cannot be used to offset non-effectively connected income in future years.

If the NRA-owned LLC only has foreign-source income and is not engaged in a U.S. business, then any LLC losses are not deductible in the U.S. Those losses may be deductible in the owner’s home country depending on its tax laws.

Can a foreign corporation own a U.S. LLC and still be tax-free?

The same basic tax rules that apply to LLCs owned by NRA individuals also apply to LLCs owned by foreign corporations. The key factor is still whether the LLC is engaged in a U.S. trade or business and has effectively connected income.

If a foreign corporation owns a U.S. LLC that is not engaged in a U.S. business and does not have ECI, then the LLC’s income generally is not taxable in the U.S. However, the LLC still must file Form 5472 to report transactions with its foreign owner.

If the LLC is engaged in a U.S. business and has ECI, then that income is taxed at the corporate level at a flat 21% rate (as of 2023). The LLC itself must file a Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, and pay the corporate tax.

When the foreign parent company takes a dividend distribution from the U.S. LLC, that dividend is subject to a 30% withholding tax, unless reduced by a tax treaty. The foreign parent can claim a foreign tax credit in its home country for the U.S. taxes paid by the LLC and on the dividend.

As this shows, the U.S. tax implications for LLCs with foreign corporate owners can be more complex than those with NRA individual owners. Proper planning and structuring is crucial to minimize worldwide taxation in these cases.

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