Setting Up a US LLC as a Non-US Resident: A 2023 Guide (Part 2)

Now, let's delve into the compelling tax advantages that a US LLC offers to non-US residents. As mentioned earlier, US LLCs do not incur corporate income tax. Instead, the LLC's profits and losses are passed through to its owners, who report their respective portions of the company's profits on their personal tax returns. This characteristic, known as pass-through taxation, holds tremendous appeal for foreigners residing outside the US.

Tax Advantages of a US LLC for Non-US Residents

From the perspective of the Internal Revenue Service (IRS), your US LLC is viewed as a transparent entity, often referred to as a "Disregarded Entity." The IRS does not tax the LLC directly but rather looks through the company to determine the tax liability of its members.

For non-US residents, here's where the advantage lies:

- Non-Resident Alien Status: If you do not possess US citizenship, do not hold a US Green Card, and do not meet the US Substantial Presence Test, you are considered a Non-Resident Alien.

- Taxation for Non-Resident Aliens: As a Non-Resident Alien, your US tax liability is limited to US-source income that is effectively connected to a US trade or business. While there is also taxation on FDAP income, which applies to passive income, we will focus on the assumption that you are establishing a US company for active business purposes.

US Trade or Business

To gain a comprehensive understanding, let's delve deeper into two crucial technical terms: "engaging in a US Trade or Business" and "US-Source Income."

US Trade or Business (ETBUS)

The consensus within taxation circles is that your US LLC becomes engaged in a US Trade or Business (ETBUS) if it satisfies the following conditions:

1. Dependent Agent Presence: Your US LLC must have at least one "dependent agent" in the United States. Dependent agents are individuals who work for you as employees or exclusive contractors. Importantly, these agents should contribute significantly to advancing your company's business activities in the United States. This contribution goes beyond administrative tasks and extends to functions like negotiating and concluding contracts.

2. Substantial, Continuous, and Regular Activity: Your business operations in the United States should be "considerable, continuous, and regular." Unfortunately, the precise definition of what constitutes "substantial, continuous, and regular" business activities is not explicitly defined in US law. However, it's crucial to note that this definition is not applied in an overly literal sense. An insight into the US trade and business community's stance on e-commerce, as documented by the Treasury Department's Office of Tax Policy, offers some clarity:

"Electronic commerce permits a foreign person to engage in extensive transactions with U.S. customers without entering the United States. Although such a person is clearly engaged in a trade or business, questions will arise as to whether he is engaged in a trade or business in the United States or has a permanent establishment in the United States."

Essentially, your US LLC needs to be deemed as a business involved in a Trade or Business in the US (ETBUS) to fall under US federal tax jurisdiction. If you are not ETBUS, you are not subject to US federal taxes.

US-Source Income vs. Foreign Source Income

Beyond the ETBUS concept, understanding the Source of Income is crucial. In taxation, the Source of Income refers to the location or country where a specific item of income is considered to have originated or been generated.

From the perspective of US taxation, a nonresident alien (NRA) typically incurs tax liability only on US-sourced income and not on Foreign-Sourced Income. The following general rules govern the determination of US source income, which applies to most nonresident aliens:

Let's illustrate this with an example: If your US LLC provides internet marketing services to a US-based client without employing any US-based employees or exclusive agents, the income generated from this service is regarded as income sourced outside the United States. Consequently, it is not subject to US taxation.

In most instances, the United States does not impose tax on income sourced outside its borders. However, there is a caveat to consider: if your Foreign Source Income is attributable through a physical office presence in the United States, that income becomes taxable if your US LLC is deemed ETBUS, in accordance with IRC §864(c)(4). Nevertheless, if you engage an agent who is not exclusive and does not engage in negotiations or sales activities within the United States, even if they conduct work through their US-based office, your Foreign Source Income remains unaffected and is not considered Effectively Connected Income to a US trade or business.

US-Source Income Doesn't Automatically Trigger Taxation

One crucial point that can perplex even seasoned accountants is the sequence of assessment. The determination of "Engaging in Trade or Business in the US" (ETBUS) precedes the consideration of income sourced from the US that is genuinely connected to that "US Trade or Business."

In simpler terms, the initial step is to ascertain whether your business qualifies as ETBUS. Only after confirming this status should you evaluate whether you possess US source income. If both criteria are met, then you become liable for US federal taxes. However, if you do not meet the ETBUS requirement, you are not subject to taxation even if you generate US source income.

Leveraging Tax Treaties

As previously discussed, once you establish ETBUS status, you must scrutinize your Source Income to distinguish between foreign and US sourced income. Another approach to circumvent the complexity of this determination, which takes into account both ETBUS and US source income, is to utilize the Permanent Establishment concept found within tax treaties.

If your country of residence has a double taxation avoidance agreement, often referred to as a tax treaty, with the United States, you can rely on the Permanent Establishment concept instead of solely adhering to the US Trade or Business concept. In international taxation, the concept of a "permanent establishment" signifies a company that maintains a fixed place of business (among other criteria stipulated in the tax treaty) in another country and is subject to income tax there.

In cases where a tax treaty exists between your country and the United States, the IRS permits the definition of Permanent Establishment to supersede the definition of US Trade or Business as outlined in the Internal Revenue Code. Consequently, even if you are involved in a US trade or business but do not possess a Permanent Establishment in the United States, you will not be subjected to federal taxes on your active business income. To ascertain whether your country maintains a tax treaty with the United States, please refer to this list provided by the IRS.

Steps to Establish a Tax-Free Foreign-Owned US LLC

We hope not to have lost your attention with our intricate explanation. If you are still seeking clarity, here are some succinct guidelines to transform your US LLC into a tax-free entity. Keep these factors in mind to avoid triggering US federal tax obligations:

- Avoid US-Based Employees or Exclusive Contractors: Do not hire individuals based in the United States or engage exclusive contractors within the US.

- Exclude US Persons as LLC Members: Ensure that your LLC does not have US persons as members.

- Residence Duration: Do not reside in the United States for more than 120 days per year.

LLC vs. Corporation: When an LLC May Not Be Suitable

As evident from the preceding discussion, the Non-US Resident US LLC emerges as a potent corporate structure for non-US entrepreneurs and founders. Armed with insights about ETBUS, Permanent Establishment, and Source Income, you can strategically organize your US LLC to mitigate your tax liabilities within the United States. However, it's essential to contemplate whether you truly require a Corporation instead of an LLC, as opting for a US Corporation entails automatic exposure to US federal taxes.

Despite its appeal, the LLC structure should not be indiscriminately applied to all circumstances. There are scenarios where a US LLC may NOT be the ideal choice for non-US business owners seeking to minimize their tax obligations:

1. Seeking Angel or VC Investments in the United States: If your strategy involves pursuing angel or venture capital investments within the United States, a different corporate structure may be more suitable to align with the expectations and preferences of investors.

2. Having a US Person as an LLC Member: If one of the members of your LLC is a US person, it can impact the taxation of the entire entity and potentially expose you to US federal taxes.

3. Intent to Issue Stock Options to Employees: If you plan to grant stock options to your employees, the structure of a Corporation might provide a more suitable framework for equity compensation.

4. Eagerness to Pay Taxes Even When Unnecessary: If, for some reason, you are inclined to pay taxes even when legally unnecessary, the LLC structure may not align with your preferences.

In these specific circumstances, it is advisable to explore alternative corporate structures or seek guidance from a tax professional with expertise in international taxation to make informed decisions tailored to your business goals and tax strategy.

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Disclaimer: While these guidelines are generally applicable and effective in most scenarios, they are not a one-size-fits-all solution. For highly complex situations, it is advisable to consult a US accountant or attorney well-versed in international taxation.