There are good reasons to form a LLC in the USA. It combines preferable characteristics such as a far-reaching legal flexibility of the corporate structure with a limited liability of its shareholders. Beside this the shareholders can choose whether the LLC shall be qualified as a corporation or as a partnership for US income tax purposes (check-the-box rules). Most LLC will be taxed as transparent entities and therefore be qualified as a partnership or a disregarded entity (if the LLC has a sole owner). Unfortunately German tax law does not follow the US-tax qualification. This can cause severe tax consequences if the qualification is different in the USA and in Germany.
Taxation in the USA
In most cases the LLC will be taxed in the USA as a pass-through entity. This means that the LLC itself is not subject to taxation. The shareholders are subject to the federal and state income tax with their profit-shares.
Qualification of the LLC in Germany for tax purposes
Germany’s tax law does not follow the US-qualification. In Germany a LLC can either be qualified as a corporation or as a partnership/sole proprietorship. If the LLC is qualified as a partnership the tax consequences are not problematic. The shareholders will be taxed in the USA. In Germany the LLC will not be taxed as long as the LLC has not permanent establishment in Germany. The profit share of shareholders being tax resident in Germany will be tax-free because of the relevant provisions of the Double Taxation Convention USA/Germany.
A tax situation differs if German tax authorities qualify the LLC as a corporation. If the LLC has no permanent establishment in Germany the profits of the LLC will not be taxed in Germany since the LLC is not tax resident in Germany. The problem occurs if profits will be distributed to shareholders who are tax resident in Germany. This income will be taxed at a combined tax rate of 26,375%. German tax authorities disallow the crediting of US income taxes against the German tax. The result is a partial double taxation of the profits received by a shareholder who is resident in Germany.
In this case the tax situation is basically the same one as for shareholders of an S corporation who are tax resident in Germany. For more information see:
Note: If a shareholder who is tax resident in Germany continues to carry out services for the LLC this might be qualified by German tax authorities as a permanent establishment of the LLC in Germany. The same result occurs if the shareholder is seen as a permanent representative of the LLC. In this cases at least parts of the profits will be taxed in Germany.
Criteria for the qualification
The letter of the Federal Ministry of Finance dated 19 March 2004 lines out the general principles. The basic idea is to verify whether a foreign entity’s legal structure is nearer to the legal structure of a typical corporation or a partnership. There are eight points of criteria:
- Centralized Management
A centralized management is an indication for a corporation. A centralized management is especially given if persons who are not shareholders or a board of directors are entitled to manage the company.
If only shareholders or members of a business entity are entitled to manage the company this is an indication for a partnership. This is especially the case if all shareholders or members are entitled to manage the company.
2. Limited liability
Limited liability of shareholders indicates a corporation, unlimited liability a partnership.
3. Transfer of shares
The possibility to transfer shares of the company to third parties without any restrictions speaks for a corporation.
Restrictions to transfer shares indicate the existence of a partnership. This is especially the case if the transfer of shares is legally impossible or only possible by approval of other shareholders or members.
4. Profit participation
If profit distributions are subject to a formal decision by the shareholders this speaks for a corporation.
If no decision is required by law, articles or by-laws this indicates the existences of a partnership.
5. Capital contribution
If equity capital is required by law or shareholders decision this speaks for a corporation. The capital contribution can be in cash or assets.
If no capital contribution is required or can be provided through personal services of shareholders this indicates the existence of a partnership.
6. Unlimited lifetime
If the duration of the entity is not limited by law, articles or by-laws this speaks for a corporation.
A limited lifetime indicates the existence of a partnership. This is especially the case if the entity terminates if one shareholder passes away, terminating the company or goes bankrupt.
7. Profit distribution
If profits will be distributed in proportion to the capital share this indicates the existence of a corporation.
If profits will be distributed by heads of shareholders or members this speaks for a partnership.
8. Formal conditions of establishment
If the establishment of the entity requires the approval of a public body and the entity has to be registered (on an official registers) this speaks for a corporation.
If the only requirement to form a business entity is an agreement between founding members this indicates the existence of a partnership.
Qualification of LLCs
A typical LLC shows in general characteristics both of a corporation and a partnership. In this case the majority of characteristics 1 to 5 will define whether the LLC is qualified as a corporation or a partnership. If there is no clear result the other criteria (6 to 8) shall also be taken into consideration.
The qualification of an LLC depends both on the corporate law of the respective US state as well as on the legal agreements between the shareholders or members. In general the by-laws give a good indication how to qualify the LLC for German tax purposes. A careful analysis is required.
Author: Peter Scheller, German Tax Adviser, Master of International Taxation