If you’ve conducted any comprehensive research into expanding to the USA, you will likely have heard about a form of business entity called a Limited Liability Company (LLC). Certainly, if you’ve consulted with American lawyers based in the USA, such an entity would have been discussed. Although it provides for limited liability, an LLC should not be confused with a corporation in the US nor likened to a limited company in the UK. Though providing limited liability just like a US corporation or UK limited company, an LLC is a different animal completely and has no counterpart in the UK.
Pioneered by Wyoming in 1977, the LLC is a hybrid entity that offers the pass-through tax treatment of a sole proprietorship or partnership, coupled with the liability protections of a corporation. Prior to its introduction, small businesses in the US had the same restricted choices they have in the UK today: Either favourable tax treatment of a sole proprietorship or partnership, or limited liability of a corporation, but not both. It’s no mystery then, that the LLC, which combined both and had been adopted by all 50 states by 1996, encouraged huge growth in small business, and by the turn of the century created about 2 million new American businesses.
While an LLC is often the entity of choice if the owner is based in the US, foreign investors must be wary of them. This has less to do with US law, and is more the product of tax law outside the US. Consider for instance the British owner of an LLC who seeks to bring his profits back from the US to the UK. Those profits will have “passed through” the LLC untaxed, but he will already have paid his US personal income tax on them before bringing his net profits back to the UK
Because the UK neither has nor recognises such hybrid entity as an LLC, HMRC must determine whether the incoming profits are those of a partnership or a corporation. If a partnership, then the income has already been fully taxed by the US and the US/UK tax treaty would protect them from further taxation.
If, on the other hand, the income is deemed to be from a corporation, then that income has only been taxed once, on a theoretically corporate level, leaving HMRC free to consider the funds entering the UK a distribution to UK shareholders. As such HMRC can tax the funds again on a personal level, without violating the treaty. Needless to say, HMRC favours the opportunity to levy a second tax, which in this situation can be a very significant amount.
None of this is to say that LLCs are to be avoided in all circumstances. They do indeed have their place for both domestic and foreign investors. Be mindful, however, that such a decision must be made with the benefit of both expert legal and tax advice. When the decision to use an LLC is made, choosing and maintaining the appropriate LLC structure becomes vital. Whether you choose to become an LLC or to do business with an LLC, a clear understanding of the actual structure of the company is necessary to avoid several very serious pitfalls. In this regard, let’s consider the independent contractor I wrote about in a prior article, which you can find here: .
In that article, a hypothetical US-based independent contractor formed himself as an LLC for the dual purposes of liability protection and helping foreign companies who hire him avoid creating a “nexus” in the state. You’ll recall that when a foreign company creates a nexus in a particular US state, that company then has to both register and file annual corporate tax returns in that state. Whether the contractor succeeds in either of these objectives depends entirely on the form and structure of the LLC he creates. With that in mind, let’s take a moment to understand the relevant characteristics of LLCs:
LLCs are very flexible entities. They can have a variety of characteristics in various categories. For our purposes, the two most important attributes are: 1. The number of owners (called “Members”) that an LLC has; and 2. The manner in which the member(s) choose to be taxed.
An LLC with one member is called a Single Member LLC (SMLLC) and is qualitatively different from an LLC with multiple members (MMLLC) as respects both legal liability and tax issues.
With regard to liability issues, while all LLCs provide limited liability, the protection provided by SMLLCs is the flimsiest and least robust of all. There are two simple reasons for this: First, most owners of SMLLCs are terrible at keeping and maintaining organised company and financial records; and in the absence of such records, a SMLLC looks an awful lot like a sole proprietorship, which enjoy no liability protection.
Second, unless an affirmative election otherwise is made by the owner, a SMLLC is taxed just the same as a sole proprietorship. The SMLLC is “disregarded” for tax purposes and profits flow directly to the owner. In sum, in many states a poorly managed LLC which has chosen to be taxed the same as a sole proprietorship, is for all practical purposes nearly indistinguishable from a sole proprietorship and therefore becomes an easy target for claimants that wish to “pierce the corporate veil”, thereby voiding the company’s limited liability and gaining access to the personal assets of a SMLLC owner.
A MMLLC, on the other hand, tends not to look at all like a sole proprietorship. Firstly, since it has more than one owner, it can’t be taxed as a sole proprietorship, but rather as either a partnership or a corporation. Second, because there are multiple owners, it is not possible to determine which LLC asset belongs to which owner. Instead, each owner has an undivided percentage interest floating throughout all the assets. Finally, by their nature, MMLLCs tend to have better management and record keeping simply because co-owners tend be more alert to details of one another’s rights and obligations. For these reasons, it’s far more difficult for a claimant to pierce the corporate veil of a MMLLC than it is to do so with a SMLLC.
Armed with this basic understanding, let’s return to our US independent contractor. If he forms himself as a SMLLC, is taxed as a sole proprietorship (i.e., the LLC is “disregarded” for tax purposes) and does nothing more, he risks not only exposing himself to personal liability, but also frustrating the expectations of any foreign company doing business with him. That is, a foreign company, engaging with the LLC considers itself as having engaged with another company, not an independent contractor, to help establish or maintain its market in the state. The foreign company thinks that it is thereby avoiding the creation of a state nexus, only to find that the SMLLC is for tax purposes a sole proprietor, an individual acting as an independent contractor for the foreign company, and thereby creating precisely the situation the foreign company had sought to avoid: A nexus that requires the company to both register to do business and pay corporate income tax in the state.
There are several ways for the contractor and the foreign company to rectify this, and as you might guess, they all have to do with changing either or both the number of members of the LLC or its tax status. A MMLLC taxed as a corporation is far less susceptible to problems than is a SMLLC. Yet between these extremes are a number of factors that must be considered from both liability and tax perspectives. In all cases, however there are a few basic formalities which must be followed to help the LLC fulfil its purpose in a reliable and effective manner.
One of the key methods of maintaining the limited liability of an LLC is to clearly distinguish the entity from the people who own it. This is done through maintaining and documenting company formalities: At a minimum, every LLC, whether single or multiple member, should have a signed operating agreement that both governs operation and administration of the business, as well as sets out management structure. In addition, there should be written minutes and resolutions of management and/or directors authorising or ratifying significant actions of the business on at least an annual basis. Financial accounts should be maintained and reviewed annually by an accountant with financial statements prepared where necessary and confirmed in minutes of the LLC.
LLCs are a wonderful form of business entity, but can in certain circumstances give a false sense of legal and tax security. If you are planning on forming an LLC, or placing reliance upon the structural adequacy of an LLC with which you are doing business, then you’ll want to avoid any nasty surprises further down the road. In any such case, an initial legal or tax consultation is a worthwhile investment.