Limited Liability Companies and the Risk of Double Taxation

One of the most important decisions that an entrepreneur needs to grapple with when starting a business is choosing what type of entity the business should be. The reason this decision is so significant is because it affects the three-letter word that business owners (and many others) dread: tax. The choice of business entity also affects the extent of public involvement in the business (e.g., public companies have more disclosure obligations than private companies), and the liability of the business owners for the debt and obligations of the business. A business can take many forms, ranging from a corporation to a limited liability company (LLC). Since there is no uniform system of incorporation throughout the United States, the scope of this article is limited to Delaware law because it is the place of incorporation for the majority of the Fortune 500 companies in the United States. Because of that, Delaware has developed extensive jurisprudence in corporate law

An LLC is a form of business entity that combines the attributes of both corporations and partnerships. The similarity between an LLC and a corporation is the principle of separate legal personality. Under the Delaware Limited Liability Company Act (the LLC Act), an LLC has a separate legal entity from its owners, as is the case with a corporation. Both provide for asset partitioning, so that in the event that an LLC is indebted to a third party, such third party cannot proceed against the assets of the LLC’s members. The LLC Act expressly excludes members from the debts and obligations of the LLC. Thus, absent an express provision in the LLC agreement, a member cannot be liable for the debt and obligations of the LLC (whether contractual or tortious).

On the other hand, the similarity between an LLC and a partnership lies in the fact that both structures are treated as pass-through entities for tax purposes. A pass-through entity itself is not subject to tax but is considered transparent for tax purposes, so that its income is taxable only in the hands of its owners. A pass-through entity is not subject to the U.S. federal income tax, provided that the company complies in ownership, structure and operations with the requirements of the Internal Revenue Code.

Despite these advantages, an LLC becomes less attractive when one considers the potential risk of double taxation, which may arise when a member of an LLC is a tax resident in a country other than the United States. This is because outside of the US, the pass-through attribute of an LLC may be disregarded. For instance, in the UK an LLC is treated as a corporation whose income is subject to income tax, and profits distributed to its members are treated as taxable dividends. To illustrate this concept, if A (a member of B LLC) resides in the US and is also a UK resident for tax purposes, A will be liable subject to income tax in the US on the portion of B LLC’s profit distributed to her. At the same time, if A remits the balance of the income to the UK, A will be liable to pay UK income tax as well.

Anson v. HMRC, a UK Supreme Court case, is illustrative of this issue. Anson was a member of a Delaware LLC and a UK tax resident. Having paid US income tax on the portion of the LLC profit received, he remitted the balance to the UK. While the UK tax authority asserted its right to tax the income remitted to the UK, Anson argued that it would amount to double taxation. Although the UK has maintained the view that a Delaware LLC should be treated as a corporation and profits distributed to its members ought to be taxed as dividends, the court ruled in favor of Anson. The court reasoned that he was entitled to the double taxation relief under the UK-US treaty because he had paid US income tax on the income sought to be taxed in the UK.

It is pertinent to state that the case was decided on a factual basis (with focus on the LLC agreement). The court found that under the LLC agreement, the income and profit of the LLC was automatically credited to its members as they arose, prior to and independent of any distribution. In other words, under the LLC agreement, the income of the LLC is considered the income of its members, irrespective of whether a distribution is made. As such, a member is entitled to double taxation relief, having previously paid tax on "his" income. However, absent such express provision in the agreement, it is unlikely that a court will take the view that the income of an LLC automatically allocates to its members regardless of distribution.

The LLC structure provides business owners an opportunity to legally combine the attributes of a partnership and a corporation. The structure presents an avenue for a business to enjoy the corporate status while avoiding US corporate tax. Business owners should ensure that their LLC agreement contains provisions that automatically credit LLC income and profit to members without the need for a distribution, as in Anson. This will enable members to seek double tax relief where applicable.