LLC Series: LLCs – US and Australian Classification and Tax Considerations
An LLC, also known as a Limited Liability Company, is a form of a private limited company specific to the US, which combines the pass-through taxation characteristics of a sole proprietorship or partnership with the restricted personal liability afforded by a corporation. It also offers greater flexibility under State laws than corporations, allowing for its operating agreement to specify its own rules and regulations.
US – Classification and Tax Considerations
In the US, an LLC may be classified as:
- a disregarded entity/sole proprietorship;
- a partnership; or
- a corporation.
Disregarded entity/sole proprietorship
An LLC owned by one US person is classified under IRS as a disregarded entity and is treated as a sole proprietorship for federal income tax purposes. The LLC is treated as an entity disregarded as separate from its owner, unless it files Form 8832, Entity Classification Election (allowing for an LLC’s member to change the classification) and elects to be treated as a corporation. This means that, as a pass-through entity the LLC itself does not pay income taxes and does not have to file a return with the IRS – its income, deductions, gains, losses, and credits are allocated to, and reported in, the member’s income tax return. However, for the purposes of employment taxes and certain excise taxes, a single member LLC is still considered a separate entity. Since a member of an LLC is an “owner” and not an “employee”, they must pay self-employment tax, similar to a sole proprietorship.
A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832, electing to be treated as a corporation. Each partner pays taxes separately based on their operating agreement. Most agreements prefer to have the taxes in proportion to the membership interest. This means that each LLC member must pay taxes on their share of the profits of the LLC whether or not they receive their share of profits from the LLC. Unlike a corporation, even if the members need to leave profits in their LLC, they are liable for income tax on their proportionate share of the LLC’s income. However, the LLC classified as a partnership needs to file Form 1065, U.S. Return of Partnership Income with the IRS, provide their members with “Schedule K-1” (a breakdown of each member’s profits & losses), and are subject to the same filing and reporting requirements as partnerships.
Alternatively, an LLC can elect to be classified as an association taxable as a C-corporation (Form 8832) or as an S-corporation (Form 2553). LLCs tend to be classified as corporations if they make a substantial profit each month and need to retain a significant portion of their profits. Corporations generally file either a Form 1120 or a Form 1120-S with the IRS. If the LLC is classified as a corporation, it must file a corporation income tax return. If it is a C-corporation, it is taxed on its taxable income and a double layer of taxation occurs as dividends paid from the C-Corporation to its stockholders are also subject to taxation at the stockholder level. If it is an S-Corporation, the corporation generally not does not pay any income tax and the income, deductions, gains, losses, and credits of the corporation are attributed to the members. S-Corporations cannot be owned by nonresident aliens of the US (i.e. someone who is not a US citizen or green card holder who lives outside of the US).
US State Taxes
Due to the nature of an LLC’s operating agreement, each State may use different tax regulations for an LLC, and income derived by the LLC and attributed to the members may be taxed at the State level if derived or sourced from that State.
Australia – Classification and Tax Considerations
In Australia, an LLC is considered a “foreign hybrid company” and is treated as a partnership and subject to the ordinary rules for partnership if it satisfies the requirements of section 830-15 ITAA 1997. The requirements are as follows:
- it is formed in the US and treated as a partnership for US tax purposes;
- it is (itself) not treated as a resident for the purposes of the tax laws of any foreign country;
- it is not an Australian resident at any time during an income year. This means that the LLC must not carry on business or have either its central management and control in Australia or its voting power controlled by members who are residents of Australia for the year; and
- the LLC is a ‘Controlled Foreign Company’ (CFC) in which an Australian resident member is an “attributable taxpayer” (i.e. an Australian resident individual holding 20% of the membership interests in the LLC).
An entity may be an attributable taxpayer in relation to a CFC, if it is an “Australian entity” whose “associate inclusive control interest” (the total direct and indirect control interests held by the taxpayer and their associates/partners) in the CFC is at least 10%.
A company is classified as a CFC, if:
- five or fewer Australian residents (each of which has at least a 1% control interest) that have or are entitled to acquire at least a 50% associate inclusive control interest in the company;
- a single Australian entity (and its associates) has at least a 40% control interest in the foreign company; or
- a group of five or fewer Australian entities (either alone or together with associates) has actual control of the company, irrespective of the interests in a foreign company.
Read more about CFCs in our previous blog: “The “Controlled Foreign Corporation” Regime: What is a CFC Anyway?”
If a US LLC satisfies these conditions, it is treated as a partnership for Australian tax purposes and is subject to the ordinary rules for partnerships, such that:
- an Australian resident LLC member / partner is taxed on their proportionate share of the profits of the partnership and are entitled to a deduction for their share of the losses incurred by the partnership; and
- a sale of the LLC/partnership interest would trigger Australian capital gains tax (CGT) for that member / partner on the difference between the market value of member’s interests in the LLC and their cost base. However, if the gain is subject to tax in the US, in Australia, it would be treated as being subject to foreign tax at that time, with an application of 50% of the foreign income tax offset (FITO) if the gain as been discounted in Australia (in accordance with the decision in Burton (see our vlog: Time to review your structure: Foreign tax credits cut in half! and our blog: Double Tax on U.S sourced Capital Gains))
If the gain is not taxed in the US (due to the application of the US non recognition rules) it would still be subject to tax in Australia without the application of FITO.
These tax issues are explored further in upcoming editions in this series.
If you are interested in establishing an LLC or hold an LLC interest as a non-US resident, please contact:
Head, US-Australia Tax Desk
Intern, US-Australia Tax Desk