When Is a U.S. LLC a Partnership for U.S. and U.K. Tax Purposes?

Editor: Anthony S. Bakale, CPA, M. Tax.

Foreign Income & Taxpayers

U.S. limited liability companies (LLCs) have become the preferred business entity in many situations because their members get the best of both worlds: legal liability protection while being taxed in the United States as a partnership. But what are the global tax implications of using an LLC if it has nonresident LLC members—for example, an individual resident in the United Kingdom?

U.S. Tax Implications

Assuming the LLC is profitable, it must pay withholding tax at the highest individual tax rate (35% for 2011) on the U.K. partner’s share of U.S.-sourced effectively connected income (Sec. 1446(b)). The U.K. individual then files Form 1040NR, U.S. Nonresident Alien Income Tax Return, reporting his or her share of the effectively connected income reported on Schedule K-1, and is taxed on his or her share of that income at the individual graduated tax rates.

U.K. Tax Implications

The June 1997 position of Her Majesty’s Revenue and Customs (HMRC) as published in Inland Revenue Tax Bulletin 29, “UK/US Double Taxation Convention—US Limited Liability Companies (LLCs),” was that a U.S. LLC is treated as an opaque entity—i.e., a corporation. (Tax Bulletin 29 was superseded by HMRC DT 19853A, but HMRC’s position remains unchanged.) The bulletin specifically provided as follows:

[F]or the purposes of United Kingdom tax we have taken the view in relation to those LLCs that we have so far considered that they should be regarded as taxable entities and not as fiscally transparent. Accordingly we tax a United Kingdom member of a LLC by reference to distributions of profits made by the LLC and not by reference to the income of the LLC as it arises. If tax is paid in the United States on the profits of the LLC, we regard that tax as underlying tax and credit relief is available for it if the member is a United Kingdom company which controls, directly or indirectly, at least 10 per cent of the voting power in the LLC.

In effect, a U.K. resident individual taxpayer will be taxed in the United Kingdom when the LLC distributes cash; it will be deemed a dividend for U.K. tax purposes and taxed accordingly. However, HMRC’s position is that the U.S. withholding taxes are deemed to be underlying taxes that will not be creditable on the U.K. individual taxpayer’s tax return. The U.K. taxpayer is therefore subject to double taxation on profits from a U.S. LLC, which is not tax efficient.

HMRC Tax Bulletin 83

In HMRC Tax Bulletin 83, HMRC discusses whether certain foreign entities are transparent or opaque, stating:

When considering the classification of a foreign entity (i.e. whether it is either opaque or transparent) for UK tax purposes, due regard is given to the approach of the Court of Appeal in the case of Memec plc v CIR (70 TC 77) and the line of case law that precedes it. In particular, the following matters should be considered:

1. Does the foreign entity have a legal existence separate from that of the persons who have an interest in it?
2. Does the entity issue share capital or something else, which serves the same function as share capital?
3. Is the business carried on by the entity itself or jointly by the persons who have an interest in it that is separate and distinct from the entity?
4. Are the persons who have an interest in the entity entitled to share in its profits as they arise; or does the amount of profits to which they are entitled depend on a decision of the entity or its members, after the period in which the profits have arisen, to make a distribution of its profits[?]
5. Who is responsible for debts incurred as a result of the carrying on of the business: the entity or the persons who have an interest in it?
6. Do the assets used for carrying on the business belong beneficially to the entity or to the persons who have an interest in it?

Some of those factors may point in one direction; others may point in another. An overall conclusion is reached from looking at all the factors together, though some have more significance than others. Particular attention is paid to factors c. and d. In considering them we look at the foreign commercial law under which the entity is formed and at the internal constitution of the entity. How the entity is classified for tax purposes in any other country is not relevant. The conclusion that is reached is then used in considering the relevant piece of UK tax law.

The tax bulletin includes a list of foreign entities for which HMRC has been asked its view on the question of transparency/opacity. HMRC’s position with respect to U.S. LLCs is that they are opaque entities. Once again, for the U.K. resident investor in a U.S. LLC, the tax implications of this position are not favorable.

One solution to this problem has been to have the U.S. entity set up as a U.S. limited partnership because the IRS and HMRC take the position that this form of entity is taxed as a partnership in both jurisdictions, and foreign tax credits are allowed in the United Kingdom for taxes paid in the United States. But a recent decision by the First Tier Tribunal (Tax) may change how a U.S. LLC is taxed by HMRC (Swift v HMRC, [2010] UKFTT 88 (TC) (2010)). HMRC has appealed the decision and for the time being intends to continue with its current general practices in relation to U.S. LLCs (see www.hmrc.gov.uk/international/faqs.htm).

Swift Case Analysis

The general facts of this case are that Swift, who is U.K. resident and ordinarily resident, had invested in a Delaware LLC, Sandpiper Partners LLC (SPLLC), whose place of business was located in Massachusetts. The LLC distributed all profits to the members on a quarterly basis and filed the appropriate U.S. withholding taxes and U.S. individual tax returns. The U.K. taxpayer reported the income from the U.S. LLC as partnership income on his U.K. personal tax return and claimed foreign tax credits for the U.S. taxes paid. HMRC disagreed with the taxpayer’s position and sought to disallow the tax relief for the U.S. tax paid.

The tribunal asked two American experts (one chosen by Swift and one by HMRC) on Delaware LLC law to answer six questions about Delaware LLCs. The experts agreed on the following:

1. The LLC is a legal entity coming into existence by the execution of a certificate of formation (filed with the Delaware secretary of state) and entering into an LLC agreement;
2. The LLC’s business is carried on by the LLC itself and not by its members;
3. The LLC (and not its members) is liable for the debts incurred as a result of carrying on business—the members have no liability for the liabilities of the LLC; and
4. The assets used for carrying on the business belong beneficially to the LLC and not to the members—the members have no interest in specific property of the LLC.

However, the experts did not agree in their answers to the tribunal’s questions about whether the LLC issued share capital and whether the LLC members had an interest in the LLC’s profits.

Share Capital Issue

The tribunal was trying to compare a membership interest in a Delaware LLC with a U.K. company or partnership. During the analysis, it noted that a Delaware partnership is not the same as a partnership in England and thus by default is not an appropriate comparison. The case discusses the nature of a membership interest in a Delaware LLC in an attempt to determine whether it is the equivalent of share capital. A Delaware LLC interest is defined as “a member’s share of the profits and losses of a limited liability company and a member’s right to receive distributions of the limited liability company’s assets” (DE Code Ann. §18-101(8)).

Ultimately, the tribunal found that based on the facts and evidence, a membership interest in the LLC

is not similar to share capital but something more similar to partnership capital of an English partnership, the transfer of which requires the consent of all the partners but the economic benefits can be transferred without consent and without the transferee becoming a partner (s. 31 of the Partnership Act 1890). Normally a share in a UK company is transferable and needs to be registered and if there are any restrictions on transfer these are that the consent of the directors (not all the other shareholders) is required.

Although it would appear that a Delaware LLC interest is not the equivalent of share capital, if a taxpayer has a non-Delaware LLC interest, it would have to go through a separate analysis to determine if its state-specific LLC interest is or is not the equivalent of share capital.

When Are Members Entitled to Profits?

The case goes through a detailed analysis to determine when the members are entitled to the profit, which is a crucial factor in determining whether the LLC is transparent or opaque. The two American experts also focused on the distribution provisions of the LLC’s operating agreement and whether the distributions were mandatory or discretionary. If distributions were mandatory, it was argued, this would indicate that the members were entitled to the profits as they arose, and thus the LLC was transparent; if not, the LLC would be opaque in nature. Although the tribunal stated that “whether distributions were mandatory . . . or discretionary, is not relevant to the question of whether the profits belong to the members as they arise,” it did spend some time analyzing the distribution section of the operating agreement. Based on this discussion, it would appear that if there is wording in the operating agreement that distributions are “mandatory” albeit subject to certain restrictions, that would be a favorable fact in making the argument that the LLC is transparent.

The tribunal’s analysis focused on the definition of an LLC interest in determining when a member is entitled to the profits:

We regard it as important that “limited liability company interest” is defined to include “a member’s share of the profits and losses of a limited liability company . . . ” (s. 18-101(8) of the Act), and that “[t]he profits and losses of a limited liability company shall be allocated among the members, and among classes or groups of members, in a manner provided in a limited liability company agreement” (s. 18-503 of the Act) with a default rule if the LLC agreement does not so provide.

Next, the tribunal focused on the allocation of SPLLC’s income and losses per the tax returns. It came to the conclusion that although the assets belonged to SPLLC until they were distributed to its members, this did not mean that the profits and losses did not belong to the SPLLC members until the cash/property was distributed. Thus, the tribunal concluded, “Accordingly, our finding of fact in light of the terms of the LLC Operating Agreement and the views of the experts is that the members of SPLLC have an interest in the profits of SPLLC as they arise.”

Tribunal Decision

The main issue of the case that the tribunal needed to decide to determine if double tax relief was available was whether Swift was liable for U.K. tax based on his share of profits from SPLLC as they arose to Swift or liable for tax on the equivalent of a dividend. The tribunal also stated that it preferred to apply the words of the United States–United Kingdom income tax treaty as opposed to looking at whether the LLC was transparent versus opaque. The tribunal referred to Memec plc v. Inland Rev. Comm’rs, [1998] BTC 251, [1998] STC 754 (Court of Appeal) (which dealt with the classification for U.K. purposes of a German typical silent partnership) and applied the approach used in that case to Swift’s situation.

The tribunal summed up its decision as follows:

SPLLC stands somewhere between a Scots partnership and a UK company, having the partnership characteristics of the members being entitled to profits as they arise and owning an interest comparable to that of a partnership interest, and the corporate characteristics of carrying on its own business without liability on the members and there being some separation between Managing Members and other members falling short of the distinction between members and directors. Since we have to put it on one side of that dividing line we consider that it is on the partnership side particularly in relation to its income.

The factor we are mainly concerned with in relation to the Treaty is whether the profits belong to the members as they arise. We have concluded that this is the effect of the LLC Operating Agreement and the Act. Accordingly the Appellant is taxed on the same income in both countries and is entitled to double taxation relief under the Treaty for the Federal tax.

Conclusion

So what can practitioners draw from this case about how profits and losses of a U.S. LLC will be taxed on a U.K. resident’s U.K. tax return? Based on Swift, it would appear that this will be treated as a facts-and-circumstances decision and that every situation will need to be considered on a case-by-case basis. The tribunal found that the crucial element of the six-factor test is whether the members are entitled to share in profits as they arise. Therefore, it is important to understand the definition of an LLC interest under the state law where the LLC is formed, and it would also appear to be important to have language in the LLC’s operating agreement indicating that profits are allocated to its members as they arise and that the members are entitled to some form of mandatory distributions. As noted above, HMRC is appealing the tribunal’s decision, and there may be changes as the case proceeds through the appeal process.

EditorNotes

Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.

For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.