Last week, we mentioned that US tax withholding may be required when a business deals with a foreign entity or individual. Here is an example of a situation that can arise if a business owner is not aware of the additional compliance requirements when there are foreign members of an LLC:
A scientist originally from Singapore has been working as a researcher at the local university for the past 15 years. She and her colleagues have developed an innovative technology, and the university has agreed to license the technology to her so that she can develop a commercially viable product. The scientist sets up an LLC, signs a license agreement with the university, and starts looking for funding. Certain members of her family agree to invest in his company. She also has been working with researchers in Germany who become members of the LLC as well. None of these individuals are citizens or residents of the US.
For the first two years, the LLC experiences losses. Partnership returns are filed and the LLC members receive K-1 forms reporting their share of the losses. In year three, a large customer contract is signed and the profits are significant. After holding back a portion of the profit for future needs, the scientist makes distributions to the LLC members.
In February, the scientist brings in the annual financial information to a CPA to have the partnership returns prepared. She is told that for those LLC members who are not US citizens and residents, the partnership must make a federal tax deposit based on the income allocated to those members. Unless there is a reduced treaty rate, the tax to be deposited is calculated using the highest federal tax rate. The amounts deposited are considered to be withheld and remitted on behalf of each of the foreign LLC members, and is charged to their capital accounts. Not only does this create cash flow issues for the LLC due to the unexpected tax deposit, the scientist must now inform her family and colleagues that they must file US income tax returns in order to recoup the portion of the deposited tax that may be in excess of the actual tax owed.
Although there may be better ways of structuring a business with foreign investors, it is not inherently wrong to operate as an LLC with foreign members. It is, however, important to be aware of the associated compliance issues. Note that there can be similar, but not necessarily identical, state tax implications as well.
Our staff can help you identify and address any US tax withholding and filing requirements. You can contact us at 607-272-5550 or at info@swcllp.com.