Pass-through for me, but not for thee

By Jerry Meek

The limited liability company (or “LCC”) is now available in every state in the United States.  Such entities have become the darlings of incorporators, largely because they offer the advantages of limited liability, combined with the tax advantages of pass-through taxation (unless some other classification is affirmatively elected).  Under the default rules, the LLC’s income and deductions “pass-through” to the owner or owners, eliminating any entity-level tax and thus avoiding the double-taxation characteristic of C-corporations.

But attorneys who advise foreign persons and entities investing in the United States should tread with caution, because not all national governments treat the LLC so favorably.  In fact, many foreign governments wrestle with how to classify such hybrid entities, both under their own national law and under various treaty obligations.

Take, for example, the decision of the United Kingdom’s Upper Tribunal Tax and Chancery Chamber, upholding the position of Her Majesty’s Revenue and Customs (HMRC).  In HMRC v. Anson, [2011] FTC/39/2010 (TCC 2011), George Anson, a resident of the United Kingdom, was a Member of a Delaware LLC.  As is common, the LLC distributed profits to its Members quarterly, withholding U.S. taxes on distributions to its foreign Members.  Anson reported the income on his personal tax return in the United Kingdom and also sought foreign tax credits for the taxes paid to the United States.

Under the relevant tax treaty between the United States and the United Kingdom, any tax paid in the United States could be credited against “any United Kingdom tax computed by reference to the same profits or income by reference to which the United States tax is computed.”  HMRC argued that the tax paid in the United States resulted from income belonging to the LLC.  The tax paid in the United Kingdom, in contrast, was the result of distributions contractually required by the LLC’s operating agreement.  Anson argued, in response, that his right to the profits arose as the profits were generated.  Thus, the tax on the distributions was computed by reference to the same income that gave rise to tax in the United States.

In the court’s estimation, the deciding factor was whether Anson’s right to the profits was proprietary or contractual.  That is, was Anson’s right to receive distributions a right of ownership or a contractual right?  Under Delaware law, the court noted, the profits and losses of an LLC are allocated in accordance with the operating agreement.  Even though the agreement may require distributions in certain intervals based upon the LLC’s profits and allocations, this is not the same as a proprietary or ownership right to the distribution.  Instead, the profits remain as assets of the LLC until distribution.  Since the tax imposed by the United Kingdom is a tax on Anson’s contractual rights, and the tax imposed in the United States is a tax on profits of the LLC, Anson was not being taxed twice on the same income.  Thus, the court concluded, he was not entitled to foreign tax credits.

The end result, of course, is that the advantage of pass-through tax treatment ordinarily available through ownership of an LLC was unavailable to Anson.  Anson ended up suffering many of the tax burdens suffered by C-corporation shareholders.  One tax essentially was paid on income belonging to the LLC; a second tax was paid on the distributions received by Anson.

It is perhaps not all that surprising that foreign governments struggle with the proper tax classification of the U.S. LLC.  After all, it was largely the emergence of the LLC which prompted the Treasury to adopt the “check-the-box regulations” in 1996, putting an end to the decades of facts-and-circumstances analyses used to determine whether an entity should be classified as a corporation or a partnership for tax purposes.  Foreign investors owning interests in U.S. LLCs don’t have it so lucky.