Discrepancy of the U.S. Income Tax Consequences for Foreign Investors Selling Limited Liability Company Units Compared to Corporate Shares

By Anthony Diosdi

When a foreign person decides to start an active trade or business in the United States (referred to hereafter as “USTB”), he or she should be aware of the various United States income and estate tax consequences associated with the type of entity he or she chooses to conduct business through. In addition, the foreign person should make his or her U.S. income tax advisor aware of his or her ultimate goal in starting the U.S. business as the tax advisor’s advice may hinge on the foreign person’s ultimate objective.

For those foreign persons who would like to start a USTB and plan on operating the business indefinitely (i.e., they do not wish to sell the business once it becomes profitable), standard tax advice may be sufficient. The domestic corporation and limited liability company (hereinafter “LLC”) each have certain tax benefits and detriments. In particular, the domestic corporation, when paired with a foreign corporation parent (referred to hereafter as a “DC/FC Structure”), provides a foreign person with good estate tax benefits, but from an income tax perspective, may be less favorable than an LLC is subject to only one level of tax. From an estate tax perspective, the LLC does not provide a foreign person with adequate estate tax protection by itself and cannot be easily owned indirectly by a foreign person through a foreign corporation. As a result, a foreign person that decides to operate a USTB through a domestic LLC should consider purchasing life insurance as a hedge against his or her potential estate tax exposure.

However, there are further differences between how the two types of entities are taxed when a foreign person sells his or her interest in the business entity. Thus, if a foreign person has the intention of building up the business so that it becomes profitable only so that he or she can then sell the business, he or she should be aware of the drastically different tax consequences of selling stock in a corporation versus selling his or her membership in an LLC.

Generally speaking, a foreign person is not subject to capital gains derived in the United States on the sale of a capital asset, with the main exception to this rule occurs when a foreign person sells a United States real property interest. In the case of the sale of personal property, whether it is located within or outside the United States, any gain from such sale is sourced according to the residence of the seller, which for a foreign person results in any gain they have from the sale of personal property generally being treated as foreign source income. Applying either of these rules to a foreign person who sells stock in a domestic corporation, the gain to the foreign person would not be subject to tax within the United States.

While on the surface the above rules seem to apply to a foreign person who sells his or her membership interest in an LLC, the Internal Revenue Service (“IRS”) has taken the position that the pass-through nature of the LLC may result in drastically different income tax consequences when the LLC is engaged in a USTB. In particular, the IRS has chosen to look through the existence of the LLC when a foreign person sells his or her interest in the LLC (which is contrary to the well-established partnership rule that the sale of a partnership interest is to be treated as a sale of a capital asset and not a sale of the underlying asset held by the partnership) and tax the foreign person as if he or she was disposing of a portion of the LLC’s assets. Therefore, to the extent that the gain on the sale of the LLC interest is attributable to property used in the LLC’s USTB, such gain will be considered to be effectively connected with the USTB and subject to United States income tax.

In conclusion, a foreign person should have a clear idea of his or her objectives before deciding on what type of entity they will use when forming a USTB. In particular, if a foreign person contemplates selling his or her interest in the business once it becomes profitable, the gain he or she would have from the sale of corporate stock would be tax-free while a portion or all of the gain from the sale of an interest in an LLC would likely be subject to U.S. federal income tax.

Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at 415.318.3990 or by email: Anthony Diosdi – adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.