Q: My Dad’s friend in India just gave me a million dollars to start a technology company, what do I now?
If you have been in the US for any length of time, the first thing you or your friends might suggest is that you need to form a Limited Liability Company, commonly known as an LLC. You don’t want to pay corporate taxes or for an expensive accountant or lawyer, so you find a website that that will register your company for you. You put your father’s generous friend down as owning half of the company, while you own the other half. $300 later, you are registered with the state and are ready to start your new venture!
You make $50,000 in income in the first year and $200,000 the second. Your father’s friend is excited about your progress and does not expect the money back soon. Since you did not distribute any money back to your father’s friend, you are not worried about his tax liability. You don’t like paying all the taxes, so you decide to call his money a loan, to deduct interest expenses to reduce your taxable income. What can go wrong?
LLCs for nonresident alien partners
The first issue to understand is that while the US government offers its US taxpayers an easy way for small businesses to avoid corporate income taxes through the use of an LLC, it does not extend that privilege to nonresident aliens. Therefore, while it is possible for a nonresident alien to operate out of an LLC, the Internal Revenue Service has made it very burdensome and expensive for foreign partners to do so.
You may believe that your father’s friend is a passive investor and just provides the money, while you run the business. While that might be the case, such a position would be very disadvantageous from a tax perspective. This is because the IRS taxes passive investor income to foreign partners at 30% of the partnership’s gross revenue. Assuming that the partnership’s second year income of $200,000 was based on $500,000 in sales, the IRS would tax his 50% share at 30% of $250,000, or $75,000. This tax is not based upon actual distributions made to the foreign partner, but the sales income of the company, so he could be taxed on money he did not receive. Further, the IRS considers the US taxpayer in a partnership with a foreign partner to be the withholding agent; this means they will go after you to recover the tax liabilities of the foreign partner.
Since the IRS has contacted you, you have decided that it is time to seek professional advice. The first thing a tax professional might do is try to establish that your father’s friend is actually, actively involved in a US trade or business. However, even if there is a clear pattern of engagement in a US trade or business by your foreign partner, the IRS may still claim that, because you did not file the correct forms in the first year, you are no longer eligible for the more advantageous tax treatment. This could occur if your father’s friend invested in you through a foreign company and did not file a form 1120-F, US Income Tax Return of a Foreign Corporation.
If it can be established that he is engaged in a US trade or business, he will be taxed on his “effectively connected income” (ECI); ECI is taxed on a net income rather than a gross income basis. This would allow him to claim deductions for the partnership’s business expenses. But, he will still be taxed at progressive individual tax rates of up to 39.6%. This approach will make his total tax bill around $21,000, saving him nearly $54,000 in taxes.
As you can see from the hypothetical above, international tax is very fact-specific and becomes complex very quickly. It is not only advisable to seek professional tax advice; but, in fact, the IRS expects and requires you to do so whenever you encounter complicated tax issues.
In Part 2 of this article, I will discuss important withholding tax issues for the nonresident alien Partner.
Guest post by Deniz Kiral, a former Big-4 Certified Public Accountant, specializing in international taxation with over 20 years of work experience in the field.