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Limited
Liability Company (LLC) |
All 50 states and the District of
Columbia have authorized the formation of LLCs. US tax
law treats an LLC on a 'pass-through' basis - a single
member LLC is simply disregarded for tax purposes, while
an LLC with two or more members is treated as a partnership
unless it opts to be treated as a corporation. In both
cases taxation is applied to the members and not to
the LLC.
If the members of an LLC are foreign
persons, then they will be taxed on all income which
is effectively connected with their conduct of a trade
or business in the US. However, the receipt of 'passive'
income on its own does not normally amount to the conduct
of a US business - passive income includes most interest
income, gains from investment in any stock market, and
gains from investment in commodities.
Foreign owners of a domestic LLC
do not pay income tax on the LLC’s foreign source export
income except under certain circumstances. If the foreign person’s LLC does not have a US
office or an agent in the US, it is unlikely that foreign
source income will be taxed as US income. If there is
a US office, then by and large the activities of the
US office will not be considered to be a material factor
in the realization of income, gain, or loss, unless
the US office provides a significant contribution to,
by being an essential economic element in, the realization
of the income, gain, or loss. An administrative office
in the US can pay expenses, deposit income and perform
accounting activities. These activities will not cause
export income to be taxed by the US taxing authorities.
An office is not considered to have
materially participated in a sale merely because one
or more of the following activities takes place: (a)
the sale is made subject to the final approval of such
office, (b) the property sold is held in, and distributed
from such office, (c) samples of the property sold are
displayed (but not otherwise promoted or sold) in such
office, (d) such office is used for purposes of having
title to the property pass outside the United States,
or (e) such office merely performs clerical functions
incident to the sale.
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S Corporation |
“S” Corporations (which are not available
to non-residents) are very popular for small businesses
in the US. An S corporation is a regular corporation
(normally taxable under subchapter C of the Internal
Revenue Code, and thus referred to as a C corporation),
or a limited liability company which has elected to
be taxed like a corporation, which files form 2553 with
the Internal Revenue Service. The result is that the
corporation's net income (after business expenses and
other permissible deductions) is required to be included
in the individual returns of the stockholders of the
corporation, in the same percentages as their percentages
of ownership of the corporation.
The imposition of a maximum corporate
tax bracket in 1988 that was higher than the maximum
individual tax bracket made S corporation status very
attractive.
A corporation must meet the following
qualifications to be eligible for an S election:
- It must not have more than 35 shareholders;
- All shareholders must be either
individuals, estates or certain types of trusts; a
corporation or partnership may not be a shareholder;
- Nonresident aliens may not be shareholders;
- The corporation may have only one
class of stock;
- The corporation must be a domestic
corporation.
A shareholder's share of net operating
loss of an S corporation is limited to the sum of the
shareholder's adjusted basis in the stock of the corporation
plus his adjusted basis in any debt the corporation
may owe him. Disallowed losses and deductions may be
carried forward to sebsequent years. Distributions by
an S corporation are treated as a tax-free return of
capital to the shareholder, provided the corporation
has no accumulated earnings and profits, to the extent
of the shareholder's basis in his stock. Such distributions
are treated as taxable gain to the extent of the shareholder's
basis in his stock. Such distributions are treated as
taxable gain to the extent they exceed the shareholder's
basis in his stock.
One disadvantage of an S corporation
election is that employee status is denied to those
shareholders with stock ownership exceeding 2 percent.
As a consequence, an S corporation cannot deduct the
cost of fringe benefits provided at the corporation's
expense (for example, accident and health insurance)
for the benefit of these shareholder-employees. Thus,
an S corporation cannot provide many fringe benefits
on a tax-free basis.
In July, 2005, Internal Revenue Service
officials announced that the agency was to launch a
comprehensive study of tax reporting compliance amongst
America's rising number of S corporations, a form of
corporate entity that has grown enormously in popularity
over the last twenty years.
According to the IRS, the study would
examine 5,000 randomly selected S corporation returns
from tax years 2003 and 2004.
Since the mid-1980s, the number of
S corporations has risen rapidly, growing from 724,749
in 1985 to 3,154,377 in 2002. Among S corporations with
more than $10 million in assets, the growth rate has
been even faster. From 1985 to 2002, the number of these
larger S corporations grew more than ten-fold, from
2,305 to 26,096.
“The use of S corporations has exploded,”
observed then IRS Commissioner Mark W. Everson. “The IRS needs a better understanding
of what this means for tax compliance. This research
is critical for achieving our strategic goal of ensuring
that corporations and high-income individuals are paying
their fair share," Everson added.
S corporations are now the most common
corporate entity. In 2002, S corporation returns accounted
for 59 percent of all corporate returns filed for that
tax year. Two million S corporations reported net income
of about $248 billion and 1.2 million S corporations
reported net losses of about $63 billion.
The last reporting compliance study
of S corporations involved about 10,000 returns from
tax year 1984, prior to the tax law changes that spurred
the growth in S corporations. The new NRP initiative
will use a study approach designed to reach statistically
valid conclusions regarding compliance behavior, while
using a smaller sample of returns than in the past.
The results of the NRP study will
be used to more accurately gauge the extent to which
the income, deductions and credits from S corporations
are properly reported on returns filed by the flow-through
corporations and their shareholders. When completed,
this research will assist the IRS in selecting and auditing
S corporation returns with greater compliance risk.
The research program on S corporations
was to be a complement to the study of individual reporting
compliance completed the previous year. The preliminary
results from that study, announced in March, indicated
that the gross tax gap is more than $300 billion each
year. IRS collection and compliance efforts reduce this
gap by about $50 billion each year.
“This research effort provides us
the knowledge we need to both improve compliance and
reduce unnecessary taxpayer burden,” said Everson.
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Limited
Partnership |
In a Limited Partnership, one or
more ‘general" partners manage the business while 'limited'
partners contribute capital and share in the profits
but take no part in running the business. General partners
remain personally liable for partnership debts while
limited partners incur no liability with respect to
partnership obligations beyond their capital contributions.
The Limited Partnership has been
very widely used for investment purposes. In the last
30 years, most major financial companies have used the
LP form to channel private capital into real estate,
oil and gas and mezzanine financing. These LPs are normally
structured to be long-term investments (typically 10
to 15 years with extension rights at the partnership's
option) and do not make any liquidity provision in the
event the investor decides to sell their partnership
interest prior to the termination of the LP.
Normally, death, disability, or withdrawal
of a general partner dissolves the partnership unless
the partnership agreement provides otherwise or all
partners agree, in writing, to substitute a general
partner. Death or incompetence of a Limited Partner
has no effect on the partnership.
The Family Limited Partnership (FLP),
which is simply a Limited Partnership used by one family,
has become the leading form for asset protection and
estate planning in the US. But there are some legal
dangers in many states, where a creditor is permitted
to “foreclose” on a partnership or LLC interest. A “foreclosure”
is a seizure of the debtor’s interest and that is a
very powerful weapon for the plaintiff. Thus, an asset
protection structure using an FLP must also protect
ownership interests with a trust.
In May, 2005, the US Treasury and
the Internal Revenue Service finalized regulations on
the tax withholding obligations of US partnerships that
include foreign partners.
Foreign individuals were subject
to US tax for income from doing business in the US,
in addition to income earned in the US through a partnership.
To ensure the tax gets collected the IRS requires that
partnerships withhold tax on behalf of the foreign partner.
The final rules, first proposed in
September 2003, provided guidance on how to determine
a foreign partner's share of partnership income and
to calculate withholding tax and payment dates. The
matter of interest, penalties and extra taxes for failure
to comply with the regulations were also addressed.
In addition, the Treasury also issued
related proposed and temporary rules covering certain
tax and non-tax attributes of a foreign partner for
purposes of determining tax withholding obligations.
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