Taxation of US LLC as a Disregarded Entity

What is a Disregarded Entity?

A Disregarded Entity is a tax term. It means an entity which will be disregarded or ignored for the Federal Income Tax purposes in USA.

When an LLC is formed, IRS will by default treat it as a disregarded entity unless LLC elects to be treated as a Corporation. A disregarded LLC is an entity separate from its owner, and its owner reports the LLC’s income and deductions on the owner’s federal income tax return.

Pros and Cons of a being a Disregarded Entity:

Some of the benefits of a Disregarded Single-Member LLC are stated below:

• Pass-through taxation: LLC’s incomes and expenses pass through to its owner for the purpose of taxation.
• Simpler Tax filing- With Pass-through taxation, only the business owner is taxed, not the business. So only the owner will have to file his Federal Income Tax Return.
• Liability- The status of a disregarded entity is only for Federal level and not at State level, hence owner of LLC can enjoy the limited liability advantages and protection of his personal assets.

     Some of the disadvantages of a Disregarded Single-Member LLC are stated below:

• Employment and excise taxes: LLC’s status of a disregarded entity is only for the purpose of Federal taxes hence LLC will still be liable for Employment and Excise taxes.
• Self-employment taxes: The owner of a disregarded entity will be liable to pay self-employment taxes.

Filing Requirements for a Foreign-owned Disregarded Single-Member LLC:

With effect from 1^st Jan 2017, All Foreign-owned Single-member LLCs that are Disregarded Entities will have to file Form 5472 and Form 1120 as per new regulations to Section 1.6038A-1 of the Code of Federal Regulations.

As per the new regulations of the Treasury Department and IRS in USA, disregarded entities owned by foreign persons/ entities will now be treated as domestic corporations for the purpose of reporting. Previously the foreign owned disregarded entities had no filing obligations but now they will be liable to obtain EIN and file Form 5472 and Form 1120.

This means that all foreign-owned Single-Member LLCs that are Disregarded Entities are now treated as Corporations for federal reporting requirements i.e., submitting information to the IRS. This doesn’t mean the LLC is paying tax like a Corporation, but rather, it’s simply reporting information like a Corporation.

Form 5472 is required to be filed by Disregarded LLCs only when they have a Reportable transaction (as explained below) between the LLC and its foreign owner.

Foreign owners of U.S. disregarded entities may have no income tax filing requirement (Form 1040/1040NR/1120-F) if no U.S. sourced income. However, form 5472 and form 1120 are required in regardless of that.

Form 8858 (Information Return of US Persons with Respect to Foreign Disregarded Entities):

U.S. persons that own a Foreign Disregarded Entities are subject to file information in Form 8858.

This form is not applicable to Non-resident Aliens who own Disregarded Entities in the U.S.

Reasons for Changes in Regulations

The above changes are to increase financial transparency and improve the IRS’s access to information needed to combat the misuse of U.S. shell companies and to share information with partner tax authorities under various tax treaties, tax information exchange agreements, and other international agreements.

The following types of LLCs must file Form 5472 and Form 1120 every year:

• A Single-Member LLC that is Disregarded and owned by a non-US resident or foreign company
• A Single-Member LLC that is Foreign-owned and taxed as a Corporation
• A Multi-member LLC that is taxed as a Corporation and has at least 1 Foreign owner that owns 25% or more of the LLC

Tax Applicability of Disregarded LLCs

If the Disregarded LLCs do not have Effectively Connected Income in U.S. i.e., they are not engaged in a trade or business in the US or did not earn any income through US sources in the calendar year reported then even if they are treated as Corporations for Federal reporting requirements to the IRS, they will not be required to pay any taxes. They will only be liable for Reporting-requirement by filing Forms 1120 and 5472. Failure to file the required forms will attract penalties of up to $25,000.

In fact, the only information required to be reported by such entities on Form 1120 is the name and address of the foreign-owned U.S. Disregarded Entity and item B and E on the first page.

Item B reports your Employer Identification Number (EIN)

Item E reports is this Corporate Return is your Initial Return, Final Return, Name change return or Address change return.

If the Disregarded LLCs have Effectively Connected Income in the U.S. then they will be subject to state income tax and Federal tax at regular US corporate tax rates.

Types of Ownership:

Filing of Form 5472 and Form 1120 are applicable to foreign-owned Single- Member LLCs that are owned directly or indirectly:

• Direct Ownership- When the owner is the foreign person or a foreign company
• Indirect Ownership- When the LLC is owned by another disregarded entity

Basic requirements for a foreign-owned Single Member Disregarded LLCs are:

1. Get an Employer Identification Number (EIN)
2. File Form 5472 and Form 1120 (only LLC name, address and item B and E are required)
3. Maintain financial records to prove the information provided in Form 5472
4. The Non- Resident Alien Owner of LLC need to get ITIN for filing his 1040-NR

All the Relevant Forms:

Form 5472:

Form 5472 is an Information Return that a US Corporation which has 25% or more of foreign-ownership or a Foreign Corporation Engaged in a US Trade or Business must file. For foreign-owned US LLCs, this filing requirement started in 2017.

A foreign-owned US LLC or Corporation with at least 25% foreign shareholding must file the information return Form 5472 for every year with “Reportable Transactions”.

Due date of filing Form 5472 is April 15^th together with Form 1120. If you file extension for your Corporate Return then due date of both the Form will October 15^th.

Penalties for Non-Filing of form 5472

For non-filing of Form 5472 or filing substantially incomplete Form 5472 will attract a penalty of $25,000 per year per form. This penalty also applies in case of non-maintenance of the required records.

Reportable transactions for Form 5472:

All transactions between the LLC and its foreign owner related to exchange of money or property including payments, rental income, sales transactions, remuneration, commission payments, capital contributions, capital reductions, & loans and interest payments. Additionally, you must also report any amounts paid or received in connection with the formation, dissolution, acquisition, and disposition of LLC including contributions and distributions from the LLC.

Form 1120:

A C-corporation or an LLC filing as corporation is liable to file Form 1120 every year. Form 1120 is U.S. Corporate Income Tax Return that corporates use of report their income, gains, losses, deductions, and credits.

You must have the below information to file Form 1120:

• Employer Identification Number (EIN)
• Date of Incorporation
• Total assets and income
• Gross receipts
• Cost of goods sold
• Any dividend, interest, royalty
• Capital gains
• Tax deductions
• Business tax credits, if any

Form 1120 can be filed electronically or by mail.

A Corporate with a year-end date of December 31^st must file its Form 1120 by April 15^th.

If you make a mistake in Form 1120, you must file an amended tax return using Form1120X. You can use Form1120X to correct the Form 1120 you already filed. You can file Form 1120X within 3 years of filing the original Form 1120.

Failure to file form 1120, will result in a Penalty of 5% of the unpaid taxes for each month or part thereof till it is filed, up to maximum penalty of 25%.

 

Form 1040 NR:

Applicability to file Form 1040-NR:

• Where a non-resident alien is engaged in a trade or business (ETOB) in the US or otherwise earned income through US sources in the calendar year reported.

Conditions when an entity is engaged in ETOB:

1. Entity has at least one “dependent agent” in the US, which are employees/ companies which work for it exclusively, dependent agent must be involved in substantial engagement to further entity’s business in US, as opposed to simply administrative engagement;
2. Entity is engaged in “considerable, continuous and regular” business in the US

• Where a person represents a deceased person who would be liable to file Form 1040-NR
• Where a person represents an estate or trust which is liable to file Form 1040-NR

Non-resident aliens must file this form to get their refund as the tax withheld from their payments generally exceeds their liability.

Form 1040-NR can be filed electronically or by mail.

Due date of filing Form 1040-NR is June 15^th of each year.

If you miss to file Form 1040-NR by the due date, you can receive a tax that is 5% of your unpaid taxes for each month or part of the month for which the tax return is not filed.

This penalty is maximum up to 25% of your unpaid taxes.

Some other relevant Tax- forms:

Form 1116: (Foreign Tax Credit for Individual, Estate or Trust)

Non-resident Aliens who pay taxes in their home country can use this form to claim a tax credit on their U.S. taxes, which reduces their overall U.S. tax liability.

Form 114: Report of Foreign Bank and Financial Accounts (FBAR)

This form is used to report certain foreign financial accounts, such as bank accounts, brokerage accounts and mutual funds if the total value of those foreign financial accounts exceed $10,000 at any time during the calendar year reported.

Whether such account produced taxable income or not has no effect on such reporting in FBAR form.

Advance Tax:

Advance tax liability of a single member LLC depends upon the estimated income of the sole member of the LLC. If an LLC has reportable income in the current year, then advance tax is to be paid in four equal instalments based on estimated income. The due dates for Advance tax payments are April 15, June 15, Sep 15, Jan 15 of the Current year. The advance tax is to be paid on SSN/ ITIN of the Sole-member of LLC.