LLC taxation: how to avoid a double burden as a German entrepreneur

Key takeaways

• For many German companies and investors, the US LLC is the legal form of choice in the United States.
• The use of an LLC must make sense from both a German and a US tax perspective and should ideally be coordinated closely with advisers in both jurisdictions.
• A US LLC carries the risk of an economic double burden of tax.

How is an LLC taxed in the USA and in Germany?

In the USA an LLC is taxed either as a corporation, as a partnership or as a disregarded entity. Taxation in Germany is independent of this: for German tax purposes the LLC has to be classified either as a corporation or as a partnership.

In the USA there is the "check-the-box" procedure: a company can elect whether it is to be classified as a corporation, a partnership or a disregarded entity. The tax consequences can be summarised broadly as follows:

• Corporation: If it elects taxation as a corporation, it is itself subject to corporate income tax and distributions count as dividends for US tax purposes. Corporate income tax returns must be filed in the USA accordingly, and withholding tax may arise on dividends.
• Partnership: If it elects taxation as a partnership, the income is in principle taxed at the level of the members. US filing obligations nevertheless arise (Form 1065, U.S. Return of Partnership Income; Schedule K-1 for each member).
• Disregarded entity: Where an LLC has only one member, it automatically counts as a disregarded entity unless another election is made under the check-the-box procedure. Its income is then attributed entirely to the member. It generally files no US tax return itself, but the income must of course be declared by the member.

For German tax purposes the classification under US tax law and the election within the check-the-box procedure are irrelevant: the company has to be classified as a corporation or a partnership according to the criteria of the so-called comparison of types (Typenvergleich). The LLC is compared, on the basis of its constitutional documents (the operating agreement or limited liability company agreement), with the "typical" corporation or partnership: in practice the combination of limited liability, a fixed participation structure and an independent appearance towards third parties means that many LLCs – including those that count as disregarded entities in the USA – are classified as corporations.

Which taxes specifically arise in Germany on a participation in an LLC?

Which taxes arise on a participation in an LLC depends on whether, in the view of the German tax authorities, the LLC is actually resident in the USA and whether, from a German tax perspective, it qualifies as a corporation or a partnership.

Without management on the ground in the USA there is a very considerable risk that the German tax authorities will take the view that the LLC is resident for tax purposes not in the USA but in Germany. What is decisive here, put simply, is the place of management. If the German entrepreneur, whose centre of life is in Germany, is also the manager of the LLC (generally the "managing member") and there is no manager on the ground, Germany will as a rule claim the right to tax all the LLC's income – in addition to any US tax that arises.

Example: A mid-sized entrepreneur based in Bavaria wants to enter the US market. He sets up an LLC and is initially its sole manager. Over several years he travels regularly to the USA and concludes a number of contracts with US clients in the name of the LLC. His centre of life is in Bavaria at his company's headquarters, and he also takes the relevant decisions for the LLC (for example those on concluding contracts) at that headquarters. This is apparent in particular from the email correspondence. Here the LLC is resident in Germany because of the place of management.

Where the LLC is – generally against the entrepreneur's wishes – resident in Germany, the further taxation in Germany depends on its classification under the comparison of types:

• Corporation: Where the LLC is qualified as a corporation from a German perspective, its profit is subject here to corporate income tax of 15 % plus the solidarity surcharge as well as trade tax, the amount of which depends on the municipal multiplier and which often brings the overall tax rate at company level into the region of around 30 % of the profit. At shareholder level, distributions to individuals holding the interest as private assets are regularly charged to 25 % withholding tax on capital income plus the solidarity surcharge and, where applicable, church tax.
• Partnership: Where the LLC qualifies as a partnership from a German tax perspective, it is in principle transparent for tax purposes. Depending on its actual activity (commercial or asset-managing), trade tax may arise. The income is attributed to the members and taxed in their hands at their personal rate.

Important: In parallel, filing obligations generally nevertheless apply in the USA and must be complied with. A US tax adviser should be brought in for this. We are happy to put you in touch with the right specialist through our network.

Where the LLC is genuinely resident in the USA, a comparison of types must likewise be carried out. The core point is then the examination of the double taxation treaty and, where applicable, the crediting of US tax against the German tax burden:

• Corporation: Distributions to members resident in Germany then count as dividends and are, for private individuals, in principle charged to the flat-rate withholding tax of 25 % plus the solidarity surcharge and, where applicable, church tax; for interests held as business assets they are captured under the partial income procedure or under the special corporate income tax and trade tax rules. Tax already paid in the USA (income tax or withholding tax) can be taken into account under the treaty and crediting provisions.
• Partnership: Where the LLC is qualified as a partnership from a German perspective, the profits are attributed directly to the members resident in Germany and taxed there as ongoing commercial or self-employment income at their personal income tax rate (and correspondingly with corporate income tax and trade tax where corporations participate). Tax already paid in the USA (income tax or withholding tax) can likewise be taken into account here under the double taxation treaty and crediting provisions.

Important: For partnerships it is essential to examine whether they qualify as "originally commercial" – in that case the right to tax that income may lie with the USA and not with Germany.

When does using an LLC make sense – and when should you refrain from it?

Using an LLC makes sense where your business requires a substantial presence in the USA: where the focus of the activity, the material functions and risks, and the staff and clients lie predominantly in the USA, an LLC can be the right vehicle for limiting liability, making use of US law and aligning taxation with the economic centre of gravity. Finally, a non-tax factor also matters: US business partners will appreciate a German entrepreneur building a "real" presence in the USA in the form of a US subsidiary.

In such cases, careful planning can ensure that US tax is levied and – as far as possible – credited under German rules. You should refrain, by contrast, where the LLC is intended merely as a "shell" while the management, core functions and value creation remain in Germany. It is then likely that Germany will treat the LLC's profits as domestic business profits while the USA levies tax in parallel.

Arrangements with a small volume but high complexity are likewise problematic: where the LLC's turnover and profit are modest but the ongoing costs for the legal form, accounting, tax returns in two states and the coordination of tax credits are considerable, simpler alternatives (direct business, agencies, project-based contracts) can make more economic sense.

What should you bear in mind now if you already have an LLC or are about to set one up?

• Take stock of the current structure: Anyone under pressure to act should first take stock of the structure, the classification and the tax flows. If you already have an LLC, you need clarity on how the LLC is currently treated for tax purposes in the USA (disregarded entity, partnership, corporation), how the German tax office would be likely to classify the company, and what tax has actually been paid in both states in past years. This includes in particular US tax assessments, proof of payment, the operating agreement, and evidence of the management and of substance in the USA.
• Examine whether tax can be credited: Next it should be examined whether and to what extent foreign tax can be credited under German law, or whether an economic double taxation has already occurred.
• Coordinate US and German tax law: If you are about to set up the company, you should determine the desired US classification before signing the constitutional documents and have its effects on German tax modelled: how high is the overall tax burden in different scenarios? Where do bottlenecks in crediting arise, in particular with disregarded entities? What substance requirements must you satisfy in the USA in order to secure the desired allocation of taxing rights?
• Act quickly where there have been errors in the past: Anyone who finds that LLC income was not declared in Germany in the past, or only incompletely, should clarify with a specialist adviser whether a correction or a voluntary disclosure is necessary in order to limit criminal risks and put the tax position in order.