The LLC and its members based in Germany (Part 2)

In the USA, the Limited Liability Company (LLC) is regarded as a form of company that is easy to set up, flexible to handle and yet offers personal limitation of liability for its shareholders (members). Special features must be observed if its shareholders are resident in Germany. Some of the special features are described in two articles.

The content of both articles is shown in the following table:

5) Permanent representative

A permanent representative exists under the following condition:

A person acting for a company who has and habitually exercises in a state the authority to enter into contracts on behalf of the company is deemed to be resident in that state for all activities that person performs for the company, unless the activities are related to the aucillary services mentioned above. This does not apply if the person is acting as a broker, general commission agent or other independent agent, provided that such persons are acting in the ordinary course of their business.

This provision is particularly tailored to the activities of sales and field staff of foreign companies operating in Germany. However, it can also apply to managing directors. A permanent representative is considered a be permanent establishment and the profits of the foreign company are partially taxable in Germany.

6) Classification of legal form

The tax classification of the LLC in Germany does not follow the tax treatment in the USA. In Germany, an LLC can be classified either as a corporation or as a partnership/sole proprietorship. If the LLC is to be classified as a partnership, the tax consequences are unproblematic. The shareholders are taxed in the USA. In Germany, the LLC is not taxed as long as the LLC does not have a permanent establishment in Germany. The profit share of shareholders who are resident in Germany for tax purposes is tax free-in Germany but with influence on the German income tax rate under the relevant provisions of the DTA.

A different tax situation arises if the German tax authorities classify the LLC as a corporation. If the LLC does not have a permanent establishment in Germany, the profits of the LLC are not taxed in Germany. The problem arises when profits are distributed to shareholders who are tax resident in Germany. This income is taxed at a total tax rate of 26.375%. The German tax authorities prohibit the crediting of US income tax against German tax. This leads to partial double taxation of profits distributed to shareholders who are tax resident in Germany.

The Federal Ministry of Finance published a letter dated 19 March 2004 in which it sets out the basis for classifying an LLC as a corporation or partnership. The decisive factor is a list of eight criteria:

• Centralized management and representation
• Limited liability
• Free transferability of shares
• Allocation of profits
• Raising of capital
• Unlimited life of the company
• Distribution of profits
• Formal formation requirements

The legal and contractual basis must be used for the assessment. These are the formation documents (articles of organization or certificate of formation), agreements between members (operating agreement) and the LLC laws of the respective US states.

The individual points have different weight. If the overall picture of the circumstances does not provide a clear result, points (1) to (5) are decisive. These are then simply counted. Practice shows that the classification often does not lead to clear results, which increases the potential for disputes with German tax authorities.

As a rule, criteria (2) and (8) cannot be changed because, on the one hand, the limited liability of the shareholders is one of the reasons why the legal form of the LLC is chosen and, on the other hand, the formation formalities (registration with the Secretary of State) cannot be avoided. However, the other points are very flexible due to the LLC law of the respective US state. It therefore makes sense to draft the operating agreement in such a way that the desired classification is achieved.

It is advisable to draft the operating agreement at the time of formation or before members relocate to Germany in such a way that the desired classification in Germany is achieved. In most cases, a matching classification in the USA and Germany is preferable. However, adjustments to the operating agreement should be avoided if one or all members are tax resident in Germany. If, for example, the LLC is to be regarded as a corporation before the amendment of the agreement and as a partnership afterwards, the German tax authorities could assume a taxable corporate restructuring, which may result in considerable tax burdens.

Further details here: https://scheller-international.com/blog-beitraege/llc-limited-liability-company-and-german-taxation.html.

7) Tax implications

The tax consequences of a commercially active LLC in Germany depend on the following criteria:

• Management of the LLC
  1. in Germany
  2. in the USA
• Main tax residence of the shareholders
  1. in Germany
  2. in the USA
• Classification of the LLC in Germany as
  1. corporation
  2. partnership or sole proprietorship

Taxation in Germany only occurs if the LLC is deemed to be resident in Germany for tax purposes or has a permanent establishment and/or its shareholders/members are tax resident in Germany.

If the LLC is taxable in Germany because it is classified as a corporation and has its management or another permanent establishment in Germany, it is treated in the same way as a domestic corporation (e.g. GmbH) for tax purposes. It is subject to corporation tax and trade business tax as well as the solidarity surcharge on its profits in Germany. The total tax burden is between 30% and 35%, depending on the location. In addition, questions often arise regarding the VAT treatment of its services. If goods are delivered across borders, customs and foreign trade regulations must also be observed.

If the LLC is classified as a corporation in Germany, profit distributions to shareholders resident in Germany are taxable at the withholding tax rate of 25% plus solidarity surcharge (total tax rate 26.375%). The determination of a profit distribution is difficult if it is not always clear whether cash flows to shareholders constitute a profit distribution. Cash flows can also be in form of capital repayments or be classified as remuneration for services provided by the shareholder to the company.

If the LLC is to be classified as a partnership and it has a permanent establishment in the form of a place of effective management or another permanent establishment in Germany, this leads to income from trade and business for shareholders. Income is taxed at the shareholder's individual income tax rate. The LLC itself may be subject to trade and business tax. A special treatment applies if the shareholder also receives remuneration for services rendered to the company. In cases of a classification as a partnership/sole proprietor, too, VAT, customs and foreign trade effects may have to be taken into account.

The taxation consequences in the USA must be considered separately. The same applies to potential inheritance tax consequences.

It should be noted that the GmbH and the LLC differ not only in terms of their corporate structure. The GmbH is commercially active in Germany by virtue of its legal form. In contrast, an LLC who holds real estate without carrying out any commercial transactions, is considered to be an asset-managing company. Its shareholders/members, according to German law, either generate rental income or other income (on capital gains realized within a period of ten years between acquisition and selling real property). This applies only, if the LLC is classified as a partnership.

8) Asset-managing LLC

An LLC is often used to hold US real estate assets for private purposes. In this respect, there are some special issues to be considered. If an LLC holds US real estate without carrying out a commercial activities, it cannot have a permanent establishment. As a result, the place of management is also irrelevant. The real estate held by this LLC also does not constitute a permanent establishment. However, this only applies if the LLC is classified as a partnership in Germany. If the LLC is classified as a corporation, it generates income from trade and business by virtue due to the legal fiction applicable in Germany. In this case, the LLC may also have permanent establishments.

The following special issues should also be observed:

• The existence of a “commercial property trading” with a very unfavorable tax treatment is particularly easily overlooked. In this case, sales of domestic and foreign real estate or real estate company shares are added together within a five-year period. This applies even if capital gains abroad are exempt from taxation in Germany under a DTA.
• In general, the involvement of a service and management company does not result in a permanent establishment of a foreign property company in Germany. However, cases in which a service and management company is legally authorized to use the facilities and equipment according to its own needs are problematic. This could be, for example, on-site supervision activities. Cases in which the service and management company belongs to the same company group as the real estate company and the same persons are managing both companies are also risky.

If a commercial activity of the LLC can be denied and it is classified as a partnership, the following consequences arise. Since the real estate held by the LLC is located in the USA and it is a US company, both capital gains and rental income are tax-exempt in Germany but with an effect on the German income tax rate (Art. 6, 13 and 23 (3) letter a DBA USA). This applies if the LLC has its principal place of residence in Germany. The corresponding US income must be declared in the shareholder’s/member’s German income tax return and has an impact on the income tax rate. If the shareholder's main place of residence is in the USA, the income has no influence on the German income tax rate. It should be noted that sales of foreign real estate outside the speculation period of ten years are not taxable in Germany at all and therefore have no tax consequences regardless of the owner's residence in Germany.

The income is subject to taxation in the USA. It should be noted that, in addition to federal income tax, state and local taxes may also apply.

Authors:

Peter Scheller, Steuerberater, Master of International Taxation. Fachberater für Zölle und Verbrauchsteuern

Alexander Wangerowski, Steuerberater, https://aw-stb.de/

Bildquelle: www.fotalia.com