Your LLC is not a subsidiary. And that is where the transfer pricing problem begins

The structure I most often see coming into the office is always the same. A Portuguese, Brazilian or Spanish company sets up an LLC in Delaware, Florida or Wyoming through an online service in two days. The owners walk away convinced they have a subsidiary in the United States. In most cases, as far as the US tax authorities are concerned, they do not.

What the US tax authorities see

An LLC with a single member is, by default, a disregarded entity. For federal income tax purposes, it does not exist. If the member is a foreign company, the LLC is treated as a branch of that company. It is not the LLC that is doing business in the US. It is the parent company, directly.

This is not a technical detail. It has three consequences that are rarely explained to the client at the time of formation.

First consequence: the parent files the return

If the LLC generates income effectively connected with a US trade or business, the filing obligation belongs to the foreign company, on Form 1120-F. The income is subject to 21% federal tax, plus state tax where applicable. On top of that, a 30% branch profits tax may apply to profits deemed to have left the branch.

Treaties reduce this additional tax. Portugal and Spain have treaties with the US. Brazil does not. A Brazilian company operating through a transparent LLC is exposed to the full rate, with no treaty to protect it.

Second consequence: the intragroup agreement does not do what you think

It is common to see carefully drafted service agreements between a parent company and its LLC, complete with margins and cost schedules. The effort is well-intentioned. But if the LLC is transparent, the parent is contracting with itself.

For the US tax authorities, the question is no longer “what is the arm’s length price between two companies?” It becomes “how much of the foreign company’s income is effectively connected with the US?” These are different rules, with a different logic. The margin written into the agreement does not determine that answer.

Third consequence: the reporting obligation survives

Here is the irony. For tax purposes, the LLC disappears. For the purpose of reporting related-party transactions, it is treated as a corporation. It must file an annual pro forma return (Form 1120) accompanied by Form 5472.

The penalty for failing to file or filing late is $25,000 per form, per year. In small groups, this is the most common and most expensive US tax risk I encounter. It does not usually arise from a pricing adjustment, but from a form that nobody knew existed.

What about the parent company’s side?

The parent’s country may view the same LLC differently. Portugal or Spain may treat it as a separate company, while the US treats it as transparent. When two countries classify the same entity differently, the anti-hybrid rules of the EU’s ATAD directive come into play. Brazil has its own rules for taxing profits earned abroad.

The result may be income taxed twice, or a deduction denied on one side. This is not a theoretical scenario. It is what happens when a structure is chosen based on the cost of formation rather than the business model.

My position

For a group with real operations in the US (customers, staff, revenue), a transparent LLC owned by a foreign company is rarely the right choice. I believe the decision should be deliberate and made at the outset.

There are two main routes. The first is to elect for the LLC to be taxed as a corporation using Form 8832. The election can be retroactive by up to 75 days. The second is to set up a C-Corp directly. In both cases, there is now a genuine subsidiary, and the transfer pricing rules between two companies begin to apply as the owners had imagined.

There are situations where transparency is exactly what is intended. Estate-planning structures owned by individuals are one example. An operating company owned by a foreign company is almost never one of them.

Three questions before discussing margins

1. Who is the LLC’s member: an individual or a company?
2. Is there a Form 8832 election? If so, on what date did it take effect?
3. Which returns have been filed in the US over the past three years, and do they include Form 5472?

If the answer to any of these is “I don’t know,” the transfer pricing conversation cannot begin yet. First, we need to know what entity exists, and in whose eyes.

At Pactum, learn more about the transfer pricing study.