Corporations formed in the United States (including LLC’s that have filed a check the box election to be taxed as a corporation) have a distinct disadvantage with regard to pass through structures such as an LLC taxed as a partnership or as disregarded entity for income tax purposes. Distributions of profits in the form of dividends are subject to a second level tax. If the shareholder is a foreigner the distribution is subject to a withholding tax of 30% at the source. This rate may be reduced if there is a tax treaty between the US and the country of residence of the shareholder (Neither Brazil nor BVI have such treaty). Thus, the corporation pays tax on its net income and the shareholder pays an additional tax on the distribution of dividends from the corporation to its foreign shareholders. In Brazil, this is not currently the case since there is no second-level tax imposed on dividends.
Clients have asked if this tax in the U.S. can be avoided if the distribution is characterized as a return of capital rather than a distribution of profits. The short answer is that if the corporation has “earnings and profits” retained in its financial statements, then the distribution is deemed to be a dividend for US tax purposes up to the amount of the retained earnings and profits. For example, US corporation (“USCO”)has paid-in capital in the amount of $1,000,000. During the year, the USCO had net operating income of $100,000. It paid US federal tax on that income in the amount of 21% thereby leaving a balance of $79,000. Any return of capital to the shareholder up to $79,000 shall be deemed a dividend distributed taxed in the additional amount of $23,700 leaving a net amount of $55,300. That is an effective tax of approximately 45%! The dividend paid is not a deductible expense of USCO.
How to avoid this high taxation in a corporate setting? First, the use of debt from the shareholder to USCO allows the payment of interest to the shareholder. The interest paid is subject to the 30% withholding tax as well but the interest is a deductible expense for USCO. Second, if all earnings and profits are retained in USCO until the liquidation of USCO, all monies distributed to the shareholder are not subject to this second level of tax. Thus, many clients will allow the monies to accumulate in USCO or reinvest the same until dissolution.
These issues related to taxation of distributions from corporations is why clients should consider “pass-through” structures that eliminate the second level of tax discussed above. This will be examined in next month’s newsletter.