After a decade of pondering, the German tax authorities have issued a Directive defining their position on the classification of US limited liability companies (LLCs) as corporations or partnerships for German tax purposes (Directive of March 19 2004). The Directive establishes no general rule or presumption in favour of one result or the other, but does identify the relevant factors for case-by-case analysis.
This is in keeping with the long-standing German approach of classifying foreign entities for tax purposes depending on their similarity to German corporations or partnerships. Germany does not permit entities to elect corporate or partnership tax treatment, and the treatment elected by an LLC under the US check-the-box rules does not bind the German tax authorities.
In the US, the law of business associations is historically reserved to individual states. Hence, a US LLC may theoretically be formed under the law of any of 50 different jurisdictions. In practice, the LLC statutes are uniform to a considerable degree. However, the organizers of an LLC may override many provisions of state law and structure the company to their own taste. LLC classification is therefore based on an LLC's organizational documents as well as the governing state law.
Classification criteria
The Directive defines an eight-point classification framework that should provide a fair degree of predictability in the use of LLCs by persons with German tax liability:
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centralized management is typical of a corporation (member management is indicative of a partnership);
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limited liability on the part of all members is typical of a corporation (personal liability on the part of one or more members is indicative of a partnership);
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free transferability of interests is typical of a corporation (transferability subject to the consent of the other members is typical of a partnership);
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distribution of profits only pursuant to member resolution is typical of a corporation (free withdrawal of pro rata earnings (distributive shares) at the discretion of each member is typical of a partnership);
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mandatory contributions to capital in cash or in kind are typical of a corporation (the absence of such contributions or rendering services in lieu thereof is typical of partnerships);
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perpetual duration (continuity of life) is typical of a corporation but also not atypical of a partnership (limited duration is, however, typical of a partnership);
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allocation of profits in accordance with contributions to capital is typical of a corporation (profit allocation rules that do not mirror contributions to capital are typical of a partnership, in that they presumably reflect services performed by a member on behalf of the entity);
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confirmation by a government agency is typically a condition precedent to the formation of a corporation (in Germany, this takes the form of entry in the commercial register after review of the articles of incorporation by the commercial register court - partnerships, by contrast, are effective as between the partners upon entry into the partnership agreement).
Little or no weight is given to the number of members of an LLC. The company's legal capacity or lack thereof is also apparently irrelevant.
Classification procedure
While limited liability and perpetual duration are typical of US LLCs, the Directive states that these criteria are not by themselves controlling. The Directive refrains from assigning weights to specific criteria. If no clear result emerges from an initial examination of all eight criteria pairs, a sort of "tie-breaker rule" classifies an entity as a corporation if it possesses a majority of the corporate attributes set forth in the first five criteria pairs listed above. The sixth criterion above (duration) will apparently also be counted for tie-breaker purposes if clearly counter-indicative of a corporation. Entities not classifiable as corporations under the tie-breaker rule will apparently be treated as partnerships.
Planning certainty
Within certain limits, the new Directive should provide sufficient planning certainty to enable German-based corporations and individuals to participate in US business ventures in the form of LLCs.
Dr Martin Lenz (mlenz@kpmg.com), Frankfurt
