Gregory T Bryant, CPA | Attorney at Law
Caroline White, Attorney at Law
General Information Only
DISCLAIMER: This article provides general information about certain tax structures and is not intended as tax or legal advice. Tax laws are complex and subject to change, and the application of tax laws depends on the specific facts and circumstances of each situation. Readers should not rely on this information as a substitute for professional advice and should consult with qualified tax and legal advisors before making any decisions regarding business structure or tax planning. The author and publisher assume no liability for actions taken based on the information contained herein.
We are frequently hear this: “I have been told that the best way to set up a business to sell products through e-commerce is to have a parent company in the United Arab Emirates (“UAE”), preferably Dubai, that owns a wholly owned limited liability company (“LLC”) because everybody knows limited liability companies are not taxed, and there’s zero tax in the United Arab Emirates.” There can be some variations on this theme, for example, using Hong Kong in place of UAE. There are many things wrong with this statement, and we will unpack them in this article. This structuring and “planning” are promoted by people in the UAE who may not have expertise in US income tax law. And as we will soon learn, “a half-truth can be a great lie.”
Companies are often set up this way to access banks and credit card processors in the United States. A US company is typically required for these purposes. The US LLC will get a tax identification number from the IRS, or what is called an “employer identification number” and use that to open bank accounts and get credit card processors, or what are called “merchant processors” to process on-line sales for them. They will also, many times, register in states under the EIN for sales tax reporting and compliance.
Here is the problem. Although it is very true that LLCs are not subject to income tax, their owner(s) are, and this means the UAE company in our example is subject to tax in the United States. So, the first half-truth is that the LLC’s income is non-taxable. It is taxable, but to the owners, not the LLC. But that is not the end to the story. The way the UAE company is taxed is not what one might think. First, the UAE company, if it does not file a timely and complete US income tax return, Form 1120-F, may be subject to US corporate income tax on its gross revenue (not net income or profits, but its total turnover). This is because if the UAE company did not file a timely tax return, it is not allowed to deduct expenses against its income.
Second, the UAE company would be subject to “branch profits tax” which includes an additional 30% withholding tax on the income. So, this means the UAE company owning 100% of a US LLC could be taxed at a rate of approximately 45% of its revenue (21% plus 30% on the remaining 79%), absent any applicable tax treaty provisions. The branch profits tax (“BPT”) treats the profits of a foreign company’s US branch as if they were sent back to the home office, just like a U.S. subsidiary’s dividends sent to a foreign parent and applies the same tax rate – 30% or a lower applicable treaty rate. The goal of the BPT is to prevent tax avoidance on repatriated earnings.
One might ask, “How would the IRS detect this structure?” Here is how. When a company uses Amazon, Shopify, and merchant processors, they will get a form 1099-K in February following each year. The 1099-K reports to the IRS the gross-dollar amount of transactions processed by that company for the LLC. It will have the LLC’s EIN and the IRS will be looking to match these values to a tax return. The IRS enforcement process can escalate over time, potentially leading to assessments, notices of intent to levy, jeopardy assessments, and ultimately collections actions including account garnishment and tax liens. The timeline and specific actions taken can vary based on individual circumstances and IRS procedures.
Here is a typical scenario. If IRS does not find a tax return that correlates to the 1099-Ks in the system or if the gross turnover amounts do not equal or exceed the total amounts reported to the IRS on the 1099-Ks, the IRS computer will issue correction notices starting a year later. These will come as CP2000 letters. These notices will continue and the penalties will escalate and over the next two-years the tone of the letters will get more hostile. Eventually, after about two and a half years, the IRS will issue an assessment and a notice of intent to levy. Six months later, the IRS may then generate a “jeopardy assessment” and start to impose collections. If the company does not respond to those letters within another year, accounts will be garnished and tax liens will start to be filed. This means the company will have a life cycle, under the UAE / LLC structure of about three to four years. Then it is lights out.
After the IRS issues a tax lien, enforcement shifts to collection and recovery. The lien gives the government a legal claim against the taxpayer’s property, both real and personal, within the U.S. The IRS can then seize bank accounts, intercept payments from third parties, and seize or sell physical assets such as real estate or equipment. The lien also attaches to after-acquired property, so future assets can be claimed until the liability is satisfied. Additionally, the Foreign Account Tax Compliance Act (“FATCA”) requires foreign financial institutions in countries that have a FACTA Intergovernmental Agreement with the US to report information about foreign accounts held by US taxpayers. Since enactment in 2010, the US has entered into FATCA agreements with 115 jurisdictions, including the UAE and Hong Kong.
There are also international exchange of information agreements that allow the US Treasury to go into the UAE and garnish foreign bank accounts and enforce criminal actions. Although Hong Kong suspended its mutual legal assistance treaty (“MLAT”) with the US in 2020, the US did enter into an MLAT with the UAE in 2022. This treaty provides for evidence sharing, cooperation between judiciaries, and investigation assistance between the countries. Additionally, in 2024, the US entered into a customs cooperation agreement with the UAE to exchange trade-related information and reduce customs violations in both countries. While these agreements primarily target criminal and customs cooperation, they enhance the IRS’s broader enforcement capabilities by facilitating access to financial and transactional information abroad.
One potential solution involves having the US LLC elect to be taxed as a C corporation. Under this structure, the US LLC would pay US income tax. If the US LLC functions primarily as a payment processor, with brand and product development, marketing, and capital expenditures occurring outside the United States, then under transfer pricing principles of “arm’s length pricing,” the US LLC may be allocated a “routine profit” which could range from 1%-2% of its turnover, depending on the specific facts and circumstances and applicable transfer pricing analyses. Any such transfer pricing arrangement must be supported by contemporaneous documentation and economic substance to withstand IRS scrutiny. This structuring may significantly reduce the risk of 45% taxation on gross sales, subject to proper implementation, documentation, and ongoing compliance with transfer pricing regulations. It also brings the entire structure into US tax compliance.
Here is why it works. By making the US LLC taxable as a corporation, the company’s tax footprint is “ring-fenced.” By this we mean the tax footprint for the company is now only the US LLC, which has elected to be taxed as a C Corporation (currently subject to a flat 21% federal corporate income tax rate on taxable income, subject to change by legislation). Transfer pricing becomes a vehicle to ensure the outcome is arms-length and in compliance with the tax law, and also to manage cashflow. However, transfer pricing arrangements must reflect genuine economic substance and cannot be used solely for tax avoidance purposes, as the IRS may challenge arrangements that lack business purpose or economic reality under the substance-over-form doctrine and IRC Section 482. This structure significantly reduces tax risk. By proactively structuring the US entity for corporate taxation and maintaining compliance, businesses can mitigate IRS enforcement actions and ensure long-term operational stability.