Legal Nature of LLCs for Tax Purposes
Federal Supreme Court – Case no. 2C_894/2013 and 2C_895/2013, 18 September 2015
A Swiss taxpayer held a 50% interest in a U.S. limited liability company (LLC), incorporated in Wyoming.
The remainder of the shares were held by their business partner, a U.S. citizen.
On 10 August 2007, they entered into an “Exclusive Option Agreement to Purchase Units and No-Shop Agreement”, in which the taxpayer, for the amount of $3 million, granted the partner the exclusive right to purchase the taxpayer’s share of the LLC. In exchange for granting the exclusive right, the parties agreed that the taxpayer was to receive $687,500.
The option was to be exercised by 31 December 2007 but foresaw the possibility of a 1-year extension if payment of a further $687,500 was made. Despite the LLC transferring $682,500 and $694,845 in 2007 and 2008 to the taxpayer, the partner ended up not exercising their option.
Subsequently, the tax administration of the Canton of Thurgau concluded that the payments constituted ancillary income from a self-employed activity and were, therefore, subject to individual income tax. The taxpayer disagreed, stating that the payments were to be treated as capital gains and were therefore tax-exempt.
The decision of the cantonal tax administration was upheld by the cantonal tax commission as well as by the administrative court. The Taxpayer filed an appeal to the Federal Supreme Court.
The primary issue of the case was whether the payments made by the US-based LLC to the Swiss taxpayer were to be treated as a tax-exempt capital gain for granting option rights to purchase share capital or as ancillary income from the self-employed activity.
Additionally, the court elaborated on how the LLC was to be characterized i.e. whether it was to be viewed as a partnership or legal entity for Swiss tax purposes.
The Federal Supreme Court initially elaborated on how LLCs in the United States are treated for tax purposes concluding that the United States generally treats LLCs as transparent entities, akin to partnerships.
The Court furthermore held, that in Switzerland, LLCs are to be treated as partnerships and not as legal entities. This resulted in the LLC being viewed as transparent for tax purposes.
This characterization was in line with the OECD Partnership Report and Art. 3 (1) (c) of the Switzerland-United States Income Tax Treaty (1996).
Additionally, the Court determined that the taxpayer’s share in the LLC constituted a business asset and the payments received thereof were deemed taxable income from self-employed activities in accordance with Art. 18 of the Federal Direct Tax Act and cantonal tax regulations.
Lastly, the Federal Supreme Court held that taxation of the payments as income from self-employment did not violate the rules of the Swiss-American Tax Treaty.
In conclusion, the taxpayer’s appeal was rejected, and the payments remained taxable ancillary income.