By: Juan Pablo, Principal Shareholder, Greenberg Traurig; co-founder idea.me & Sauber Energy.
An emerging trend in Latin America is the significant number of Latin regional venture businesses that are using a Delaware company as a holding company for their Latin based operating group. Sometimes these are de novo holding companies and sometime these are “Delaware Flip” transactions-where a local holding company is replaced or merged (“flipped”) into a Delaware company.
There are a number of reasons why it makes sense to put a Delaware holding company at the head of Latin based operations. The main reason is that the U.S. remains the most active venture financing market in the world for technology companies. Although some American venture funds are willing to invest in foreign startups, a large number of U.S. venture funds prefer to invest into a U.S. holding company. And since Latin technology companies are almost by definition multi-country plays, they require a holding company. Thus, the U.S. (usually Delaware) becomes a natural choice.
An issue that comes up frequently is whether initially that U.S. holding company should be a C-Corp (an “Inc.”, equivalent to an “S.A.” in Latin America) or some other type of corporate entity, perhaps a Limited Liability Company (an “LLC”, a bit similar to a “Limitada” in Latin America).
Conventional wisdom is that a company that aspires to be venture backed needs to be a C-Corp. I agree that a C-Corp is the way to go for an U.S. based company with U.S. founders that is raising money from U.S. VC funds. U.S. funds and institutional investors generally resist investing into an LLC because LLCs give “K-1″/pass through income which funds want to avoid.
However, before incorporating a C-Corp as a holding company, a Latin entrepreneur must keep in mind that many Latin technology companies (i) initially aren’t going to be “engaged in a U.S. trade or business”, (ii) will have a significant percentage of non-U.S. owners/investors and (iii) will likely not receive initial seed round of financing from U.S. VC funds.
While many Latin entrepreneurs expect to raise money in the future from U.S. VC funds, many Latin entrepreneurs might find (as several of my LatAm entrepreneurs clients have found recently):
(i) they end up raising their Series A capital from a wealthy Latin family or Latin based funds,
(ii) they end up selling the company faster than they expected (without bringing in a U.S. fund), or
(iii) once their business gets going they decide they don’t need a U.S. based holding company to raise funds and they decide to move the holding company to Spain, Luxembourg or Holland (which have better tax treaties with Latin American countries) before their institutional capital raise.
Latin American entrepreneurs that flip into a C-Corp at an early stage will face:
(i) double U.S. taxation–that is, worldwide earnings will be subject to U.S. corporate income and U.S. dividend withholding tax,
(ii) in many cases the inability to relocate the holding company outside of the U.S. without triggering U.S. tax, and
(iii) the C-Corp will pay U.S. tax on the income of its non U.S. subsidiaries (in certain cases these taxes may be credited against the C Corp’s U.S. corporate tax liability).
Often an LLC holding company can be viewed as a free option. A company can usually go from an LLC to a C-Corp without triggering U.S. tax. Such a conversion requires some straight-forward paperwork and the holding company retains its taxpayer ID number so it maintains the same bank account. On the other hand, the conversion from a C-Corp to a LLC is treated as a de facto sale, and thus is a taxable transaction in the U.S.
To summarize, the tax benefits/considerations of an LLC for a non U.S. based business are:
(i) The LLC won’t be subject to U.S. federal or state income tax (in most states) on its earnings derived from the non-U.S. subsidiaries because the LLC is not a taxpayer in itself.
(ii) The Non-U.S. Members won’t be subject to individual U.S. federal or state income tax return filing requirements on their earnings derived from the LLC, so long as the LLC is not engaged in a U.S. trade or business and the LLC does not earn U.S. source income
(iii) The U.S. Members will get to deduct their pro rata of the losses the LLC generates in the first few years (until the LLC is profitable) against their current U.S. (often passive) income.
(iv) The U.S. members should in many cases be able to obtain favorable U.S. long-term capital gains rates on their sale of the LLC interests.
(v) The LLC holding company can sell the downstream entities (the Latin American subsidiaries) without any U.S. tax to the non-U.S. members. And the LLC holding company can relocate outside of the U.S. in the future without the relocation being treated as a “sale”.
These tax benefits are why Brazil considers U.S. LLC’s tax haven type entities (“privileged tax regime” in the words of the Brazilian tax authorities).
An LLC will have to adhere to certain reporting requirements which create some administrative borders. The LLC will be subject to U.S. reporting requirements on an annual basis, consisting of: (a) a Form 1065 reporting the LLC’s income, gain, losses, deductions and credits and allocating such items among its members; (b) an FBAR with respect to its non U.S. financial accounts, as well as the non-U.S. financial accounts of certain of its subsidiaries if certain conditions are met; (c) disclosure forms with respect to ownership of non-U.S. companies, such as Form 5471 for the non-U.S. subsidiaries down the chain of ownership; and (d) an annual filing with the Delaware Department of Corporations and payment of $250 annual tax. In some cases, the use of the LLC may cause the underlying non-U.S. corporations to be “controlled foreign corporation,” which could have adverse affects on the U.S. members. This usually can be avoided with proper planning.
Also the Non-U.S. members/owners of the LLC will be required to obtain a U.S. tax identification number for purposes of allowing the LLC to fulfill its U.S. tax reporting obligations. If the members do not wish to apply for a U.S. tax identification number, they could consider using a non-U.S. corporation to hold their interest in the LLC so the non-U.S. corporation applies for such U.S. tax identification number instead of them individually.
In short, using LLCs always raises some static in venture companies. While C-Corps work well for U.S. based venture companies, the considerations are very different when non U.S. based operations and non U.S. founders are involved. Before “flipping” into an U.S. C-Corp, Latin entrepreneurs should at least consider the advantages of using an LLC.
Juan Pablo is a Principal Shareholder in the Latin American Group of Greenberg Traurig, an international 2,000 lawyer law firm. Juan Pablo was the general counsel and a director of Patagon.com, which was sold to Banco Santander for a transaction value of over US$750 million.
Juan Pablo is also a well known entrepreneur and deeply involved in supporting venture capital in Latin America. He co-founded (i) www.idea.me, the first Latin America crowdfunding site and (ii) Sauber Energy, a green energy company in Chile that resolves the problem of “harmonics” in the electrical grid, while remaining a serial ”seed investor” supporting many projects including Senzari (an international music site like Pandora only better), Urbita (a regional travel site), and LinkedStore (an Argentina site that supports SMEs).
He also serves on the advisory board of the Pino Entrepreneurship Center at Florida International University, as well as the advisory board of the Institute of Global International Effectiveness at the Kelly School of Management, Indiana University.