On February 22, 2017, the Tel-Aviv District Court reached a decision in a case concerning the taxation in Israel of a limited liability company formed under the U.S. Limited Liability Company’s law (“LLC”).[1] For many years, the Israeli tax authorities (“ITA”) have considered (and debated) the appropriate tax treatment applicable to Israeli taxpayers’ profits earned through LLCs. The ITA have had to decide whether to treat such companies as pass-through entities for tax purposes (i.e., single layer of tax) or whether to treat them as a corporation (i.e., double layer of tax, one at the corporate level, the other at the shareholder level, upon dividend distributions), whether such companies are entitled to enjoy the beneficial provisions of the tax treaty between the United States and Israel, or whether tax paid in the United States may be used against the tax liability in Israel.

The ITA chose a hybrid treatment, where the company is not entitled to treaty benefits, it is pass-through only with respect to income and tax credits, but not for losses.  It is worthwhile to note that in order to receive such pass-through treatment, a taxpayer must file an election with the ITA, together with the first tax return filed with respect to the LLC. The ITA had not issued a form on which such election should be made, and the failure to file such election, cannot be cured.

Facts of the Case:

Mr. Yaakov Harel is the sole owner of Yono Simul Ltd., an Israeli company (the “Company”) that is classified under Israeli law as a ‘family company’ and thus its profits are taxed at the hands of a specified individual shareholder owning the company. We assume (and it has not been discussed at court) that the Company had filed IRS Form 8832 with the Internal Revenue Service (the “IRS”) to be classified as a pass-through company in the United States.

The Company owns two-thirds of the membership interests in a Delaware limited liability company (the “LLC”), which, as a default, under U.S. law, is, too, classified as a pass-through entity, and therefore, the LLC’s income is considered to be gained directly by its interest holders. In the event there are more than one holder, a limited liability company would be classified as a partnership and each holder will be liable to pay tax on his/her/its pro rata share of the limited liability company’s income, and if the limited liability company is owned by a single entity, then it would not be regarded as an entity for tax purpose. It will, however be regarded as a separate entity for corporate law perspective. Given our assumption that the Company elected to be classified as a transparent entity for U.S. tax purposes, consequently, its income is taxed directly at Mr. Harel tax return in the United State, based on Mr. Harel share of such income.  

When Mr. Harel filed his tax returns in the United States, he included, as required by law, the income of the LLC allocated to him, which allocation requires a tax withholding. Under the Internal Revenue Code of 1986, as amended (the “Code”), allocation of income (and not necessarily actual distribution) to a foreign resident requires tax withholding.  

Taxation of limited liability company:

Under the U.S. corporate law, a limited liability company is generally treated as a separate legal entity, which its owners enjoy limited liability on the one hand and enjoy the ability to elect its form of taxation on the other hand. Shareholders in a corporation are usually taxed twice – once at the corporation level and again when dividends are distributed to shareholders. A partnership is a pass-through entity, whose income is taxed at the partners’ level alone. Unlike Israel, the United States allows owners of limited liability company to determine whether to be taxed as a corporation, or as a partnership. The United States even allows limited liability company owners to change their mind and, subject to certain limitations, alternate between the taxation methods.

The Israeli Tax Authority and the courts, as reflected from the Harel decision, regard limited liability companies as corporations – personal tax on top of the corporate level tax. Israel does not differentiate between the company’s legal classification and its classification for tax purposes. However, the Israeli Tax Authority issued in 2004 a notice (the “2004 Notice”) allowing holders of limited liability companies to elect to be treated as a pass-through entity and to offset tax paid in the United States against their Israeli tax liability. However, Israel does not allow a holder of a limited liability company to offset the limited liability company’s losses against his personal income, or even to offset losses of one limited liability company against another limited liability company owned by the same taxpayer.

The court has concluded that Mr. Harel paid the tax in the United States due to the LLC’s pass-through classification (i.e., taxes paid on the LLC’s business income) and that the tax paid in Israel was for gains distributed from the LLC as a corporation, hence the U.S. taxes are not creditable. The Israeli Income Tax Ordinance (the “Ordinance”) provides that taxes paid to a foreign country should be used to offset against tax liability in Israel only in circumstances where the tax is paid on the same basket of income (active, passive). As Mr. Harel’s taxation in the United States was classified as business income (active), and in Israel as dividend income (passive), the court did not allow the treatment provided under the 2004 Notice and therefore, did not allow an offset.    

The differences between the Israeli and the U.S. tax laws create discrepancies and, in many cases, double taxation, which has attracted criticism (and tax planning) by practitioners in Israel for many years. Moreover, the United States allows a taxpayer who holds interests in two separate limited liability companies to offset the profits of one company against the losses of the other, taxing only the true economic gain, whereas Israel does not allow such offset; therefore, a taxpayer whose losses overcome profits may end up paying tax on an economic loss.    

LLC and Tax Treaties:

In an obiter, the court added that limited liability companies are not entitled to benefit from the tax treaty between Israel and the United States. A discrepancy occurs once again, as the United States does not set such limitation. The United States allows limited liability companies to enjoy the benefits of a treaty by deeming the income as direct income of its holders. For instance, a limited liability company held entirely by an Israeli taxpayer will enjoy, in the United States, the benefits of the tax treaty between Israel and the United States, while a limited liability company held by an Israeli taxpayer and a U.K. taxpayer would enjoy (a) the tax treaty between Israel and the United States with respect to the Israeli holder’s allocable share of the income of the limited liability company and (b) the tax treaty between the U.K. and the United States with respect to the U.K. holder’s allocable share of the income of the limited liability company.

Many U.S. citizens choose to invest their money in Israel through limited liability companies, which provide them with the limited liability and one level of tax, as discussed above. However, the discrepancy that results from the inapplicability of the tax treaty between Israel and the United States with respect to income derived by U.S.-owned limited liability companies is driving many U.S. investors to seek creative tax planning.


The court decision provided with a thorough review of the ITA’s policy towards the taxation of limited liability companies and their owners, which, as we saw, are deemed as companies for all purposes. Such interpretation is not aligned with the law in the United States, which results in discrepancy and which requires carful tax analysis and planning.

Most of the foreign investments in Israel, by U.S. investors are done through the use of limited liability companies because it provides the holders of such companies with the limitation of liability protection and a pass-through tax treatment in the United States. Many of the investments in the United States by Israeli investors are also done through the use of limited liability companies for the same reasons, and because, in certain circumstances, it may protect non-U.S. persons from the U.S. estate tax, which taxmay not be offset against any tax in Israel. We believe that Israeli lawmakers and the ITA should reconsider Israel’s existing policy and adopt the United States’ flexible tax treatment of limited liability companies.