A limited liability company (“LLC”) is a common type of entity used by U.S. persons investing in or operating a business in Canada. While it may not be optimal many Canadians use LLC’s to invest in or operate a business in the United States. LLC’s can be created in a number of States and may have single or multiple members (not shareholders). For U.S. income tax purposes, a single member LLC is disregarded and a multi-member LLC is treated as a partnership unless the member(s) elect(s) to treat the LLC as a corporation. LLC’s are popular for U.S. resident individuals because the members are taxed personally but receive the same level of protection against personal liability as a corporation (not a flow-through entity) would provide. LLC’s may work well for domestic U.S. planning but become problematic once Canadian tax rules come into play.
Canada considers both single and multi-member LLC’s to be corporations for Canadian tax purposes. The difference in the treatment of an LLC in Canada and the U.S. can result in more than double taxation to Canadian or U.S. members.
A Canadian member of an LLC is taxed in the U.S. on the LLC’s profits (whether or not they are distributed), and as such will pay U.S. Federal and state tax. However, the Canadian member will not generally be taxed on the earnings for Canadian tax purposes (we will not address the Canadian Foreign Accrual Property Income (“FAPI”) rules in this Tax Tip). The Canadian member will be taxed in Canada when funds are withdrawn from the LLC. Canada generally treats these payments to be dividends from a foreign corporation, taxable at regular marginal rates in Canada.
The lack of congruence between the Canadian and U.S. tax treatments usually results in tax in the U.S. in a different year than there is tax in Canada. Even if the tax is incurred in both countries in the same year, there may only be limited ability for a Canadian member to claim a credit for the U.S. tax paid.
To make matters worse, LLC’s are not entitled to the benefits of the Canada U.S. tax treaty. The treaty is applied at the member’s level. For U.S. persons or businesses operating in Canada through an LLC, branch tax will be calculated based on the treaty entitlement of the members. For example, Canadian branch tax of 25% will apply to the extent the LLC members are U.S. individuals. A subchapter S corporation is also often a flow through entity for U.S. tax purposes but it receives treaty benefits. As such, the branch tax for a subchapter S corporation would only be 5% once cumulative profit exceeds $500,000, even though the owner is an individual.
For the reasons noted above (and the FAPI implications) LLC’s may not be the best vehicles for cross-border planning. Subchapter S Corporations are generally better for U.S. individuals doing business in Canada and limited partnerships are usually better for Canadians investing or doing business south of the border.
However, like anything in tax, there are exceptions to the rule. There are situations where LLC’s can create very good cross-border tax results. If you are considering making a cross border investment we can help you determine what structure is best for you.