Cross-Border Tax Issues: Are Suitable LLCs For Canadians?
by George Gonzalez
The Limited Liability Company (LLC) is a popular type of entity with U.S. investors. It is distinct from other entity types such as corporations, partnerships, and limited liability partnerships.
The first state to enact LLC legislation was Wyoming, in 1977. In 1982, Florida enacted its own LLC legislation. For many years, however, LLCs were not that popular among U.S investors, mainly because it was uncertain how the Internal Revenue Service (IRS) would treat the LLC for U.S. tax purposes.
Would the IRS treat it as a partnership? A corporation? For several years there was little guidance on this.
Finally, in 1988, the IRS ruled that an LLC would be treated as a partnership for tax purposes, or as a “disregarded entity” if it had only one owner. This means that all of the LLC’s income, deductions, etc., are passed through directly to the partners, or sole owner, and reported in their U.S. individual income tax returns as if the LLC operated as a partnership, or sole proprietorship.
In contrast to this special treatment for LLCs, a corporation is taxed on its taxable income as a separate taxable entity, and therefore pays tax on that income.
The IRS ruling was viewed favorably by U.S. investors: most considered it better for tax purposes to have their LLC treated as a partnership than having it treated as a corporation subject to its own U.S. taxation.
LLCs became very attractive among U.S. investors as an investment vehicle because the LLC’s members are taxed personally, rather than the LLC itself being taxed, yet the LLC’s members receive limited legal liability protection, as is the case with a corporation’s shareholders.
Limited legal liability means that the entity’s owners—LLC owners in the case of a LLC, and shareholders in the case of a corporation—are generally not personally liable for the debts incurred by the business or as a result of lawsuits. Creditors therefore can’t collect against an LLC owner’s personal assets—instead, they are limited to collecting from the LLC’s assets. In other words, the liability of a LLC member, like that of a corporate shareholder, is limited to the amount of their investment in the company.
After the 1988 IRS ruling, nearly every state in the U.S. enacted a LLC statute. The LLC has since been a widely used business form by U.S. investors. From many U.S. investors’ point of view, the LLC offers the best of both worlds: limited legal liability with flow-through income taxation.
The LLC’s members include their allocable portion of the LLC’s taxable profits and losses in their U.S. individual income tax returns. It is worth noting that this is regardless of whether net profits are distributed by the LLC to its members. Distributions or no distributions, each member must include in their individual tax return their allocable share of the LLC’s taxable profits. On the other hand, LLC distributions to members (withdrawals) are not taxable, regardless of when they occur.
The IRS also allows LLCs to elect to be treated for tax purposes as a corporation, rather than as a partnership or disregarded entity. If such election is made by the LLC, it pays its own U.S. taxes as a taxable corporate entity. To make this election, the LLC must file a designated form with the IRS. Depending on circumstances, it could be advantageous for the LLC’s members if their LLC is taxed in as a corporation rather than as a partnership or disregarded entity. In such cases, the LLC can elect to be taxed as a corporation.
There could also be situations in which an LLC is initially treated as a partnership for U.S. tax purposes but later when conditions change, the LLC’s members decide to switch to corporate treatment and file the election to be treated as a corporation for U.S. tax purposes with the IRS.
The popularity of LLCs among U.S. investors later led to some countries following suit and enacting their own LLC legislation, in an effort to attract business from U.S. investors. One popular jurisdiction for LLC formation, for example, is Nevis. Its LLC laws are modeled after those of the U.S.
Why would a U.S. investor form an LLC in another country, e.g., Nevis, rather than in the U.S.? For at least two reasons. First, because a foreign LLC may facilitate investing in foreign markets and, second, because it could offer stronger asset protection, i.e., protection against creditor lawsuits, than a U.S.-based LLC.
With this background, let’s look at the Canadian tax ramifications of LLCs.
LLCs Are Not Recognized As A Distinct Entity In Canada
A U.S. partnership is treated as a partnership in Canada. A U.S. corporation is treated as a corporation in Canada. A U.S. LLC, however, is not recognized as a distinct entity under Canadian tax laws. Instead, an LLC is treated as a corporation in Canada.
This difference in the Canadian tax law treatment of LLCs versus that of the U.S. can have confusing and oftentimes disadvantageous tax results for the LLC in general and Canadian LLC members in particular.
Let’s look at a couple of examples.
#1: U.S. LLC Doing Business In Canada
A group that sells household products to retailers is expanding their business into the Canadian market. The group forms a U.S. LLC to establish operations in Canada and facilitate sales to Canadian customers. All of the LLC’s income is Canadian-source income.
The LLC has three members: one is a Canadian resident and the other two are U.S. residents.
For U.S. tax purposes, the LLC is treated as a partnership—its taxable profits and losses flow through to its members. The two U.S. members, therefore, include their allocable share of the LLC’s taxable profits and losses in their U.S. individual tax returns.
The Canadian LLC member, a resident of Canada, is not taxable in the United States, but is subject to Canadian taxation. However, since the LLC is treated as a corporation in Canada, the Canadian member does not report its allocable share of taxable profits and losses in their Canadian individual income tax return, as the U.S. members do in their individual U.S. tax returns. Instead, the LLC would be subject to Canadian corporate taxation: it would pay Canadian corporate taxes as if it were a foreign corporation doing business in Canada.
The amount of taxes payable to Canada will depend on several factors, such as whether the U.S. LLC has a “permanent establishment” in Canada and whether it is subject to the branch profits tax for foreign corporations doing business in Canada. Regardless, the main point is that the LLC will pay be treated as a corporation under Canadian tax law.
When the LLC makes distributions to its Canadian members, they will have to declare those dividends as income in their Canadian individual income tax returns, resulting in double taxation. For the U.S. members, this means that the same profits that are included in the U.S. members’ individual U.S. tax returns as allocable LLC income are also taxed at the corporate level (corporate profits) and individual level (dividend income) in Canada.
This is a bad outcome. A better approach would have been to use a U.S. corporation rather than a U.S. LLC, or perhaps even set up a Canadian corporation for doing business in Canada. One would have to look at the complete picture to determine what would be the most tax efficient structure.
With either of these latter two options, the corporation would pay its own taxes, while it could pay salaries and/or make dividend payments to its owners, depending on what would work best, considering all factors.
The corporation and its owners might also be able to avail themselves of the provisions of the Canada-U.S. tax treaty to minimize or eliminate potential double taxation.
#2: Nevisian LLC Doing Business In Central America
A group that sells household products to retailers is developing business in Central America. It forms a Nevisian LLC to establish operations in Central America and facilitate sales to Central American customers. The LLC has three members: one is a Canadian resident, and the other two are U.S. residents.
Depending on the countries in Central America in which the LLC is conducting business, there may be corporate and/or individual taxes payable to those countries. Assume that corporate taxes are paid as required to Central America taxing authorities. For U.S. tax purposes, the LLC is treated as a partnership—its taxable profits and losses flow through to its members. The two U.S. members therefore include their allocable share of taxable profits and losses in their U.S. individual tax returns.
In line with the discussion above about the Canadian tax treatment of LLCs, Canadian tax law would view the Nevisian LLC as a corporation. However, since the LLC is not conducting business in Canada there would be no Canadian corporate taxation of the LLC.
For the Canadian LLC member, the allocable share of the LLC’s taxable profits and losses would not be included in their Canadian individual tax return, unlike with the U.S. members having to include their allocable share of the LLC’s taxable profits and losses in their U.S. tax returns.
When the LLC makes distributions to its members, the Canadian member will include those distributions in their individual income tax return as dividend income, while the U.S. members would have no tax consequence from those distributions. (the U.S. members will include their allocable share of the LLC’s profits and losses in their tax returns).
If LLC distributions are made after a number of years of accumulation of profits, instead of annually, the Canadian member would have to effectively include multiple years’ of their allocable share of profits in their individual tax return, possibly putting those LLC distributions, which are treated as dividend income by Canada, into a higher tax bracket than would otherwise be the case if profit share allocations had been distributed annually.
In this second example the outcome does not look as bad as in the first example. Nevertheless, there could be taxation “timing differences” for the three members, i.e., the Canadian member could end up paying Canadian taxes on their share of the LLC’s profits in different years from the U.S. members’ paying their U.S. taxes on their share of the LLC’s profits and, as mentioned, could potentially be put into a higher tax bracket. From an accounting and administrative standpoint, this could be messy and burdensome.
There are other provisions in Canadian tax law that must be considered and could make the use of an LLC in the above situations, in which there are both Canadian and U.S. members, even more complex. A complete discussion of these is beyond the scope of this article, but I will briefly mention some of them.
One Canadian tax law provision that must be contended with relates to the definition of corporate residency. A corporation (or LLC) formed outside of Canada is often immediately thought of as non-resident in Canada. This would not necessarily be the case, though.
Canadian tax law looks at where the corporation’s “central management and control” is located to determine residency. If the corporation’s or LLC’s management (board of directors, etc.) are composed of individuals that reside in Canada, or if management otherwise lies preponderantly in Canada, then under Canadian tax law the corporation or LLC would be considered resident in Canada. Accordingly, the corporation or LLC would pay Canadian taxes on its worldwide income.
It is possible that the corporation/LLC may be deemed a resident of Canada and simultaneously a resident of the country in which it was formed, or possibly even another jurisdiction in which it conducts business. One must look at any applicable tax treaties between Canada and the other jurisdiction(s) to resolve such conflicts in residency. In the absence of a tax treaty, resolving the conflict becomes more complicated.
Another Canadian tax law provision that may have to be considered is the Foreign Accrual Property Income (FAPI) rules. These rules, which apply to foreign corporations that are majority-owned by Canadian residents and earn passive income, are discussed in a separate article on Canadian taxation and foreign corporations in these web pages.
The purpose of this article is to shed light on the potential tax consequences to Canadian investors using LLCs. In the two simple examples presented, the overall tax consequences to the LLC and its members, including the Canadian member, were disadvantageous.
For the Canadian resident taxpayer, it is best to proceed with caution, and preferably seek competent professional advice, when considering the use of an LLC.