The limited liability company (“LLC”) is a very common US business entity that unfortunately can cause Canadian tax problems for its owners. These problems primarily arise from a fundamental difference in how many LLCs are taxed in the US and Canada. For a Canadian corporate or individual taxpayer who owns an interest in an LLC, there are a few possible strategies to improve the situation.
1. Differing Tax Treatment of LLCs
In the US, LLCs are by default taxed as flow-through entities, meaning that every dollar earned by the LLC is treated as if it were earned directly by the owners. Note that some LLC choose to be taxed differently (see suggestion B below), but this post solely discusses LLCs treated as flow-through entities.
By contrast, Canada considers all LLCs to be taxable corporations rather than a flow-throughs. That means that Canada considers the LLC itself to earn income, while the owners don’t have to pay tax until the LLC actually pays a cash distribution.
2. Common Problems
The disconnect between the two countries’ treatment of the same entity creates ugly tax results. Canadian individual and corporate taxpayers who own LLCs can wind up with total tax rates in excess of 70% on income earned by the LLC and 50% on capital gains once all cash is in the hands of the individual owner. Those rates are well in excess of the highest Canadian tax bracket.
The technical reasons for the very tax rates will differ depending on the exact circumstances but may include:
- Income from an LLC can be taxed twice to the owner—once in the US and once in Canada.
- US tax is owed when income is earned, while Canadian tax isn’t owed until cash is distributed. This means US and Canadian tax may be owed in different years, and the owner may not be able to offset tax paid to one country against the tax liability in the other country.
- Even if the tax arises in the same year, Canada will generally not provide a foreign tax credit for the full amount of US tax paid.
- If the LLC sells assets and then pays the sale proceeds to its Canadian owner, the owner would be taxed on the full sale price rather than just the gain. This can result in the Canadian taxpayer owing over 50% tax on the return of capital invested in the LLC.
- An LLC may owe Canadian corporate tax if it is managed from Canada.
- A Canadian taxpayer who owns a US LLC may have to file Form T1134 which can result in significant penalties if not completed.
- A Canadian corporation owning a direct interest in a US LLC has all of these problems plus US branch tax owed on income or gain earned from the LLC. That makes the problem worse.
3. Possible Solutions
While Canadian taxpayers may be better off avoiding ownership in pass-through LLCs in the first place, some strategies may be available for a Canadian who already owns an interest in an LLC. Because of the complexity of the tax issues and potential solutions, each of these strategies requires detailed tax advice and the following is only a brief discussion.
A. The LLC converts to a Limited Partnership. A limited partnership (LP) is a flow-through entity in both Canada and the US, so it does not have the same problems as the LLC. The conversion is generally tax neutral in the US but taxable in Canada.
B. The LLC elects to be taxed as a corporation in the US. The US and Canadian treatment of the LLC can also be harmonized if the LLC elects to be treated as a corporation for US tax purposes, the same way it is treated in Canada. There are a few downsides with this approach:
1) The Canadian taxpayer needs to have control over the LLC or cooperation from the other owners for the LLC to make the election;
2) Going forward, the US corporation must pay US tax on its worldwide income; and
3) Distributions out of the US corporation are subject to a high tax rate in Canada.
C. The taxpayer reorganizes its ownership of the LLC. The following ownership structure resolves many of the problems:
Canadian individual
↓
Canadian corporation
↓
US C Corporation
↓
US LLC
This reorganization is complex, but may be tax neutral in the US and Canada. However, this structure results in significantly higher capital gains tax cost going forward than other structures.
D. On exit, the taxpayer sells their LLC interests rather than the LLC conducting an asset sale and distributing the proceeds. Selling the LLC units can reduce the tax liability to 26.75% of the gain (with a tax-free return of principal), while an asset sale would result in 53.5% tax on the full sale price.
E. The LLC’s management is conducted outside Canada. Unlike other legal entities, an LLC cannot use the Canada-US Tax Treaty to terminate its Canadian tax residency. To avoid Canadian residency and the accompanying Canadian corporate tax, the board of directors may wish to meet and make decisions outside Canada.
F. The LLC’s documents are amended so that it is eligible for tax free return of capital. In certain cases, it may be possible to amend the formation documents of the LLC so that a Canadian taxpayer can receive tax free return of capital.
The bottom line is that prospective Canadian owners of US LLCs should be aware of the complexity and high tax rates. However, for Canadian taxpayers who already own interests in a pass-through LLC, options may be available to mitigate the tax consequences.