A limited liability company (LLC) is a very common legal structure in the U.S. through which many U.S. businesses and real estate ventures choose to operate. The income of an LLC flows through to its owner(s) and it offers liability protection similar to a corporation. For U.S. tax purposes, if an LLC has only one owner, it is considered a “single-member” and a “disregarded entity”; in this case, there is no requirement for a separate tax return and the income/loss of the LLC is reported by the owner directly (for example, on the personal tax return if owned by an individual). If an LLC has multiple owners, it is treated like a partnership; a separate partnership tax return is required, but the income/loss of the LLC is reported by the owners in proportion to their ownership percentage.
Problem
There is an inconsistency for Canadian tax purposes that cannot be understated. For Canadian tax purposes, all LLC’s are treated like corporations. This means that the income from an LLC does not pass through to the owners on an accrual basis as it does for U.S. tax purposes. Rather, it is taxable only when there is a distribution to the owners, much like a dividend.
This can be problematic as there is potential for income to be reported in different periods on either side of the border. In the U.S., the income is always recognized in the period in which it is earned, whereas it could be taxable in Canada in a later period if actual cash distributions are deferred. This can lead to a lack of coordination of foreign tax credits and ultimately result in double taxation.
Additionally, an LLC, while a U.S. entity, can be deemed to have a Canadian corporate branch if it is managed from Canada. This would trigger Canadian corporate filings and potential tax in Canada.
Approach
When seeking out any kind of venture as a cross-border investor, the most straightforward mitigation tactic is to avoid an LLC setup. U.S.-based promoters of real estate or business deals often do not cater to Canadian investors and insist on a LLC setup that generally benefits their domestic partners. Therefore, it may be worthwhile to seek out Canadian-based promoters who tend to utilize U.S. limited partnerships, a structure that avoids all the aforementioned issues for Canadian investors.
If a Canadian is compelled into investing in a LLC structure, perhaps because of the reluctance of U.S. counterparts to operate through an alternative structure, there are certainly options available in mitigating the potential double tax. These strategies can involve equalizing the tax treatment in both countries or layering ownership in the LLC through other entities such that the income will not be subject to direct Canadian taxation.
Disclosure Requirements
There are certain disclosure requirements Canadians should be aware of that fall outside of standard tax returns and attract harsh penalties if ignored. On the U.S. side, Form 5472 may need to be filed annually to report ownership by and transactions with non-U.S. individuals or entities. On the Canadian side, T1134 may need to be filed to report similar information.
GG Observations
If an LLC cannot be avoided, you should work carefully with an advisor that can understand your venture and help structure your holdings appropriately so that the adverse Canadian tax consequence do not eat up your return on investment. There are also potential solutions available even after LLC ownership has been established, especially if not much time has elapsed. Grewal Guyatt LLP has cross-border tax experts with a deep knowledge of taxation and compliance requirements on both sides of the border. Please do not hesitate to contact us.
