Limited liability company – Tax authorities

Introduction – Reducing your tax burden when investing in the United States

A variety of tax-efficient vehicles are available to Canadians buying and holding assets or doing business in the United States. As a general rule, it is best for Canadians to avoid using a limited liability company (LLC), a popular investment vehicle that is only available south of the border. Canadian and US tax authorities classify an LLC differently, and this difference often results in double taxation of a Canadian taxpayer who is a member of an LLC. Therefore, Canadian taxpayers are generally advised to avoid using LLCs to structure their affairs. In light of recently lowered U.S. federal tax rates, there is a more tax-efficient investment structure for those doing business or looking to invest in the United States.

What is a Limited Liability Company?

A Limited Liability Company (LLC) is a hybrid structure with the characteristics of both a corporation and a partnership. Like a corporation, LLC offers legal liability protection to its members, and similar to a partnership, this investment entity offers transfer treatment for tax purposes.

Uniquely, an LLC can choose how it is taxed under United States tax laws. It can be treated as an ignored entity, partnership or corporation. As a disregarded entity, LLC income is taxed in the hands of the LLC member alone. When designated as a partnership, the income of the LLC is allocated among the members of the partner LLC in accordance with their partnership agreement and taxed in the hands of each partner. As a corporation, the LLC’s income is subject to corporate tax rates and its distributions are taxed in the hands of the members of the LLC, in the same way as corporate dividends are in the hands of the shareholders of a corporation. society.

Double taxation problem: how is a limited liability company taxed in Canada?

The Canada Revenue Agency (CRA) classifies LLCs as a corporation for tax purposes. This means that many of the tax efficiencies provided by the LLC resulting from its “transfer” treatments under United States tax laws are not available to Canadian taxpayers.

The classification of the LLC as a corporation by the CRA has a number of implications for Canadian taxpayers who are members of an LLC. First, if Canadian residents control the LLC, the CRA will likely treat that entity as a Canadian resident corporation. Common law rules dictate that the residence of the “directing mind” of a corporation, in this case the Canadian taxpayers who are members of the LLC, determines the residence of the corporation. If the LLC has elected to be treated as either a disregarded entity or a partnership under US tax laws, there is a mismatch in its classification under Canadian and US tax laws.

The mismatch in LLC classification under Canadian and US tax laws results in double taxation. The LLC must report its income to the United States Internal Revenue Service (IRS). As an overlooked entity or partnership, the IRS taxes LLC income in the hands of members of the entity, subject to individual personal tax rates. The LLC, as a Canadian resident corporation, also has the obligation to report its income to the CRA and is therefore subject to Canadian corporate tax rates. The same income is therefore taxed twice. There is no remedy for this double taxation.

The tie breaker rules of the Canada-U.S. Tax Treaty cannot be applied to remedy double taxation. The Treaty tiebreaker rules are set out in Article IV(1) and apply where an entity is subject to tax in both Canada and the United States. As an overlooked entity or partnership, the CLC is only subject to taxation in Canada and therefore the tie breaker rules are not triggered.

It is important to note that not only is the same income taxed twice, but also that tax credits that would otherwise be available to shareholders of a foreign corporation are not available to LLC members. The same income is taxed again when the LLC distributes the income to its Canadian resident members. Because the CRA treats the LLC as a corporation, its income is taxed once at the corporate level, and once the dividends are distributed, the income is taxed once again in the hands of the shareholders, in this case the members of the LLC. Because the LLC is likely considered a Canadian resident corporation, the LLC member cannot apply the foreign dividend tax credit to account for tax already paid to the IRS. As a result, the income is taxed once again in the hands of the Canadian taxpayer who is a member of the LLC.

Tax advice from a Canadian tax lawyer for a limited liability company

Generally, using LLCs as an investment vehicle is not only tax inefficient, but also a cumbersome choice for Canadian taxpayers. There are exceptions to this rule. Given the recently reduced federal tax rates in the United States, there are circumstances where using an LLC offers Canadians an optimal choice for organizing their affairs. The suitability of the LLC depends on the individual circumstances of a particular taxpayer. Speak to one of our experienced Toronto tax attorneys about your tax planning options when investing in real estate or other assets in the United States. Planning a tax-efficient structure has the potential to significantly reduce your tax burden and therefore free up more capital for investment and business purposes.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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