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Canadians and LLCs - Don't Use Them in the US

Submitted by inclawyers on Wed, 17/03/2010 - 2:10pm

When a Canadian business owner thinks about setting up in the US, often the first question is what kind of corporate structure should be used.

In simple terms, the choices available for a business structure in the US are similar to the choices available in Canada. The reason why different structures exist is that they allow different combinations of limited liability and tax treatment for the entity and its owners.
 

  • Unincorporated: which is done by being a proprietor (if there's a single owner) or through a general partnership (if there's more than one owner). The drawback of this choice is that the business owner does not obtain the benefit of limited liability. The proprietorship or partnership itself is not a taxable entity; the net income or loss is passed through to the actual owners and taxed in their hands personally.
  • Limited partnership: A limited partnership does gives liability protection to the limited partners, but only if those persons do not participate in the business. The general partner takes on all the liability -- and for that reason is often an incorporated entity to protect whoever is actually behind the GP. But this is a somewhat complicated structure to set up and for a typical business owner is probably not going to work. Tax treatment is that same as for an unincorporated business.
  • Corporations: In Canada, we generally have only one flavour. It's a limited liability entity that is taxed at the corporation level, and distributions to shareholders (dividends) are then taxed at the shareholder level. In the US, there is one kind of corporation as such, but under their tax system, a corporation may elect to be a "C" corporation or an "S" corporation. A "C" corporation means that the entity itself pays regular corporate income tax. An "S" corporation is treated as a flow-through entity. Note, however, that the "S" election is no good to anyone other than a US taxpayer. (So Canadian businesses can ignore that distinction.)
  • Hybrid entities: These aren't available in Canada, but they are available in the US, usually under the name "limited liability companies" (LLCs). Their beauty is that they provide the same limited liability that shareholders of corporations have, but with the flow-through tax treatment that an unincorporated business has.
Now before we all decide to move permanently to the States to take advantage of the LLC structure, be aware of this key difference: the US corporate tax system allows for significant double taxation, and Canada's tax system (on the whole) doesn't. Double taxation means that the corporation will pay tax at the usual rates on its net income, and then the shareholder will pay tax again if dividends are distributed to the shareholder from that net income.
In the jargon of the tax policy specialist, Canada's tax system is "integrated". In general terms, integration means that the total tax paid to all levels of government on any given net income will be roughly the same, regardless of whether the income is earned through a corporation and then paid by dividends to the shareholders or whether the income is earned through an unincorporated business.

From the number of accounting and tax law firms in Canada, you've probably guessed by now that it's more complicated than that, but on the whole in Canada the existing levels of corporate income tax rates, dividend tax credits, and personal income tax rates do an excellent job of preventing the double taxation that might otherwise happen in the US. Integration means that our income tax legislation is more complicated, though.

The tax policy choice in the US has been to allow double taxation if a corporate structure is used (their tax code is already complicated enough). The US solves the double tax problem by providing a greater choice of tax treatment and legal entity than we have in Canada.

A further complication for a country's tax system arises when a business goes cross border. When that happens, the results from one tax system (the US) have to be made to work with the results from an entirely different tax system (Canada's). For that reason, Canada has entered into tax treaties with many other countries around the world, including the US. One of the main reasons behind such tax treaties is to prevent double taxation between countries. In general, with a tax treaty in place between two jurisdictions, if a business pays tax in one jurisdiction, the other jurisdiction will recognize and credit any foreign tax paid.

All of this discussion is a long introduction to point the reader to a good article at today's Globe & Mail newspaper making the point that Canadian business owners who wish to set up operations in the United States should form a US corporation and not a LLC structure.

If a Canadian taxpayer uses an LLC to do business in the US, the tax treaty system breaks, and using the LLC will expose the Canadian to significant double taxation.

For that reason, Canadian businesses are usually best off forming a standard US corporation that is then owned by a Canadian corporation. The US corporation (which will choose the "C" election for US tax purposes) will pay tax in the US, and pay dividends up to the Canadian parent. There may be some withholding tax on the dividends (at the rate established by the US/Canada tax treaty), but any such tax paid will qualify for a credit for Canadian tax purposes.

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