Investing in U.S. LLCs: The Canadian Perspective

By Patrick Westaway

Canadians investing in the U.S. are frequently asked do so through U.S. limited liability companies (LLCs). Unfortunately, while this structure works well for U.S. taxpayers, it represents a serious tax trap for Canadians. And. while these traps can generally be avoided by interposing a U.S. C-Corp, doing so raises additional issues. The nature and purpose of LLCs and C-Corps, and the tax issues they raise, are the subject of this brief note.

What are LLCs and why are they used?

The LLC is a form of corporation unique to the U.S. As corporations, LLCs are separate legal entities and limit the liability of their shareholders; but, provided that a certain box is ticked in their tax filings, they are disregarded for U.S. income tax purposes. So, instead of paying income tax at both the corporate and shareholder levels at the aggregate rate of (in round numbers and making various assumptions^{[1 ]}) 50% in the case of “qualified dividends” and 62% in that of non-qualified dividends, income tax would apply only at the shareholder level at the comparative rates of 31% and 48% applicable to individuals.

In contrast, the Canadian system is based on “integration”, according to which a “gross-up and dividend tax credit” mechanism reduces the tax otherwise payable by the individual shareholder so that the aggregate income tax paid at the corporate and shareholder levels approximates the tax that would have been paid by the shareholder alone if the shareholder had earned the income directly. For example, the combined top marginal federal and Ontario rate applicable to ordinary income earned by an individual in 2023 is 53.53%. If such income were earned through a corporation, the effective combined rate at the corporate and shareholder levels would be 53.51%. LLCs therefore address a problem particular to the U.S. tax system.

Why should Canadian investors avoid investing in LLCs directly?

On the U.S. side, if the LLC is a disregarded entity then the LLC’s members (“member” being the term applied to a shareholder of an LLC) would be considered to carry on the LLC’s business directly. Canadian members would, therefore, be subject to all of the U.S. tax filing obligations and liabilities that this entails. Further, an LLC carrying on business in the U.S. would typically have what is known as a “permanent establishment” within the meaning of the Canada-U.S. Tax Convention (1980) (the “Treaty”) such that a treaty exemption would be denied to the Canadian member.

Matters are worse on the Canadian side. From the Canadian perspective, an LLC is a corporation like any other. It’s status as a disregarded entity is not recognized. Accordingly, U.S. income tax paid by the LLC’s members is considered to have been paid on the LLC’s behalf rather than on the members’ own. Canadian members would therefore be denied foreign tax credits for the U.S. income tax they paid, resulting in double tax when the net profits are distributed as dividends and subjected to Canadian income tax.

For the sake of completeness, it should be noted that a similar problem would arise if a Canadian business were to use a (disregarded) LLC to expand into the U.S. In that case, the mind and management would be in Canada such that the LLC would be resident in Canada notwithstanding its incorporation in the U.S. The LLC would therefore have dual residence and so be taxable in both jurisdictions. And, because the LLC would not be taxable in the U.S., it would not be considered U.S. resident for purposes of the Treaty such that the Treaty’s tie-breaker rules would not apply.

What are C-Corps and what additional issues do they raise?

The usual solution to all of the above problems is to use a C-Corp as a “blocker”. A “C-Corp” is an ordinary, fully taxable, corporation named in reference to subchapter “C” of Chapter 1 of the U.S. Internal Revenue Code. The C-Corp would hold the LLC units (“unit” being the term applied to an LLC’s shares) and would in turn be owned by the Canadian investor.

While the C-Corp would solve the problems identified above, new issues would arise which would vary with the circumstances. For example, whether the Canadian investor is a corporation or an individual will determine the availability of foreign tax credits on dividends paid by the C-Corp or, in the alternative, the deductibility of the dividends. The rules are complex but these options are generally mutually exclusive. Deductibility will also depend on the nature of the income received by the C-Corp as this will affect the C-Corp’s “exempt surplus” calculation. And, further, the potential application of Canada’s foreign accrual property income (FAPI) rules, considered to be the most complex of all tax regimes, must also be considered if Canadian income tax is to be avoided on income retained in the C-Corp. Such are the most significant issues to be considered but an exhaustive list cannot be provided out of context.

In summary, Canadian investors should always get specialized advice on what are uniquely cross-border tax issues before investing in a U.S. LLC. The consequences are too varied and complex for a one-size-fits-all approach.