Demystifying LLCs for Canadians

Allan Madan, CA
 Dec 1, 2013
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LLCs for Canadians

With the housing costs at an all time low in the U.S., you are certain that this is your once in a lifetime opportunity to invest in a rental or a commercial property south of the border. From general research online, you discover about the Limited Liability Corporation (LLC) and all of its benefits: liability protection for you and simpler tax filing requirements. You even consult a U.S. lawyer who confirms your finding and attest that thousands of Americans are already doing this.

It seems that investing through the LLC is a no brainer – right? Wrong. This article will detail the perils of LLCs for Canadians buying US Real Estate.

What exactly is a LLC?

For U.S. tax purposes, LLCs for Canadians can be treated in three different ways:

  1. Corporation
  2. Partnership
  3. Disregarded entity (flow-through)

Persons belonging to the LLC are called ‘members’. If a LLC consists of only a single member, the default classification is disregarded entity which means that the LLC does not exist for tax purposes and all of the income/expenses earned by the LLC are reported by the single individual member on his or her personal tax return. For an LLC with multiple members, the default classification is a Partnership and the entity will be required to file a U.S. Partnership information return on an annual basis.

Regardless of whether a LLC has one or multiple members, it can choose to be taxed as if it were a corporation by filing the Form 8832 – Entity Classification Election before the time limit. By doing so, each member will effectively become a shareholder of the LLC and the entity will file a U.S. Corporation Income Tax return.

Many U.S. lawyers will promote single-member LLCs as the best structure for owning U.S. real estate (or 2-members LLCs if you are married) and rightfully so. Countless number of Americans have benefited from the legal liability protection and ability to avoid the administrative burden needed for maintaining a corporation. However, as I will describe below, this structure has a serious negative consequences for Canadians.

Canadian treatment of the LLCs and double taxation

While the U.S. may offer you three different options for classifying your LLC, Canada recognizes LLCs only as a corporation. The implication is that the LLC could be treated as a flow-through or a partnership for U.S. tax purposes and as a corporation for Canadian tax purposes, which creates a mismatch between the two countries’ tax systems.

Example: A Canadian investor invests in a rental property in the U.S. through a LLC which is considered disregarded. In Year 1, he earned $1,000 in net profit. His tax rate in both countries is 20%. He has not withdrawn any money during the year from the LLC’s bank account:

Year 1

U.S.

Canada

Income reported on personal return $1,000 $0*
Tax (20%) $200 $0
     
After tax income $800 $0

* As Canada considers a LLC as a foreign corporation, income/expenses of the LLC belongs to the corporation and is not reported on the member’s personal tax return. Only a draw (dividend) when taken is reported on the member’s personal tax return

Furthermore, in year 2, the LLC was inactive but the investor decides to withdraw the $800 to purchase a new TV:

Year 2

U.S.

Canada

Income reported on personal return $0 $800*
Tax (20%) $0 $160
     
After tax income $0 $640

* As the dividend is considered coming from a foreign corporation, no dividend tax credit is permitted

Effectively, the investor paid $360 ($200 + $160) as tax on an income of $1,000 which is a significant double taxation given his tax rate of 20%. Although a limited foreign tax credit can be claimed if the investor in the example withdrew the money in year 1, double taxation would not be completely eliminated.

Alternative solutions – LLCs for Canadians

Considering the plight of holding a LLC for Canadians, there are several viable alternative structures that can be implemented instead. One simple alternative is to hold the investment property directly inside a U.S. corporation or a LLC that has elected to be treated as a corporation. Another alternative is to hold the property inside a U.S. Limited Partnership with a U.S. corporation acting as the general partner. For more detail on this structure, please see my article on: The most tax-efficient ways for Canadians buying a real estate property in the US. These strategies are complex and should not be pursued before consulting a tax professional.

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Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.

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