A Cross-Border Perspective on LLCs: One Size Does Not Fit All

When expanding into the United States (U.S.) choosing the right entity type is critical, especially for tax purposes. For U.S. residents, the answer is simple and straightforward. Using a limited liability company (LLC) is an appealing choice due to its flexibility and tax advantages. However, for Canadian entrepreneurs, the U.S. LLC structure often proves to be less than ideal. This article will examine the LLC structure for Americans vs. Canadians.

What is a U.S. LLC?

For U.S. tax purposes, a U.S. LLC is a hybrid business entity that combines elements of a corporation and a partnership. LLCs offer limited liability protection to their owners, shielding their personal assets from business liabilities.

An LLC's defining characteristic is its single-level taxation. By default, the profits and losses of an LLC are passed through directly to its owners to report on their individual tax returns.

This differs from a corporation, where profits and losses are taxed at the corporate level first, and again when distributed to shareholders in the form of dividends.

An LLC with a single owner is known as a disregarded entity and taxed as a sole proprietorship, whereas an LLC with two or more owners is, by default, treated as a partnership.

Why a U.S. LLC Might Seem Attractive

On the surface, a U.S. LLC offers several advantages:

1. Simplicity. Forming an LLC is relatively straightforward.
2. Flexibility. By default, an LLC is a pass-through entity for U.S. tax purposes. In addition to being able to be taxed as a sole proprietorship or a partnership (depending on the number of owners), an LLC can also be taxed as a U.S. “S corporation” or “C corporation” by filing the appropriate elections.
3. Limited liability protection. Owners are not personally liable for the company’s debts or lawsuits.
4. No corporate taxes: With pass-through taxation, the LLC avoids double taxation that is often associated with corporations.

Given these benefits, it’s understandable why many entrepreneurs find LLCs appealing. However, the situation becomes complicated when a Canadian resident is the owner of the LLC.

Why a U.S. LLC is Not Ideal for Canadians

1. Tax Implications

The U.S. tax advantages of an LLC can be lost for Canadian residents due to how Canada’s tax system interacts with U.S. LLCs. In Canada, the Canada Revenue Agency (CRA) treats a U.S. LLC as a corporation for tax purposes, not a pass-through entity. This discrepancy creates a scenario where the LLC’s income could be taxed twice:

• U.S. taxation: The LLC’s income is taxed in the U.S. on a pass-through basis, requiring Canadian owners to file U.S tax returns and pay U.S. taxes.
• Canadian taxation: Since Canada treats the LLC as a corporation, the CRA does not recognize the U.S. taxes paid by the owner. This can result in double taxation.

Example: Imagine a Canadian resident owns a U.S. LLC that earns $100,000 in profits. The U.S. taxes the income at 24% (blended tax rate of federal and state), leaving $76,000 in the entity. However, when the $76,000 is brought into Canada, the CRA may treat it as a foreign dividend and tax it again. Without a tax treaty to mitigate this, the owner ends up paying tax on the same income a second time.

2. No Treaty Benefits

The Canada-U.S. Tax Treaty is designed to prevent double taxation for many business entities. However, LLCs are excluded from some of these benefits because Canada does not treat LLCs as pass-through entities. Consequently, Canadian owners of U.S. LLCs cannot fully leverage the treaty’s provisions, further compounding their tax liability.

3. Limited Liability May Be Misunderstood

While LLCs provide limited liability protection under U.S. law, Canadian courts may not fully respect this shield for Canadian entrepreneurs. If a legal issue arises in Canada related to the U.S. LLC, Canadian courts may override the U.S. LLC structure, exposing the owner’s personal assets to potential liability.

A Better Alternative to a U.S. LLC for Canadians

To avoid the pitfalls associated with U.S. LLCs, Canadian entrepreneurs should consider incorporating a C Corporation while expanding into the U.S.

C Corporation

A U.S. C corporation is treated as a separate legal entity in both the U.S. and Canada. Although it is subject to corporate taxation, exposure to double taxation can often be avoided or minimized through careful tax planning and the Canada-U.S. Tax Treaty.

Example: A Canadian entrepreneur forms a C corporation in the state of Delaware. The company pays corporate taxes in the U.S. When dividends are distributed, the treaty allows reduced U.S. withholding tax, and the Canadian owner may claim foreign tax credits on their Canadian return—avoiding double taxation.

Setting up the Right Structure in Canada

To fully utilize the treaty and allow for further tax optimization, choosing the appropriate business structure in Canada is also essential.

Use a Blocker Corporation

Canadian residents can interpose a Canadian corporation as a blocker between the U.S. C corporation and themselves.

If the Canadian resident individual operates a small business corporation and wishes to preserve their lifetime capital gains exemption for future tax planning, establishing a Canadian holding company to hold the shares of the U.S. C corporation is advisable. This setup may also offer potential liability protection for the Canadian operating company.

Steps to Take Before Setting Up a U.S. Business

1. Consult cross-border tax professionals. Engage tax advisors familiar with both U.S. and Canadian tax laws to evaluate your specific circumstances.
2. Understand state regulations. Tax and legal obligations vary by state. Research the state where you plan to operate.
3. Plan for compliance. Ensure you have systems in place to meet the filing and reporting requirements in both countries.

Conclusion

While U.S. LLCs can be a great option for American entrepreneurs, they're often not the best choice for Canadians. Mismatched tax treatment, limited treaty benefits, and administrative complexity make LLCs a poor fit for cross-border ventures.

Canadian entrepreneurs may find a U.S. C Corporation to be a better fit when expanding into the U.S. market. Furthermore, having a Canadian holding company directly own the U.S. company can help optimize tax obligations and protect assets.

With careful planning and the right professional guidance, you can establish a U.S. business structure that aligns with your objectives and avoids potentially costly mistakes.

About the Author

Sandy is a licensed CPA in both Canada and the U.S., with nearly 20 years of experience in cross-border and inbound U.S. tax. She began her career at Deloitte and has since held roles at Grant Thornton and PwC, later launching a U.S. tax practice at McGovern Hurley. Today, she leads her own boutique firm, helping public and private entities navigate complex tax matters with clarity and confidence.