Since many legal and tax practitioners in the U.S. have been recommending the use of Limited Liability Companies (LLC's) for a wide variety of business ventures, this page intends to provide some basic information about this form of business entity.
A state-registered limited liability company (LLC) can be taxed as a partnership for federal income tax purposes. However, its members, like corporate shareholders, are not personally liable for the entity's debts or liabilities. Under the check-the-box rules, an LLC can choose partnership status to avoid taxation at the entity level as an "association taxed as a corporation."
Unlike limited partners, LLC members may participate in management without risking personal liability for company debts. No limitations are placed on the number of owners (compare, a maximum of 100 shareholders for S corporations) or different types of owners of an LLC (S corporations may generally only have U.S. resident individuals or certain types of trusts as shareholders). Additional advantages over S corporations include the ability to make disproportionate allocations and distributions (Code Sec. 704) and to distribute appreciated property to members without the recognition of gain (Code Sec. 731(b)). Members may also exchange appreciated property for membership interests without the recognition of gain or loss (Code Sec. 721).
Conversion from Partnership to LLC. A conversion of a partnership into an LLC that is taxed as a partnership for federal income tax purposes is treated as a nontaxable partnership-to-partnership conversion. The conversion is treated as a contribution of assets to the new partnership under Code Sec. 721 and does not result in gain or loss to the partners. The tax results are the same whether the LLC is formed in the same state as the former partnership or in a different state. Upon such a conversion, the tax year of the converting partnership does not close with respect to any of the partners, and the resulting LLC does not need to obtain a new taxpayer identification number.
International Implications for the LLC:
Under former rules, certain entities which are disregarded for income tax purposes in the United States, or which are considered “flow through” entities are considered corporations in Canada. This gave rise to many tax problems related to the recognition of foreign tax credits (especially since the hybrid entity was not considered taxable in the U.S.) Under the new rules, income which is treated as being earned by a member or shareholder of such an entity, will be deemed to be earned by the recipient in the country of residence. (A corollary rule to take effect in two years provides that if income is NOT to be recognized by the individual member in the country of origin, it will NOT be taxable in the country of residence.) If a U.S. LLC earns interest income in Canada, the new rules will presume that the U.S. residents earned the income, and will thus eliminate withholding taxes on the income in Canada.
Under new rules contained in the Fifth Protocol to the Canada U.S. Income Tax Convention, U.S. fiscally transparent entities such as LLC’s will be recognized as taxable entities, and will be eligible for Treaty benefits. Although the LLC will be required to file a tax return in Canada since it is considered a corporation, it will be eligible to claim Treaty benefits attributed to its members in the U.S. under the new “look-through” treatment in the Fifth Protocol.
However, the changes in the Fifth Protocol do not correct certain income recognition issues for residents of Canada who contemplate invesments in U.S. business or real estate ventures, and alternate structures such as limited partnerships should be considered for these types of investments.
New Rule Affecting Single Member LLC's with a Canadian Resident Member
A single member LLC is considered a “disregarded entity” for U.S. tax purposes, and accordingly its operations are reported on the member’s individual tax return. Where a single member LLC is owned by a non U.S. person or entity, new regulation 301.7701-2(c)(2)(vi)(A) classifies these entities as corporations. This triggers Internal Revenue Code section 6038A under which, effective for tax years ending after 2016) form 5472 must be filed timely each year to report transactions with foreign owners, even if a tax return is not required. Failure to file form 5472 can result in a penalty of $10,000 per occurrence.
Please contact us for a comprehensive review of these new provisions in the event you are considering participation in a U.S. business or rental venture.