U.S. Flow Through Entities Owned by Residents of Canada

In the United States certain business entities such as Limited Liability Companies (LLC) or subchapter S corporations are “flow through” entities, where the entity does not pay tax,  but where the net income and other tax results flow through to the members or shareholders on a pro rata basis.  Due to the ease of establishment and simplified operation, entities like the LLC are the choice of many U.S. practitioners.

Effect of Direct Ownership of a Flow Through Entity

Canadian residents doing  business in the United States should only consider direct ownership of a flow through entity once they have become non residents of Canada.  Because Canada does not recognize the flow through nature of these entities and considers them to be corporations the income effect on Canadian residents is complicated, since a foreign tax credit is not fully available for taxes paid in the U.S.  This is primarily because the U.S. taxes the allocated income (from form K-1) from a flow through entity, whereas that allocated income is not taxable in Canada (since it is the income of a corporation.)  When a distribution is taken from a flow through entity, it is not taxable in the U.S., since it represents the distribution of otherwise taxable profit allocations, but in Canada a distribution is considered to be a dividend from a corporation.  Since tax was never paid in the U.S. on the distribution, and since the flow through entity is not itself taxable, foreign tax credits, if available at all, would be limited to the maximum credit available for dividends (15%).  This results in an element of double taxation.

New Rule Affecting Single Member LLC's

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.