Canadians and LLCs - Don't Use Them in the US

When a Canadian business owner thinks about setting up in the US, often the first question is what kind of corporate structure should be used.

In simple terms, the choices available for a business structure in the US are similar to the choices available in Canada. The reason why different structures exist is that they allow different combinations of limited liability and tax treatment for the entity and its owners.

• Unincorporated: which is done by being a proprietor (if there's a single owner) or through a general partnership (if there's more than one owner). The drawback of this choice is that the business owner does not obtain the benefit of limited liability. The proprietorship or partnership itself is not a taxable entity; the net income or loss is passed through to the actual owners and taxed in their hands personally.
• Limited partnership: A limited partnership does gives liability protection to the limited partners, but only if those persons do not participate in the business. The general partner takes on all the liability -- and for that reason is often an incorporated entity to protect whoever is actually behind the GP. But this is a somewhat complicated structure to set up and for a typical business owner is probably not going to work. Tax treatment is that same as for an unincorporated business.
• Corporations: In Canada, we generally have only one flavour. It's a limited liability entity that is taxed at the corporation level, and distributions to shareholders (dividends) are then taxed at the shareholder level. In the US, there is one kind of corporation as such, but under their tax system, a corporation may elect to be a "C" corporation or an "S" corporation. A "C" corporation means that the entity itself pays regular corporate income tax. An "S" corporation is treated as a flow-through entity. Note, however, that the "S" election is no good to anyone other than a US taxpayer. (So Canadian businesses can ignore that distinction.)
• Hybrid entities: These aren't available in Canada, but they are available in the US, usually under the name "limited liability companies" (LLCs). Their beauty is that they provide the same limited liability that shareholders of corporations have, but with the flow-through tax treatment that an unincorporated business has.

Now before we all decide to move permanently to the States to take advantage of the LLC structure, be aware of this key difference: the US corporate tax system allows for significant double taxation, and Canada's tax system (on the whole) doesn't. Double taxation means that the corporation will pay tax at the usual rates on its net income, and then the shareholder will pay tax again if dividends are distributed to the shareholder from that net income.

In the jargon of the tax policy specialist, Canada's tax system is "integrated". In general terms, integration means that the total tax paid to all levels of government on any given net income will be roughly the same, regardless of whether the income is earned through a corporation and then paid by dividends to the shareholders or whether the income is earned through an unincorporated business.

From the number of accounting and tax law firms in Canada, you've probably guessed by now that it's more complicated than that, but on the whole in Canada the existing levels of corporate income tax rates, dividend tax credits, and personal income tax rates do an excellent job of preventing the double taxation that might otherwise happen in the US. Integration means that our income tax legislation is more complicated, though.

The tax policy choice in the US has been to allow double taxation if a corporate structure is used (their tax code is already complicated enough). The US solves the double tax problem by providing a greater choice of tax treatment and legal entity than we have in Canada.

A further complication for a country's tax system arises when a business goes cross border. When that happens, the results from one tax system (the US) have to be made to work with the results from an entirely different tax system (Canada's). For that reason, Canada has entered into tax treaties with many other countries around the world, including the US. One of the main reasons behind such tax treaties is to prevent double taxation between countries. In general, with a tax treaty in place between two jurisdictions, if a business pays tax in one jurisdiction, the other jurisdiction will recognize and credit any foreign tax paid.

All of this discussion is a long introduction to point the reader to a good article at today's Globe & Mail newspaper making the point that Canadian business owners who wish to set up operations in the United States should form a US corporation and not a LLC structure.

If a Canadian taxpayer uses an LLC to do business in the US, the tax treaty system breaks, and using the LLC will expose the Canadian to significant double taxation.

For that reason, Canadian businesses are usually best off forming a standard US corporation that is then owned by a Canadian corporation. The US corporation (which will choose the "C" election for US tax purposes) will pay tax in the US, and pay dividends up to the Canadian parent. There may be some withholding tax on the dividends (at the rate established by the US/Canada tax treaty), but any such tax paid will qualify for a credit for Canadian tax purposes.

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What I Learned from Gordon Ramsay's Kitchen Nightmares

You can observe a lot by watching - Yogi Berra

I like to watch - Chance the Gardener, from the Peter Sellers movie, Being There


Gordon Ramsay is a controversial guy, not everyone's cup of tea, but the wise business owner shouldn't be afraid to get ideas from any legitimate source.

Ramsay's television show Kitchen Nightmares is one of the better shows out there for a small business owner. Sure, he's a chef and tells restaurant owners how to run their businesses. And maybe your business isn't a restaurant. But that doesn't mean you should ignore what Ramsay says.

The show of course has a formula: Ramsay investigates the restaurant of the week; (usually) blows up at the owner for a deplorable state of operational and financial matters; assesses how committed the owner is to change; (most times) gets the owner to buy into making much-needed changes; implements the change; and then tests it out in the closing section -- usually with success.

At a more general level, here are some of the key business issues the show addresses. These are applicable to any business:

• Motivation: This is the gut-check question, and in Ramsay's interaction with the restaurant owner, it's usually the first issue that he addresses. Does the owner have the caring, the commitment that will be needed to turn the business around. Some of the restaurant owners may have started out with passion, but it's clear the daily grind of hassling operations and losing money has worn them out. Warren Buffett talks about tap-dancing to work each day.
• Staff issues: Once the owner's motivation is back on track, the next challenge is usually to deal with performance of the staff running the business. In a small business, this sometimes means that the owner has been blind to what good performance actually means (all those scenes where Ramsay is cleaning out disgustingly old food). But sometimes the change to higher levels of performance reveals a poor choice in the current employees, so that one or more have to be fired. For some owners, this is a difficult decision.  But if an employee is holding back your business, you've got to do what's best for the business -- and getting rid of an employee that doesn't fit the business is probably a good thing for the employee, even if it hurts in the short term.
• Appearance matters: Any business that interacts with customers has to look the part. This is a part of the show that is more a magic transformation: Ramsay sends his team in, and literally overnight they do a full makeover on the restaurant decor. Partly, it's a matter of caring enough to notice details (such as outdated signs), and partly it's a matter of being able to bring fresh eyes to a tired presentation.
• Business process matters too: The final issue dealt with is to simplify and refresh the menu. Can your business be re-jigged so that production is simpler but better for your customers? In the restaurant setting, this often results in cost savings because of less wastage, or Ramsay's insight that a particular cuisine will work better given the kind of customers that are avialable to the business.

I've been watching the effect of a changeover in the cafe downstairs. For the last few years, it was run by a couple as a Chinese restaurant. New owners took over, with a totally different kind of restaurant idea: paninis, fresh salads, and coffee. They are drawing customers -- local workers -- that I never saw before when the Chinese restaurant was operating.

Not all TV is trash -- use it to get better ideas for your business!

Small office phone systems - Part 2

The story so far: A small law firm needed to change its phone system. A hardware PBX system was out of the question as too cumbersome and too costly; the home-office solutions were too small and insufficiently featured; and a virtual PBX solution had the drawback of creating an ongoing expense.

But the research into a virtual PBX solution revealed a potential open-source PBX software and hardware solution. Open-source PBX software meant that acquisition and ongoing expenses would potentially be nil. In particular, Asterisk telephony software, the leading open-source solution, was of high interest.

 As Linux-based product, Asterisk can be installed on a re-purposed desktop computer. To ease the roll-your-own aspect of things, we researched various installation and operation tutorials at sites such as Nerd Vittles and solution providers such as PBX in a Flash.

Asterisk certainly provided the features we were after in a phone system. But difficulties arose on the hardware side, specifically the need (or wish) to interface the PBX box with our telco land lines. Without getting into the technical details, the main solution would have required buying interface cards, such as those offered by Digium, which can be inserted into a desktop computer case like any other hardware interface card.

Another solution, which on a cost-benefit basis, is reasonably priced, is the Warp appliance, from Pika Technologies, an Ontario-based company. Their Warp appliance consists of a special purpose computer that runs Asterisk software and comes with various options for telco interface cards.

In theory, with software PBX you wouldn't need a telco interface card; it did seem to be possible in theory to run a completely network-based solution, using VOIP lines instead of telco land lines and plugging in the handsets to the network (or even giving up handsets as such; and deciding to run things through a software phone, such as X-Lite, on your computer). Unfortunately, cutting the cord to a true land line just wasn't a worthwhile technical option. At least in our experience, VOIP simply isn't ready for prime time -- or at least to the exclusion of giving up telco land lines.

In the end, we decided that we didn't want to spend the rest of our days installing and running a phone system. An all-in-one solution was what we really needed.

In the end, that solution turned out to be Microsoft's Response Point phone system. They did the software and partnered with three hardware providers.

We managed to find a supplier, who directed us to the particular hardware solution we chose: an all-in-one box running the Response Point software and with an interface card large enough to handle the telco land lines that we decided to stick with.

Installation was quite straightforward once the boxes arrived; it took about a day.

Sad to say, of course, no sooner was the thing installed than Microsoft discontinued the project.

So we slipped in under the wire. So far, we're pleased with Response Point as a solution. Some of our small business clients have noticed the change to our phone system, and asked us about it. Which tells us there is something to it.

Small office phone systems - Part 1

In the summer of 2009, we had to replace our phone system, such as it was.

I find phone systems to be mysterious. For all the simplicity that we've grown up with in terms of picking up the handset and dialing, if you actually have to go out looking for a phone system, it's a murky part of technology.

Since moving our offices to Richmond in May 2003, we had been using a 4-line Panasonic model, which had a base unit which we had bought with one wireless handset. After six years, the handset was failing: the buttons were refusing to work; and the wireless aspect had never been that good. Used handsets were available on Ebay, but that didn't seem to be a solution.

Although in recent years, the phone manufacturers had created a ton of 2-line systems, readily obtainable from any electronics store, there is absolutely nothing out there for a small business. If your operations were larger than the 2-line, you had to make a jump to some kind of PBX (private branch exchange) installation.

Given the improvements that computers and networking had experienced over the last decade, it's surprising that phone systems are still opaque to a typical small business. We're not alone in that view. But not a lot of 4-line systems are out there. We looked at a review or two of the latest Panasonic offering, and were heartily disappointed. You'd think if the phone manufacturers could put together a 2-line home system, they could simply expand it to a 4-line system for a small business. But the world doesn't work that way in this little area of technology.

We had used a PBX system during our dozen or so years with an office in downtown Vancouver. That kind of installation requires a dedicated box in a utility room, and then you populate each desk with a handset. Our old PBX system, that did serve us well for many years, we had bought used, but it's not the sort of thing you can move easily if you change offices.

We had some kind of budget for new phones, but didn't want to spend the kind of money that a standard hardware-based PBX installation would need.

We looked at the software-based PBX solutions (sometimes called virtual PBX), such as RingCentral, but they didn't seem to apply to Canada or, if they did provide service to Canadian small businesses, didn't seem to be the kind of solution for us.

But the virtual PBX systems did lead to further research and ultimately our buy decision, which I'll cover in the next post.

Unlimited Liability Companies for British Columbia

Good news for US businesses or US residents looking to do business in Canada!

On March 29, 2007, the BC government passed into law amendments to the Business Corporations Act (BC) that will allow the incorporation of unlimited liability companies (ULCs) in BC. The amendments aren't in effect as of yet; a staffer we spoke to at the BC Corporate Registry said to expect this for the fall of 2007. (It is possible right now to register in BC an out-of-BC created ULC. In Canada, this means either an Alberta ULC or a Nova Scotia ULC.)

Highlights of the new amendments include:

• The filing process will be simple. As with ordinary corporations, an online filing will be available, so the creation process for ULCs should be as smooth as it is for ordinary corporations now. The bad news is that the government will charge a premium for a ULC incorporation: a filing fee of $1,000 compared to the regular corporation filing fee of $350. Compare Nova Scotia, which used to charge $4,000 to incorporate a ULC, plus annual filings of $2,000, but which in light of competition from BC and Alberta for ULCs has recently dropped the incorporation filing fee to $1,000, though they raised the annual filing fee of $2,750. Alberta does not charge a premium for a ULC. Only the ordinary corporate filing fee ($100) and annual report filing cost ($0, but you have to pay a service provider to do the filing) apply.
• BCULCs will be required to have either "Unlimited Liability Company" or "ULC" in their corporate name. The terms are interchangeable with each other for all purposes. A numbered BCULC must use the phrase "B.C. Unlimited Liability Company" in its name.
• The notice of articles for the ULC and all share certificates issued by the ULC must contain the statement: "The shareholders of this company are jointly and severally liable to satisfy the debts and liabilities of this company to the extent provided in section 51.3 of the Business Corporations Act."
• The amendments do allow conversions. An existing BC limited liability corporation can file to convert into an unlimited liability company (with the shareholders thus becoming liable for all debts and liabilities existing whether before or after the date of conversion). And a BCULC can convert into a regular corporation, but the legislation seems to keep the shareholders liable (when the company eventually liquidates or dissolves, if it ever does) as if the conversion had not taken place.
• Foreign corporations are prevented from amalgamating into British Columbia with a BCULC and continuing as either a regular BC company or BCULC. Amalgations that result in a BCULC are restricted to existing BC companies. This means that a foreign corporation would first have to continue into BC as an ordinary BC limited company and then amalgate with another BC company to effect the creation of an amalgamated BCULC. It is also possible to amalgamate a BCULC with another corporation (a broader term than "company") to end up with an amalgamated BC limited liability company, but the same rules about shareholder liability apply to the amalgamated entity.
• Transfer into BC (continuance in) of foreign ULCs is allowed only if they come from Alberta, Nova Scotia or another jurisdiction specified by regulation.

Advantages of ULCs arise primarily for US corporations and individuals who want to carry on business in Canada. The advantages are primarily tax-driven (from a US tax perspective only). In Canada, any ULC will be treated as a regular corporation for corporate taxation and other purposes.

As to the unlimited liability of shareholders, BC has gone for the Nova Scotia approach, which is more favourable than the Alberta approach. Under the Alberta ULC legislation, shareholders are on the hook from day one. In BC and Nova Scotia, shareholders of a ULC are only on the hook once the company decides to stop operations and wind up.

For BCULCs, note that all existing and even former shareholders bear the liability. There are exceptions for former shareholders who transferred their shares one year or more before the date the company goes into liquidation (a formal court process for winding up the company) or dissolution (a less formal process for winding up the company).

"Joint and several" liability means that the existing and qualifying former shareholders as a group must make good on the debts and liabilities and each particular shareholder is also liable. This allows the creditors to go after the shareholder with the deepest pockets. That shareholder would then in turn have a right to claim contribution from the other shareholders. Note that this liability does not depend on the class of shares held by a particular shareholder. However, one wonders whether, as between different classes of shareholders themselves, share rights could specify how the various classes of shareholders contribute to the liability.

In practice, a Canadian ULC is often set up so that the only shareholder is an intermediary US corporation or LLC with limited liability itself, and whose only role is to hold the shares in the ULC. However, where a US individual holds the ULC shares directly, they will want to be careful about the umlimited liability aspect of Canadian ULCs.

The new amendments are good to see. They show a certain level of competition between provinces for business, and a general openness to foreign, particularly US, business in Canada. We'd be pleased to help with any inquiries about forming a ULC whether in BC or another part of Canada.

Employees Profit Sharing Plans in Canada

An Employees Profit Sharing Plan (EPSP) is a plan set up by an employer to benefit one or more of its employees . They're a tool offering benefit to both the employer and the employee.

Those who like to look at source documents can consult: Income Tax Act (Canada), s. 144; Income Tax Regs 212 and 1500; and Interpretation Bulletins IT280R, IT379R, and IT502; which can be found through the Canada Revenue Agency (CRA) website: www.cra.gc.ca.

EPSPs are set up as a special form of inter vivos trust. Typically, the trust will need three trustees, who can be the key managers of the business. There is no need to register an EPSP with CRA, although EPSPs that use a certain profit-sharing formula ("payments out of profits") must make an election with CRA to qualify the plan as an EPSP. The election requires that the EPSP be filed with CRA. A further benefit to the employer is that, beyond certain annual maintenance requirements, the EPSP trust itself does not have to prepare and file the usual federal trust income tax return with CRA. Annual maintenance requirements includes making allocations to the employees who belong to the plan and issuing T4PS Summary and Supplementary slips.

The benefits of EPSPs to employers include:

• motivating key employees through a profit-sharing arrangement;
• the ability of the employer to deduct contributions of the employer to the EPSP, so long as the contributions are made within four months of the financial year of the employer;
• a tax deferral advantage arising from the fact that contributions to EPSPs are not subject to withholdings for income tax, CPP or EI contributions;
• in a closely held corporation, the ability of the plan (if set up this way) to loan plan monies to the corporation for use until the monies need to be returned to the plan.

The benefits of EPSPs to employees include:

• a tax deferral advantage gained from the lack of a withholding requirement when the employer contributes to the plan; and
• income splitting opportunities, if there is a high-income employee and lower-income employees in the same family. Money that might otherwise have to be paid to the high-income employee can be contributed to the plan and then allocated to the lower-income employees, to take advantage of lower rates of tax.

The tax deferral benefit works best for employers whose financial years finish in September to December of the year. For example, an employer with an October 31, 2006 year end can wait until February 28, 2007 to contribute to the EPSP and still get a deduction for 2006. The trustees of the plan can then allocate the contribution among the plan members in 2007, and the plan members will not need to report that income until the following April, when they file their 2007 tax returns. The plan contribution can be put to work for those extra roughly 12 months and earn income before the government gets its portion.

For example, an employer with, say, $700,000 of pre-tax income would probably bonus down (ie, issue a bonus to certain employees) about $300,000 to get to the $400,000 small business deduction limit. With an EPSP, that $300,000 amount could be contributed to the EPSP without immediate deduction and be put to work for about 12 months before it was paid out to cover the tax bill for the employees.

Note, however, that the employer contributions must actually be money, not just a bookkeeping entry. The EPSP rules set a minimum annual contribution (for example, plans with an "out of profits" formula might use 1 percent of employee's salaries); and the amount of the contribution must be calculated only by reference to the profits of the employer and not by reference to other factors. Profits must be calculated in the ordinary way; and if the employer is profitable, the contribution must be made; deferrals or suspensions of contributions are not allowed. Conversely, if the year results in a loss, a contribution cannot be made. However, the source of funds for the contribution are not restricted: they can come from cash on hand, or borrowings, or whatever source of monies the employer can find. Subject to the minimum contribution requirement, EPSPs can achieve a certain flexibility in the amount of contribution to be made in a profitable year. Be aware, though, that some believe that the reasonableness provisions in the Income Tax Act (Canada) may limit the maximum amount that could be contributed to an EPSP. And CRA does scrutinize contributions that are made as part of plan to diminish CPP or EI contributions.

One drawback for employees who belong to the EPSP, though, is that they must report their share of the annual contribution plus any income or gains made by the EPSP trust in the year. Earnings of the trust that are eligible dividends or capital gains or losses retain their character when the employee reports them (that is, the employee can access any available dividend tax credit, and the lower rate of tax on capital gains). However, the employee will be reporting income and paying income tax for which he doesn't necessarily receive immediate cash, which could work hardship unless suitable arrangements are made with the employer and EPSP to provide the employee with the monies needed to pay the tax bill.

The tax deferral advantage and income splitting possibilities mentioned above can provide the necessary benefit to justify setting up an EPSP. If you're interested in setting up an EPSP for your business, please call or e-mail us.

Canada Small Business Financing Act

It does take money to make money. The founders of a start-up business will be the first to provide money, but once they've drawn on their credit cards or mortgaged their house and run through their family and friends, where will they turn to next? Most businesses won't want, or be able, to attract financing from venture capital firms or angel investors, or go to the trouble of trying to raise equity through a more or less formal share offering under the securities laws. So, in Canada, many small businesses turn to the banks.

Some businesses will have the wherewithal to be able to borrow money from the banks on ordinary terms. For those that qualify, though, some may want to see whether the loan program under the Canada Small Business Financing Act will work for them. (This Act is the successor to the Small Business Loans Act.)

For example, during 2004 - 2005, just over 11,000 loans were made under the program, with an average size of $94,000. A further 314 capital leases were allowed under a related pilot project, with an average value of $90,000 per lease. Start-ups (not defined) are said to account for 60 percent (almost $623 million) of the loans made under the program, so it's definitely worth a shot, even if you aren't fully established.

The CSBFA works like this:

• Only small businesses qualify, which means businesses with revenues, or expected revenues, of under $5 million per year, but excluding always farms and charitable or religious organizations.
• The borrower must meet certain eligibility criteria.
• The maximum size of the loan is $250,000. (You can see that this amount will not be enough for certain businesses.)
• The loan must be used for only specified purposes, and the loan must not exceed a certain proportion of the entire cost of those purposes.
• A lender's loss on a loan that goes bad is guaranteed by the federal government (provided certain conditions are met, such as the lender paying an initial registration fee plus an annual maintenance fee -- both of which would no doubt be passed on to the borrower). The government initially limited its total liability under this guarantee to a total of $1.5 billion. (I haven't checked to see whether this amount has since been updated.) And there's a sliding scale of liability: during any five year period, a lender can recover 90 percent of the first $250,000 of losses under this program dropping to only 10 percent for losses over $500,000. There are other provisions in the Act that further limit the government's liability. So the Act provides some incentive, but not a huge incentive to lenders. And there have been defaults: In 2004-2005, the government paid out on 1,639 claims at an average cost of $47,342 per claim ($77.6 million) for loans issued in the 1999 to 2005 period.
• The Act penalizes borrowers for misrepresentations or for disposing of assets put up as security for the loan. The penalties are for fines up to $50,000 or $500,000 or for imprisonment up to 6 months or 5 years, or both a fine and imprisonment. A three-year limitation period applies.
• The government must review the program every 5 years. The first review was for the 5 year period ending in 2004. The report confirmed that the program was useful and effective. (Though in 20 years of law practice, I must admit I've never dealt with someone who had used the program. But maybe know that you know about it, you can ask and see whether it will work for your business.)

The Act has regulations attached to it. The regulations set out the details of the loans allowed under the program. These details include amount, duration, repayment terms, interest rate, security, and so on. Highlights of the details include:

• The maximum duration of a loan is 10 years, including all renewals, if the lender allows renewals.
• All loans must be secured, and have first position, or in some cases equal rank to other first position security.
• The purpose of the loan must fall into these three main categories: buying or improving real property owned by the borrower and used in its business; obtaining or improving leasehold improvements for premises leased by the borrower and used in its business; or buying equipment. A portion of the loan can also be used to pay the required registration fee under the Act. There are restrictions about the kind of and use of real property a loan may be used for.
• Usual due diligence by the lender is required as to credit references for the borrower, appraisals and other information.
• The lender can, but is not required to, take personal guarantees. Any such guarantee must be limited to no more than 25 percent of the loan amount, plus applicable interest and legal fees and costs of collection. A guarantor may be released if the loan is in good standing and the borrower has repaid at least 50 percent of the principal. (Who says the government doesn't have a sense of humour?)
• If default occurs, the lender may give the borrower a cure period. If the default isn't cured, the lender can pursue its various remedies. However, for partnership or proprietorships, outside of the assets used in the business, the lender may only seize personal assets not worth more than 25 percent of the original amount of the loan (plus applicable interest and legal fees and costs of collection).

You can find out more about the program at the website of Industry Canada, the ministry of the federal government that is responsible for the program. Who knows, it might just be the sort of money that will bump your business to the next level.