If you are doing business offshore, you need to understand the IRS Controlled Foreign Corporation rules. It is these tax laws that allow you to retain earnings from an active business offshore. These same rules force you to pay tax on passive income. If you have a non-U.S. partner, then avoiding the Controlled Foreign Corporation rules is great international tax planning.
Any business that is incorporated outside of the United States with a U.S. shareholder or shareholders directly or indirectly owning or controlling more than 50% of the entity and is a Controlled Foreign Corporation for U.S. tax purposes (Section 957 (a)).
It is important to note that it is more than 50% of the vote or control, which is another way to say ownership or control of the company. So, while you might assign nominee directors and voting proxies to an offshore corporation, so long as a U.S. person is pulling the strings (control), the entity is a Controlled Foreign Corporation. Back in the day, nominees were powerful tools. Under current IRS rules, they are of little value.
Indirect ownership of a Controlled Foreign Corporation can also refer to shares held by your children. Even if they are not U.S. persons (you are living outside of the U.S. and they don’t hold U.S. passports), the attribution rules mean the offshore company you and your kids control is a CFC. See Section 958(b).
These same attribution rules apply to ownership of the offshore company by a foreign trust. Most offshore trusts are taxed as grantor trusts. In that case, the settlor of the trust (presumably you) is deemed to be the owner of the shares of the company because you control the trust.
If the offshore company is owned by an offshore trust that is not a grantor trust, your heirs are usually the beneficiaries. In that case, ownership is attributed back to you, the settler, and, again, the offshore company held by the offshore non-grantor trust is considered a Controlled Foreign Corporation.
What Does Being a Controlled Foreign Corporation Mean?
So, what does it mean to you, the American business person operating abroad, that your offshore company is a Controlled Foreign Corporation? It means that the subpart F anti-deferral rules defined in Section 951 of the U.S. tax code apply. These rules disallow continued reinvestment by forcing the distribution of certain types of income, summarized as passive income. It also means that these types of income, regardless of whether actual corporate dividends are paid, will not be eligible for U.S. income tax deferral as retained earnings.
Now, let me translate that into English.
Because your offshore company is categorized as a Controlled Foreign Corporation, you don’t get to defer U.S. tax on passive income and capital gains the business generates. Assuming you are living and working abroad, and qualify for the Foreign Earned Income Exclusion, you can defer U.S. tax on active business income by holding it in the company, but not passive income.
Also, if you have passive income, such as capital gains and interest on your investments, and you don’t pay it out to the shareholders, those owners are still required to report and pay tax on it. This often frustrates partners because they are paying tax on money they did not receive, but that’s offshore tax law for you.
Let’s say you are living and working in Panama, and operating your business through a Belize entity to minimize or eliminate tax in Panama. That company nets $300,000 in profits this year (2014). You and your wife are both working in the business and both qualify for the Foreign Earned Income Exclusion. Both you and your spouse should take out the maximum Foreign Earned Income Exclusion as salary from the Belize company. Let’s round that up to $100,000 each, for a total of $200,000.
As a result, the offshore company has left over profits of $100,000. The Controlled Foreign Corporation rules allow you to keep that $100,000 in the corporation and not pay U.S. tax on it until you take it out as a dividend or in some other form… which is great for you. You are operating free of tax in Panama and free of current tax in the United States because of your structure. Your U.S. taxes are deferred for as long as you leave the cash in the offshore company.
Now, let’s assume you’ve built up $1 million in retained earnings in your offshore company over a few years. That cash generates $30,000 per year of interest income (a 3% return from your bank).
Because your offshore company is a Controlled Foreign Corporation for U.S. tax purposes, that $30,000 is taxable on your personal income tax return, Form 1040. If you distribute it out to yourself, you have $30,000 in hand with which to pay the tax. If you leave this interest income in the offshore company, you still must pay the tax.
There is only one way to avoid this Controlled Foreign Corporation issue. If your business partner is not a U.S. citizen and not a U.S. resident, and he or she owns 50% or more of the venture, then the company is not a Controlled Foreign Corporation and may be eligible to retain passive income.
Note that you are still required to report an offshore company which is not a Controlled Foreign Corporation to the IRS on Form 5471. So long as U.S. persons hold 10% of an offshore company, you will have U.S. reporting requirements.
I hope you have found this article on Controlled Foreign Corporations to be helpful. For assistance in structuring your offshore company or business, please give us a call or send an email to firstname.lastname@example.org. We will be happy to work with you to structure your affairs.
You can find additional information on this site on how to eliminate your U.S. filing obligations, such as Form 5471, the FBAR, and others… assuming you have a partner or spouse who is not a U.S. person for tax purposes.