Tag Archive for: FEIE

Foreign Earned Income Exclusion 2020

Foreign Earned Income Exclusion 2020

In this article, I’ll look at the Foreign Earned Income Exclusion 2020. The FEIE is the most powerful tool in the expat’s kit and is the focus of international tax planning for individuals and small business owners living abroad. The Foreign Earned Income Exclusion 2020 is the only major tax planning option left after Trump’s 2017 tax law changes. 

I wrote that the Foreign Earned Income Exclusion 2020 is the ONLY tax deal left after Trump’s changes to the US tax code. In previous years, small business owners could use the FEIE to eliminate the tax on their first $100,000+ and then retain profits in excess of the FEIE in an offshore corporation. These days are gone… we Americans can no longer retain profits in our offshore corporations tax-deferred. 

And there was a time when we had hope that the Foreign Earned Income Exclusion would be made obsolete by President Trump. During his campaign, he had indicated that he would move the US to a territorial tax system. Rather than taxing US citizens and residents on our worldwide income, we could pay tax only on profits made in the United States. 

Well, big corporations and multinationals moved to a territorial tax system, but the little guy got the shaft (per usual). We expats are still taxed on our worldwide income and we lost the ability to use an offshore corporation to retain profits over the Foreign Earned Income Exclusion 2020 amount tax-deferred. For more, see President Trump’s Tax Plan and Expats

With that in mind, here’s what you need to know about the Foreign Earned Income Exclusion 2020.

As stated above, the most important tool in the expat’s U.S. tax toolbox is the Foreign Earned Income Exclusion for 2020.  And, in most cases, the Foreign Earned Income Exclusion 2020 is the ONLY tax break you get for living abroad. 

If you qualify for the FEIE, you can exclude up to $107,600 in 2020 of earned income free from U.S. Federal income tax. This amount is up from $105,900 for the tax year 2019, $104,100 in 2018, $102,100 in 2017 and $101,300 in 2016. If you’re married, and both spouses qualify for the exclusion, your total combined exclusion may be up to $215,200.

There are two ways to qualify for the Foreign Earned Income Exclusion 2020. You can be out of the US for 330 out of 365 days or you can be a resident of a foreign country for a full calendar year. 

The first option, referred to as the 330-day test, is the easiest to use. Just be out of the US for 330 out of any 365 day period. For example, if you are out of the US from March 30, 2020, to March 15, 2021, you qualify for the Foreign Earned Income Exclusion 2020. 

The second option, known as the residency test, is much more challenging to implement. To oversimplify a complex topic, you need to move to a foreign country with the intention of making that place your home for the foreseeable future. You should have a residency permit and pay taxes in this new home. 

In most cases, you will use the 330 day test for the Foreign Earned Income Exclusion for the first year or two you’re living abroad. Once you’ve put down roots in a new country, you can switch to the residency test. 

Maximize the Value of the Foreign Earned Income Exclusion 2020

While you can’t retain earnings in an offshore corporation in 2020, you still need a structure in a tax-free country to maximize the value of the FEIE. 

First, if you use a personal bank account or a US company to run your business, you must pay self-employment tax on your income. The Foreign Earned Income Exclusion does not reduce self-employment or payroll tax. 

If you draw your salary from an offshore corporation, you can eliminate SE tax. This is a savings of about $15,000 a year for a single person earning $100,00 and about $30,000 for a husband and wife where both are working in the business. 

Second, if you operate a business without a corporate entity, the amount of your Foreign Earned Income Exclusion for 2020 will be reduced in proportion to your expenses. 

For example, the FEIE is $107,600 for 2020. Let’s assume you gross $160,000 from business and your net profit is $80,000 after deductible business expenses. You report this income on Schedule C and use Form 2555 to calculate the Foreign Earned Income Exclusion. 

Your allowed business expenses are about 50% of your gross. Because you are using Schedule C, your FEIE will be reduced in proportion to your deductible expenses. So, your available FEIE for 2020 is 50% of $107,600 = $53,800. 

You will be allowed to exclude $53,800 of your $80,000 net using the FEIE. Thus, you will pay US tax on $26,200. 

If you had operated your business through an offshore corporation for 2020, you would have paid zero in self-employment taxes and would have been allowed the full FEIE amount of $107,600. 

Perpetual Travelers and the Foreign Earned Income Exclusion 2020

There’s one group of expats that can never use the residency test. A perpetual traveler is someone that is out of the United States but never puts down roots. This group includes military contractors and those who can’t become residents of the country in which they work and Americans who travel constantly. 

If you’re a perpetual traveler, you won’t have a home base. You won’t get a residency visa and you will not pay taxes in any foreign country. In this case, you must use the 330-day test because you will never qualify for the Foreign Earned Income Exclusion 2020 using the residency test. 

Because the residency test allows you to spend more time in the United States, it might be in your best interest to gain residency in a low or no-tax country. For a list of options, see Which Countries Tax Worldwide Income?

One of the easiest residency programs for Americans is Panama’s Friendly Nations Reforestation Visa. Invest $25,000 in teak and get residency. For more on this topic see Best Panama Residency by Investment Program (note the investment amount has increased from $20,000 to $25,000 for 2020). 

I hope you’ve found this article on the Foreign Earned Income Exclusion 2020 to be helpful. If you need assistance preparing your US tax returns, drop me a line to info@premieroffshore.com and I will connect you with a tax prep expert. If you would like to form an offshore corporation to maximize the value of the FEIE, you can reach me by email or at (619) 483-1708

nonresident FEIE

How to become a nonresident of the United States

The 330 day test for the Foreign Earned Income Exclusion is being eliminated by President Trump. If you want to keep this tax break, you need to become a legal resident of a foreign country as soon as possible. Here’s what you need to do to become a nonresident of the United States for tax purposes.

Of course, the most important component of the residency test for the FEIE is residency. You must be a legal resident of a foreign country for a full calendar year to qualify for the FEIE using the residency test. Where the 330 day test was over any 12 month period, the residency test is January 1 to December 31.

It doesn’t matter where you get your residency visa for US tax purposes. So long as you have legal residency in a country which is your home base, you’re covered.

Of course, if you want to minimize your worldwide tax obligations, you should become a resident of a country that doesn’t tax foreign source income. For more on this, see: Which Countries Tax Worldwide Income?

For those that want to live in Europe, the most popular residency visa is Portugal. Buy a home for 500,000 euros, or deposit 1 million euros in a local bank, and you can qualify for residency. A resident of Portugal can live anywhere in the EU. You just need to spend a few weeks  a year in Portugal.

The most popular visa in the world is Panama. Invest $20,000 in their friendly nations reforestation program and become a permanent resident. This visa can also lead to citizenship and a second passport in 5 years. For more, see: Best Panama Residency by Investment Program

Once you have your residency visa, you need to cut as many ties with the US and create as many ties with your new home country as possible.  That is to say, a US citizen who wants to become a nonresident for US tax purposes must truly move and become a part of their new community, including:

  • Selling your US home;
  • Leaving US employment and becoming an employee of an offshore corporation reported on IRS Form 5471;
  • Establishing and spending time in a home located in your new country. This home should be of equal size, cost, and amenities as your US home;
  • Establishing business and social ties in the new country;
  • Discontinuing business and social ties in the United States;

Do not:

  • Keep your US home and let the children live there;
  • Have children in school in the United States;
  • Vote in State elections (Federal elections by mail, listing your foreign home as your residence is OK);
  • Have mail sent to your old address in the US. Establish a PMB address if necessary;
  • Continue to use US physicians, dentists, or other professionals who require the taxpayer’s physical presence to transact business.

Remember that you need to be a nonresident for Federal and State tax purposes. Sometimes these tests are different. Here is a list of ties a California court listed as indicating residency (In the Appeal of Stephen D. Bragg, May 28, 2003, 2003-SBE-002).

  • The location of all of the taxpayer’s residential real property, and the approximate sizes and values of each of the residences;
  • The state wherein the taxpayer’s spouse and children reside;
  • The state wherein the taxpayer’s children attend school;
  • The state wherein the taxpayer claims the homeowner’s property tax exemption on a residence;
  • The taxpayer’s telephone records (i.e., the origination point of taxpayer’s telephone calls);
  • The number of days the taxpayer spends in California versus the number of days the taxpayer spends in other states, and the general purpose of such days (i.e., vacation, business, etc.);
  • The location where the taxpayer files tax returns, both federal and state, and the state of residence claimed by the taxpayer on such returns;
  • The location of the taxpayer’s bank and savings accounts;
  • The origination point of the taxpayer’s checking account transactions and credit card transactions;
  • The state wherein the taxpayer maintains memberships in social, religious, and professional organizations;
  • The state wherein the taxpayer registers automobiles;
  • The state wherein the taxpayer maintains a driver’s license;
  • The state wherein the taxpayer maintains voter registration and the taxpayer’s voting participation history;
  • The state wherein the taxpayer obtains professional services, such as doctors, dentists, accountants, and attorneys;
  • The state wherein the taxpayer is employed;
  • The state wherein the taxpayer maintains or owns business interests;
  • The state wherein the taxpayer holds a professional license or licenses;
  • The state wherein the taxpayer owns investment real property; and
  • The indications in affidavits from various individuals discussing the taxpayer’s residency

The above is basically a list of why expats have relied on the 330 day test. It’s easy, you don’t need to invest or spend money to get a visa, and you don’t need to worry about your ties to the US. Just be out of the US for 330 out of 365 days and you’re good to go.

The problem is that expats often pushed their days in the US and the IRS loves to audit these returns. Many don’t realize that travel days and time in international waters can count as US days. Because the FEIE is all or nothing, the risk in these cases is significant.

More importantly, President Trump is moving the US from a global tax system to a territorial tax system. This likely means an end to the 330 day test and a move towards residency.

Because it takes time to become a legal resident of a foreign country, and time to break ties with the US, and you must qualify for a calendar year, I’m recommending clients begin this process as soon as possible.

I hope you’ve found this article on how to become a nonresident of the United States for tax purposes to be helpful. For information on residency visas, or to setup an offshore business, please contact me at info@premieroffshore.com or call us at (619) 483-1708. 

Foreign Earned Income Exclusion for 2018

Foreign Earned Income Exclusion for 2018

On October 19, 2017, the IRS announced the Foreign Earned Income Exclusion for 2018. The FEIE for 2018 is a nice bump up from 2017. Here’s what you need to know about the Foreign Earned Income Exclusion for 2018 and how it might be affected by President Trump’s residency based tax proposal

Under Section 911 of the US tax code, the Foreign Earned Income Exclusion for 2018 increases from $102,100 in 2017 to $104,100 in 2018. The FEIE amount for 2016 was $101,300, 2015 was $100,800, and 2014 was $99,200.

This increase is based on the annual inflation adjustment for 2017 which applies to more than 50 provisions in the US tax code. For all the details see IRS Rev. Proc. 2017-58.

However, the Foreign Earned Income Exclusion for 2018 is subject to change. President Trump is proposing major changes to the US tax code which could change the FEIE amount for 2018 (or, more likely 2019). He might also succeed in his effort to move the United States from a citizenship based tax system to a residency based tax system.

If President Trump is successful, and all of us expats are hoping he is, the FEIE will be eliminated and those who are residents of a foreign country will pay zero US tax on income earned abroad.

In order to understand the Foreign Earned Income Exclusion for 2018, and how it might change next year, allow me to summarize it here.

As I said above, the Foreign Earned Income Exclusion for 2018 is $104,100. If you’re living and working abroad, and qualify for the Foreign Earned Income Exclusion, you can exclude up to $104,100 in salary or wages on your US Federal income tax return.

This salary can come from your US employer, a US corporation you own, a foreign employer, or an offshore corporation you own. If it comes from a US company, you and your employer are liable for payroll taxes. If you get paid from a foreign corporation, you are generally exempt from payroll taxes (which are about 15% combined on $100,000 in wages).

The Foreign Earned Income Exclusion for 2018 is to be reported on your 2018 personal income tax return using Form 1040 and Form 2555. Only income earned outside of the US qualifies for the FEIE. That is to say, US source income goes on Form 1040 and not Form 2555.

At the time of this writing, there are two ways to qualify for the Foreign Earned Income Exclusion in 2018. You can be out of the country for 330 days during any 365 day period or be a legal resident of a foreign country.

President Trump is saying he’ll convert the US from a citizenship based tax system to a residency based tax code. If that happens, the 330 day test would likely be eliminated and only those who are legal residents of a foreign country would qualify for the Foreign Earned Income Exclusion in 2018.

Under this tax system, the FEIE would eventually be eliminated and those who are legal residents of a foreign country would be allowed to exclude all of their foreign income. It seems likely that that the Foreign Earned Income Exclusion for 2018 will remain as described herein and that we will move to a residency based system in 2019.

Regardless of whether President Trump succeeds, we’re advising all of our clients using the FEIE’s 330 day test to convert to the residency test during 2018. You should be ready by January 1, 2019 to qualify for the residency test. Here’s why:

First, the residency test is lower risk than the 330 day test. Many of our clients have been caught missing their 330 days and have lost the FEIE. If you miss your 330 by even one day, you lose the Foreign Earned Income Exclusion entirely and 100% of your worldwide income becomes taxable in the United States.

Second, the residency test is easier to use in the long term. Sure, it’s simple to calculate how many days you were in the US and how many days you were in a foreign country. But, counting travel days year in and year out is a real headache.

When you use the residency test, you don’t need to keep track of your days to closely. You can be in the US on business for 2 or 3 months a year without an issue. Try not to exceed 4 months a year and never spend more than 183 days in the US, and you’ll qualify for the residency test.

Third, the residency test requires you to be a resident of a foreign country for a full calendar year. That means it must start on January 1 of 2019. I’m recommending that our clients spend 2018 getting their affairs in order and planning for the FEIE throughout 2018.

It takes a great deal of time and effort to qualify for the residency test. You need legal residency in a country you can call your home base. Plus, you need to cut as many ties to your home country as possible and create as many ties to your new country of residence as possible.

So, plan to use the Foreign Earned Income Exclusion for 2018 with the 330 day test and be ready with the residency test in 2019.

This means that you must secure legal residency in a country that will be your home base to maximize the value of the Foreign Earned Income Exclusion in 2019. It doesn’t matter for US tax purposes which country. So long as you’re a legal resident, you’ll qualify for the FEIE and Trump’s residency based tax system if it passes.

Of course you don’t want to exchange one high tax country for another. You want to secure residency in a country that won’t tax your foreign capital gains and your foreign sourced profits. For a list of these countries, see: Which Countries Tax Worldwide Income?

For example, I don’t recommend Mexico or Colombia because they tax residents on their worldwide income. I do recommend Panama because this country taxes residents on their local source income but not their foreign sourced profits.

If you’re living in Panama and selling to persons in the US, Panama won’t tax those gains. If you’re living in Panama and selling to Panamanians, you will owe tax on those sales.  

Next, you need a country with an efficient residency program that fits your budget… and there are a number of options here.

For example, if you have the cash, you can get residency in the European Union through Portugal’s golden visa program. Portugal requires you deposit € 1,000,000 in a local bank or purchase real estate for € 500,000 or more.

If you wish to live in Asia, you can get residency in Hong Kong by investing about $1.3 million in a local business. You can also gain residency in the Malaysia with a deposit of about $135,000 in a local bank or in the Philippines by investing $75,000 in a government approved business.

The easiest and lowest cost residency for US citizens is Panama’s Friendly Nations Reforestation Visa program. Invest $20,000 in one of the approved reforestation projects and get residency immediately. And this investment covers you, your spouse, and your dependent children 18 years of age and under. Government and legal fees apply to each applicant in addition to the investment.

If you can make Panama your home base, I guarantee that the Panama Reforestation Visa is the most efficient residency program and the best way to qualify for the Foreign Earned Income Exclusion in 2018 and beyond. For more information on this program, see: Best Panama Residency by Investment Program

I hope you’ve found this article on the Foreign Earned Income Exclusion for 2018 to be helpful. For more information, or for assistance with residency in Portugal or Panama, please contact us at info@premieroffshore.com or call us at (619) 483-1708. We’ll be happy to assist you with your international tax plan and support  you through the coming changes.

perpetual traveler

How to Escape the Perpetual Traveler Tax Trap

Under the US tax code, a perpetual traveler is a US citizen or green card holder living outside the United States who doesn’t becomes a tax resident of another country. Being labeled as a perpetual traveler limits how many days you can spend in the US and can cause all kinds of problems for expats. Here’s how to escape the perpetual traveler tax trap.

A perpetual traveler is someone who travels from place to place never putting down roots. A perpetual traveler doesn’t have a residency visa, doesn’t file taxes in any country other than the United States, and never spends 183+ days in any one country.

The problem being labeled a perpetual traveler is that you can only spend 35 days a year in the United States. Spend one day more and you lose 100% of the tax benefits of living abroad. The international tax benefits that come from living abroad are no prorated over the time you spend abroad… you either qualify for the exclusion and get to take the full deduction or you don’t and get the joy of paying US tax on 100% of your income.

Let’s take a step back… We US citizens and green card holders are taxed on our worldwide income no matter where we live. Also, there’s no benefit to living offshore when it comes to capital gains. We always pay US tax on our passive income and dividends no matter where we live.

  • The only exception for capital gains on the planet is the US territory of Puerto Rico.

Business income and your salary from an active business conducted outside of the United States is eligible for significant international tax breaks. The tax benefits of operating a business offshore are:

  1. The Foreign Earned Income Exclusion allows you to exclude up to $102,100 in salary from Federal income taxes in 2017. A husband and wife working in this offshore business can exclude over $200,000 combined.
  2. You can hold / retain foreign sourced business income in an offshore corporation tax deferred.

To qualify for the FEIE, you must meet the physical presence test or the residency test. The physical presence test is, in theory, very simple: be out of the United States for 330 days during any 12 month period. That’s all there is… easy enough, right?

I say the physical presence test is simple in theory because everyone tries to push the boundaries and spend more time in the United States. Family emergencies, vacations, business meetings, flight delays, I’ve heard it all.

Unfortunately, the FEIE physical presence test is very rigid. If you’re off by even one day, and spend only 329 days abroad, you lose the entire exclusion. Because most Americans try to push the boundaries, the IRS loves to audit expats who take use the physical presence test.

The second and more reliable way to qualify for the FEIE is through the residency test. You can exclude up to $102,100 in salary from work performed outside of the United States if you’re a tax resident of another country.

A “resident” is someone who makes a foreign country their home and their home base. It’s where they return when they travel, where they have residency, and where they intend to be for the foreseeable future. A resident also breaks as many ties to the United States as possible.

The benefit of being a tax resident is that you don’t need to watch your days in the US so closely. You can spend 3 or 4 months a year in the US without issue. You’ll only have trouble if you spend more than 6 months or 183 days in the United States.

As I said above, the FEIE physical presence / 330 day test is easy to calculate and difficult to implement. The residency test takes work and commitment to qualify for but allows you to spend as much time as you need in the US and greatly reduces your probability of an IRS audit.

With all of that said, in order for a perpetual traveler to qualify for the Foreign Earned Income Exclusion, they must be out of the United States for 330 days a year. This is a challenge and increases your risk of an audit.

The solution to the perpetual traveler tax trap is to gain legal residency in a country that won’t tax your business profits. Find a country that you can make your home base and won’t tax your business. For a list of possibilities, see: Which Countries Tax Worldwide Income?

In my experience, the easiest tax free country for a US citizen to gain residency in Panama. Panama won’t tax your foreign sourced business profits. That is, they won’t tax sales to people and companies outside of Panama. Of course, if you sell to locals, you’ll pay tax in Panama.

And the most efficient residency visa in Panama is the friendly nations reforestation visa. Invest $20,000 into Panama’s green initiative (which means to buy $20,000 worth of teak trees) and get residency. This is by far the lowest cost and lowest investment required in any developed country.

The key to escaping the perpetual traveler tax trap is residency in a zero tax country. Do your research and you’ll find that Panama is the most efficient choice for a home base.

I hope you’ve found this article on how to escape the perpetual traveler tax trap to be helpful. For more information, please contact me at info@premieroffshore.com or call us at (619) 483-1708. We will be happy to assist you to set up offshore and connect you with local experts for the friendly nations reforestation visa.

Cayman Islands Internet Business

Move Your Internet Business to Cayman Islands Tax Free

Are you looking for a high quality of life, no taxes, and a cool offshore jurisdiction from which to operate your internet business? Ready to move you and your team to paradise for a few years to rake in the cash tax free? Then consider moving your internet business to Cayman Islands.

Cayman Islands had a tax deal you can’t refuse. Move to this business-friendly group of islands with its first-world infrastructure and amazing climate, and pay no taxes. You will also get a 5 year renewable work / residency visa for you, your staff, and their families. There are no restrictions on the number of workers you can bring with you and no requirement to hire locals.

Historically, visas and work permits were extremely difficult to obtain in Cayman. Securing residency previously required you to buy real estate of $500,000 to $1 million dollars and navigate  river of red tape.

Because a residency permit and work visa are essential for the American to qualify for the Foreign Earned Income Exclusion, very few small businesses set up in Cayman.

Suffice it to say, those days are gone and now Cayman Islands is open for business. Today, you can relocate your internet business to Cayman Islands efficiently and without (most) of the impediments.  

Moving a business to Cayman also gets you access to their world-class banks and credit card processing facilities that have been shut to Americans for several years now. Only US persons with a licensed business or a home on Cayman may open a account on the Island.

For example, to further reduce your contacts with the US, you might process credit cards through First Atlantic Commerce, a leading global online payment solutions provider. This enables you to accept payments in up to 145 world currencies in real-time on a 100% PCI-compliant platform. Merchant services include:

  • Multi-currency, multi jurisdictional settlement
  • Real-time processing
  • Virtual Terminal
  • Repeat and Subscription Billing
  • Card Number Tokenization
  • 3-D Secure™ (bank dependent)
  • CVV2/CVC2/CID and AVS checks
  • PCI Compliant gateway

We also highly recommend banking and credit card processing services from Royal Bank of Canada.

Now on to US Taxes.

Here’s how to move your business to Cayman Islands tax free. Do it right and you and your staff can earn up to $101,300 tax free in salary. That’s right, everyone who moves to Cayman with you gets $101,300 tax free. That equates to about a 35% pay increase on your first $100,000 in salary… certainly worth hanging out on a beautiful Caribbean island for a year to earn.

  • You will pay US taxes on salary over $101,300. You might create defined benefit or other retirement structures to further defer tax. A small business might simply hold retained earnings tax deferred.

Even better, you and your team won’t be required to pay self employment tax or any of the US social taxes. No FICA, Medicare, or Obama taxes. That’s a savings of about 15% (7.5% to the employer and 7.5% to the employee).

Of course, you’re in business to make a profit, not just pay your employees. Any income generated by the Cayman Islands corporation can be held offshore tax deferred. If you accrue $5 million in net profits over 3 years on the island, so long as you hold them in your Cayman corporation, you won’t be required to pay US taxes.

The devil is in the details of the US tax code and I’ll get to that.

First, let me point out that I am talking about moving you and your business out of the United States and to the Cayman Islands. This is not some tax dodge using shell companies or hiding from the IRS. This is committing to the business, making the move, and earning the tax benefits.

Shell companies and offshore structures with no substance behind them are so 2000. These days, if you want to cut your US taxes, you must have employees and operations outside of the US. For most businesses, this means moving you and your workers out of the United States for a time.

Then and only then will some of the income generated by this division qualify to be held in the Cayman Islands corporation tax deferred. More on this soon….

In support of this fact, the Cayman Islands Government has granted a number of globally competitive tax holidays / tax free zones throughout the Island. They allow your businesses to establish a physical presence plus offer fast-track business licensing and visa processing. These programs attempt to eliminate the red-tape, excessive costs, and uncertainty that one would normally experience when trying to set up a business in Cayman Islands.

These tax free zones provide the following benefits:

  • No corporate, income, sales or capital gains tax in Cayman Islands – tax payable in the USA is a complex matter summarized below.
  • 100% foreign company ownership permitted
  • A 3-4 week fast-track business licensing regime
  • Renewable 5-year work/residency visas granted in 5 days
  • Cutting-edge IT and business infrastructure
  • Offshore hosting & payment gateway
  • Minimal Government regulation
  • No Government reporting or filing requirements
  • A tech cluster with massive cross-marketing opportunities
  • ’One-stop-shop’ Administration services
  • Work visas for your staff and residency permits for your spouse and children at no additional cost.

Note that you must operate your business in one of the Island’s tax free zones to get these benefits. Also, your business must be in one of the industries to which a tax holiday is available. Qualified businesses include:

  • Internet & Technology
  • Media, Marketing or Film
  • Biotechnology & Life Sciences
  • Commodities & Derivatives
  • Maritime Services

How to Maximize the US Tax Benefits of Moving Your Business to Cayman Islands

Let’s get back to the devil (the IRS) and those details.

The key to the offer in Cayman is the fact that you and your employees will receive work and residency permits on the island. In the past, these have been extremely difficult to get and required that you hire a proportional number of Cayman citizens.

As of 2016, Cayman understands that the days of the shell company are coming to an end. The government is moving to a service based offering that allows you to establish a real business with substance and employees who qualify for the Foreign Earned Income Exclusion. One that will pass muster with the IRS and allow you to minimize your US taxes.

Of course, you need to do your part to make Uncle Sam happy as well. You need to move your business, your workers, and yourself to Cayman Islands. You must reside on the island as a legal resident with a work permit (we have that covered for you), qualify for the Foreign Earned Income Exclusion, and obtain a license from one of their tax free zones.

To qualify for the Foreign Earned Income Exclusion, you need to move to Cayman for the foreseeable future, make the Island your home base, and stay out of the US approximately 8 months of the year.

  • Cayman Islands should be your home base and the jurisdiction from which you operate your business. You don’t need to spend a certain amount of time on Cayman, but you do need to be out of the United States for about 8 months a year.

This allows you to earn up $101,300 in salary from your Cayman corporation tax free in the United States, avoid US social taxes, and retain net profits from your active business in the Cayman corporation tax deferred. The fact that you are structured and licensed in one of the Cayman tax free zones means you operate tax free in Cayman also.

Note that I said net profits / retained earnings in your Cayman Islands corporation will be tax deferred – not tax free – in the United States. When you will decide to take out these retained earnings from your corporation, they will be taxed in the United States. You can decide when that occurs, but you must pay Uncle Sam some day.

The Foreign Earned Income Exclusion is a complex topic, and I have merely skimmed the surface here. For more details, see:

  1. Foreign Earned Income Exclusion 2016
  2. Foreign Earned Income Exclusion Basics
  3. Benefits of an Offshore Company
  4. Eliminate U.S. Tax in 5 Steps with an Offshore Corporation
  5. How to Prorate the FEIE

As you read through these thrilling posts, keep in mind that we are talking about moving you and your business to Cayman. You will qualify for the Foreign Earned Income Exclusion using the residency test and not the physical presence test.

Costs of Setting Up in Cayman Islands

I’ve been working offshore since 2000 and I can tell you that Cayman Islands is without a doubt the most beautiful tax paradise. Add to this  their world class services, IT infrastructure, and top legal and business talent, and it’s an amazing place from which to operate an internet business. Cayman Islands is NOT a low cost option Cayman is the Hyatt or Nieman Marcus of the offshore world, not Wal Mart or Best Western.

Cayman is one of the more expensive jurisdictions from which to run your business. You will need to pay your employees the same as you do in a major US city like Los Angeles or New York to cover the cost of living. Everything you do, from equipment to meals to lodging, will cost about the same as the United States. And everyone will want to travel back and forth to the US to escape that Island Fever.

If you are looking for one of the most beautiful and professional spots on the planet from which to operate your business, Cayman Islands is it.

If you are looking for a place that offers low cost labor and a 4% tax rate, and you have at least 5 employees, consider Puerto Rico.

If you want to maximize the value of the Foreign Earned Income Exclusion in a lower cost city, consider Panama. Yes, Panama regardless of the BS you read about the Panama Papers.

Here is a summary of the costs of setting up your business in Cayman Islands. Note that the minimum number of employees in Cayman is one. The tax benefits described here assume you (the business owner) are the first employee. You might be the only employee or you can bring with you as many support staff as you like. 

The tax free zones have created turn-key offerings that include your residency visa, work permit, and office. The total cost for all of this in a shared / group space is about $1,550 per month. The minimum term of the lease is 3 years and the first year of $18,500 is due at signing

  • You can have up to two people working in the group space. If you have 3 or more employees, you will need a private office. See below.

The cost for a private office for one person with 90 to 100 sq ft., again including all permits, is about $3,000 per month on a three year contract. This includes furniture, phone system, etc. Payments are made quarterly at $9,237.50.

A three person office is $53,450 per year and a 2 person office can be either $41,250 or $49,250 per year depending on if a chooses the standard or large 2 person office. Payments are made quarterly and  the minimum term is 3 years.

In addition, each resident will need to have health insurance, which starts at about $200 per person per month. Family plans are available.

And, speaking of families, there is no additional cost to bring your spouse and dependent children under 18 years of age to Cayman in this program. Their residency permits are basically processed for free and included in your office rent.

However, you might consider setting up an office and work permit for your spouse. That will allow him or her to also earn $101,300 per year tax free under the FEIE working in your family business In this way, you can double the value of the Foreign Earned Income Exclusion.

Also, your kids must be enrolled in private school in Cayman. They are not allowed to roam the streets unchecked. Private school costs about $1,300 per month and a wide range of options and price points are available.

Finally, employees are required to have some type of retirement account on Cayman after 9 months of employment. This may provide additional tax planning options.

As I said above, the cost of living in Cayman Islands will be the same or higher than a major US city. Rent in a residential neighborhood for a two bedroom will run you $2,000 to $3,000 per month. The commute would be about 20 minutes to the office. .

If you want to go big, the rent for a two bedroom on Seven Mile Beach will run you $5,000 to $6,000 per month. If you would like to scope out the area, I suggest you stay at one of the many hotels on Seven Mile.

We can have you setup and operating from Cayman Islands in about 40 days. For more information, and a quote on forming your Cayman corporation and US / Cayman tax planning, please contact me at info@premieroffshore.com or call us at (619) 483-1708.

Cayman Islands vs Puerto Rico

Allow me to close by comparing Cayman Islands to the US territory of Puerto Rico. Puerto Rico offers a tax holiday at 4%, a tax rate which is guaranteed for 20 years. The catch is that your business must move to Puerto Rico and have at least 5 employees on the island.

  • If you have fewer than 5 employees, Puerto Rico is not an option. Focus on Cayman Islands or Panama.

The tax deal in Puerto Rico is very different from that of Cayman Islands. In fact, it’s the reverse of the Foreign Earned Income Exclusion described above.

In Cayman, you earn $101,300 tax free and leave the balance of the profits in the offshore corporation tax deferred.

In Puerto Rico, you draw a reasonable salary and pay tax at ordinary income rates on that money. The remaining net profits of the business are then taxed in the corporation at 4%. If you are living in Puerto Rico, you can pull these profits (less the 4%) as tax free dividends.

So, if your salary is $100,000, and your remaining profit is $2 million, you will pay about $110,000 in Puerto Rico tax (($100,000 x 30%) + ($2 million x 4%) = $110,000). This is all of the tax you will ever pay on this income.

In Cayman, the $100,000 salary is tax free. At some point, you will pay US tax at 35% on the $2 million, or $700,000.  This might be years or decades in the future, but the bill will come due.

For more on this topic, take a read through Puerto Rico’s Tax Deal vs the Foreign Earned Income Exclusion.

I also note that you, as a US citizen or resident, do not need an visas or special permission to move to Puerto Rico. It’s a domestic flight and you can relocate as easily as you would from New York to Miami.

Next, your cost of labor in Puerto Rico will be 30% to 40% lower than in Cayman Islands. The same goes for your cost of living and operating the business.

Finally, Puerto Rico allows you to spend more time in the US. You should be on the island for 183 days a year, not 240 as you should with the Foreign Earned Income Exclusion using the residency test.

Conclusion

Whether you want to operate your business from an island paradise like Cayman Islands or a fiscal paradise like Puerto Rico, all tax deals these days require substance. This means a business with employees abroad adding value and working in the business.

You need to move you and your business outside of the US to maximize the benefits of the Foreign Earned Income Exclusion or of the US territorial tax offerings of Puerto Rico.

I hope you’ve found this article helpful. For more information on moving your business to Cayman Islands or Puerto Rico, please contact me at info@premieroffshore.com or (619) 483-1708 for a confidential consultation.

Puerto Rico Tax Deal

Puerto Rico Tax Deal vs Foreign Earned Income Exclusion

The Puerto Rico tax deal is the inverse of the Foreign Earned Income Exclusion. Here’s why:

  • With a Puerto Rico tax contract you can live in the US, your first $100,000 or so in salary is taxable, with rest deferred at 4%.
  • If you live offshore and qualify for the FEIE, your first $101,300 is tax free in 2016 and the rest is taxable in the US as earned.

The FEIE is intended for those living abroad and operating a business that earns $100,000 to $200,000 max. The Puerto Rico deal is intended for those who live in the US or PR and net $400,000 or more.

This article will compare and contrast the Foreign Earned Income Exclusion with the Puerto Rico Tax Deal. There are still deals out there for Americans if you know how to work the system.

Here’s how the Foreign Earned Income Exclusion works:

If you live abroad and work for someone else, or have your own business, the Foreign Earned Income Exclusion is the best tool in your expat toolbox. The FEIE allows you to exclude up to $101,300 in salary in 2016 from your US taxes.

This salary can come from your own offshore corporation or from your employer. So long as the company is located outside of the US, and you qualify for the Exclusion, you’re golden.

If a husband and wife are both working in the business, they can each earn $101,300 in salary tax free for a total of $202,600. Take out more, and the excess is taxable in the US at about 40%.

Likewise, if you work for someone else, the amount you earn over the FEIE is taxable in the United States. If you work for yourself, and hold earnings in an offshore corporation, you can usually defer tax on these retained earnings.

To qualify for the Foreign Earned Income Exclusion, you must be 1) outside of the US for 330 out of any 365 days, or 2) be a legal resident of a foreign country, file taxes in that country, and travel to the US only occasionally for work or vacation.

  • What qualifies you a resident of a foreign country is a complex matter. For a more detailed article on the FEIE, see: Foreign Earned Income Exclusion Basics
  • The above assumes you are living in a low or no tax country and does not consider the Foreign Tax Credit.

The Foreign Earned Income Exclusion is an excellent tax tool for those willing to live and work outside of the US. If you wish to spend more than a couple months a year in the US, or to take out a salary of more than $101,300, the FEIE might not be your best bet.

Here’s how the Puerto Rico Act 20 tax deal works:

If you incorporate your business in Puerto Rico, you can qualify for an 4% corporate tax rate. That is to say, you can live in the US, operate your business through a Puerto Rico company, and get tax deferral at 4%.

In order to qualify, you must hire at least 5 full time employees in Puerto Rico and provide a service from the island to businesses or individuals outside of PR. Popular examples are affiliate marketers, website developers, investment funds, phone and online support providers, and any other business that is portable or operates via the internet. Really, any company that can put a division in Puerto Rico can benefit from Act 20.

  • If you don’t need 5 employees, we might create a joint venture that allows partners to share employees in one corporation that benefits the group.
  • EDITORS NOTE: On July 11, 2017, the government of Puerto Rico did away with the requirement to hire 5 employees to qualify for Act 20. You can now set up an Act 20 company with only 1 employee (you, the business owner). For more information, see: Puerto Rico Eliminates 5 Employee Requirement

If you, the business owner and operator, live in the US, you must take a “fair market” salary that’s taxable and reported on Form W-2. This might be around $100,000, but the exact amount will depend on many factors. The remaining net profits of the income attributable to the Puerto Rican company will be taxed at 4%.

This is basically the inverse of the Foreign Earned Income Exclusion. With a Puerto Rico contract, you pay tax on your fair market salary and defer the balance at 4%. With the FEIE, the first $100,000 (or $200,000 if married and both are working in the business) is tax free and the excess is taxable at ordinary rates.

I note that the Act 20 offer is a better deal than the multinationals have in Europe. Most of them are paying about 12.5% for tax deferral. Even at 12.5%, their tax contracts are under constant attack by the US and the EU. If you want to out maneuver Apple, and get an offshore tax deal blessed by the US government, move your business to Puerto Rico!

So, what’s different about Puerto Rico? As a US territory, it’s tax code trumps the Federal Code… or, more properly put, PR’s tax code is on equal footing with the US Federal code.

This is not the case in a foreign jurisdiction. So long as you hold a US passport, you’re subject to US taxation. The IRS doesn’t give a damn about the laws of your new country. They want their cut.

The US code is clear when it comes to Puerto Rico: Income earned in a Puerto Rican corporation, or as a resident of Puerto Rico, is exempt from US taxation. See: 26 U.S. Code § 933 – Income from sources within Puerto Rico.  

The code as applied to foreign jurisdictions is incredibly complex. Try reading up Controlled Foreign Corporations, Passive Foreign Investment Company rules, and Sub Part F of the code.

I suggest a Puerto Rico tax contract is best suited to firms with at least $400,000 in net profits that can benefit from (or, at least, break-even on) three employees in Puerto Rico. 

In contrast, the FEIE is great for those who wish to live outside of the United States and earn a profit of of $100,000 to $200,000 from a business. Additional tax deferral is available to business owners who live abroad operate through an offshore corporation.

I hope you have found this article on the Foreign Earned Income Exclusion vs. the Puerto Rico Tax Deal helpful. For more information, please send an email to info@premieroffshore.com or give me a call at (619) 483-1708. 

Foreign Earned Income Exclusion 2016

Foreign Earned Income Exclusion 2016

Good news, the Foreign Earned Income Exclusion for 2016 has increased by $500 to $101,300.

The International Revenue Services has increased Foreign Earned Income Exclusion in 2016 to  $101,300, up from $100,800 for 2015. This means that you can earn a salary from your employer, or from your own corporation, of up to $101,300 free of Federal income Tax if you qualify for the FEIE in 2016.

The FEIE is still the most important tax break for Americans living, working and doing business abroad.

The US taxes its citizens on our worldwide income. If you qualify for the FEIE, you can deduct your first $101,300. If your salary is more than the FEIE, you may still get the joy of paying in to the US system.

The 2016 FEIE gives you exclusion on your personal income tax. If your income is $250,000, you pay personal income tax on $250,000 minus $101,300 or $148,700.

Note that the Foreign Earned Income Exclusion for 2016 covers Federal income tax only. If you are self-employed, or operating a business abroad without an offshore corporation, you will pay 15% in self-employment tax.  Likewise, if you are employed by a US corporation, you will pay US social taxes.

If you are operating a business outside of the US, you should be doing that through an offshore company. This will save you on SE tax and maximize the benefit of the Foreign Earned Income Exclusion.

My posts on the Foreign Earned Income Exclusion for entrepreneurs include:

Please send an email to info@premieroffshore.com if you have questions about forming an offshore corporation or maximizing the FEIE as an entrepreneur.

Estonian E-Residency Makes No Sense

The tiny country of Estonia is selling a new kind of residency… one it calls e-residency or e-citizenship. Here’s the bottom line on why e-residency in Estonia is a waste of time for Americans… and might get you into trouble with the IRS.

The Estonian e-residency program has been written up by the Wall Street Journal and The Guardian, and recommended by Simon Black and International Man. Simon went so far as to suggests it will change the “nation state” as we know it.

What a bunch of BS… here’s the real story.

Let’s start with the pitch: Sign-up for e-residency, turn over your information and biometrics, pay small fee (about $62), appear at one of their embassies and you get a biometric ID card.

What can you do with your Estonian e-residency card? Not a lot.

That card “allows” you to form a company in Estonia online. WIth corporation in hand they  might, just might, allow you to open a bank account in the country. Note that you’ll need a legitimate business purpose and travel to the bank in Estonia to open the account.

The ID card doesn’t make the process of opening an offshore bank account easier or provide any additional privacy. The bank will want all of the usual supporting documents, such as your US passport and reference letters. No, you can’t use the card as your ID to open the bank account and they’ll report your account under FATCA just like any offshore bank.

Sure, e-residency in Estonia sounds hip and cool, but it offers zero value. In fact, it might get you into trouble.

Now, you might be wondering what I’m on about. So what if people want to spend $62 for an online ID card? Most of the headlines cited above are from 2014. Why am I harping on it now?

Because the Estonian e-residency program might cause all kinds of confusion and IRS trouble for Americans.

First, e-residency isn’t a path to citizenship, a second passport, or even traditional residency. It’s only an online identification card… which doesn’t include your photo, so it can’t even be used as an ID or travel document in the normal world.

And here’s my real concern with this program:

I new client came into my office last week looking to prepare his U.S. taxes. Let’s call him Bob.

Bob spent about 240 days out of the U.S. in 2014, operated an online business through an offshore corporation and netted about $100,000.

Bob thought he qualified for the Foreign Earned Income Exclusion because 1) he was out of the US for most of the year and 2) he was an e-resident of Estonia.

Bob was wrong. In order to qualify as a resident of a foreign country under the FEIE you must be living in the country, have legal resident status, and generally “make that country your home.” You should be filing taxes there and it should be your base of operation… the place you return to after traveling.

Estonia’s e-residency program provides none of those things. Sure, you can call yourself a resident, but all you really have is a fancy online ID card.

Had he not been confused, Bob could’ve qualified for the FEIE without putting down roots or paying for a real residency permit. But he should have been out of the U.S. for 330 out of 365 days, not 240.

Had he not been confused by internet sites hyping Estonia’s e-residency program, and had he planned his offshore business structure properly, he could have saved big money in 2014 and again this year.

This confusion cost Bob about $36,000 in US taxes in 2014. He’ll probably pay through the nose again this year. He relied on the e-residency program, and his own research rather than a hiring a professional, and got burned.

Those of us who write about the offshore industry are always looking for the next big thing. What can we do to increase privacy and protect our assets? In the case of Estonian e-residency, I must call BS.

The bottom line is that Estonia e-residency offers little value to the American and is likely to do more harm than good.

You will find many articles on this site on how to legally minimize taxes and protect your assets abroad. If you’re new to this offshore thing, take a read through my Getting Started section.

Don’t be like Bob. Hire a firm experienced in U.S. tax planning to form your offshore structure and plan your offshore adventure.

 

foreign earned income exclusion 2015

The Foreign Earned Income Exclusion 2015

The Foreign Earned Income Exclusion 2015 has finally hit six figures. The FEIE for 2015 is $100,800, up from $99,200 for 2014. The FEIE is the best way to minimize your US taxes as an Expat and the most important tool in your tax kit.

This means that each American living and working abroad, who qualifies for the Foreign Earned Income Exclusion in 2015, can earn up to $100,800 in salary without paying personal income tax. If that salary comes from a US employer, then you still pay social and employment taxes (7% deducted from your check and 7% paid by your employer). If you are self employed and don’t have a corporation, then you pay self employment tax at 15%.

Basically, if you have a US structure, or are self employed without a foreign corporation, you pay 15% tax + Obamacare and other charges on your 2015 salary. The FEIE only cuts out your personal income taxes.

If you work for a foreign employer, or you operate your business through an offshore corporation, then you can avoid this 15%+ tax. It is possible to use the Foreign Earned Income Exclusion 2015 with an offshore corporation and pay zero to Uncle Sam on income of $100,800. If a husband and wife both operate the business and qualify for the FEIE, you can take out $201,600 in salaries tax free!

Next, if your profit exceeds $100,000 or $200,000, you can retain earnings in the offshore company and defer US taxes on that income. This tax deferal is a major benefit of living and working abroad for high net worth business owners.

Let’s say your net profit is $300,000 in 2015. You and your wife take out $200,000 in salary using the FEIE. This leaves $100,000 in untaxed profits. If you hold this money in the offshore corporation, you can defer US tax until you take a distribution. If you draw it out as salary, commissions, dividends, or in any other form in 2015, you will pay US taxes at about 32% (Federal).

For a 100+ page book on expat tax issues and how to maximize the FEIE 2015, please join my mailing list.

My posts on the Foreign Earned Income Exclusion for entrepreneurs include:

Finally, if you’re a glutton for punishment, I recorded a 3 hour dissertation on the Foreign Earned Income Exclusion for the Overseas Radio Network. See my ORN page.

I hope this post has been helpful. Please send an email to info@premieroffshore.com if you have questions about forming an offshore corporation or maximizing the FEIE as an entrepreneur.

State Tax for Expats

State Tax for Expats

If you are planning to live, work, or invest offshore, you need to plan for your state taxes.  This State Tax For Expats guide will help you eliminate your state’s taxes and keep you out of trouble with local tax authorities.

If you move offshore, and plan to return to your home state, then your state’s tax laws apply to all income you earn abroad.  So, state tax for expats battles center around the issue of your intent to return… whether you moved out of your state and took up residency elsewhere, or if you remain a tax resident of that home state.

If your state’s tax laws remain attached to your income, then you need to know how your state treats foreign income.  For example, some states have laws that match the federal government’s Foreign Earned Income Exclusion so you can earn up to $99,200 in wages while abroad and pay no federal or state tax.

Others have a variation of this law, while yet others, like California have no FEIE and thus attempt to tax ALL income you earn abroad.  You must research your state’s laws before you devise a plan to move offshore.  I’ll focus on California because that’s the state I’m most familiar with.  If you are living in a tax free state like Texas or Florida, your state tax for expats analysis is simple – no problems.

As I said above, State Tax For Expats is focused on your intention.  If you move abroad and intend to return to your home state, then its laws govern.  If you move to another country, become a tax resident, and do not intend to return, then you should have no state tax obligations.  While this sounds great, it is much more difficult to prove… especially if you are moving from a hungry and aggressive state like California.  I also note that the burden of proof is on you to show that you intended to move out of your state and not return for the foreseeable future.

For example, if you are a contract worker in Iraq, on a 3 year agreement, and you keep a home and family in California, you remain a resident of California for tax purposes.  No one will believe you intended to move to Iraq for the foreseeable future… you intended to work there for the term of your contract and then return to your home and family in California.

That is to say, your state will want its share if you leave sufficient contacts in that state.  If your wife, school aged children, home which you have not rented out on a long term contract, bank accounts, driver’s license, are all in California, you are probably a tax resident of California.  If your job is such that you obviously intend to return to California, then you are probably a tax resident of California.

Though, it is possible to be a tax resident of a foreign country and not a state in the U.S., while your wife and children are here.  I have had three clients over the years in that situation.  One was an attorney living and working for 15 years in the U.K., while his wife and kids remained in California.  He would spend about 30 days a year in the state.  Note that is one of the toughest state tax for expats situations, but it can be overcome.  In this case, he qualifies as a resident of the U.K.

Of course, California found a way to get to at least some of his worldwide income.  They passed a law that basically says the income of a family unit is attributable equally to each spouse.  This law passed legal challenges in community property states and means that 50% of the U.K. lawyer’s income is attributable to his wife’s support (taking care of the children, etc.) and is thus California source income and taxable in the state.

That’s right, if you are living and working abroad, qualify for Foreign Earned Income Exclusion, are a tax resident of a foreign country, and remain married to someone living in a community property state, 50% of your income is taxable in that state.  One solution is to get a divorce.  Some suggest that prenuptial or transmutation agreements may also help.

Adding insult to injury, because California has no Foreign Earned Income Exclusion, state tax applies to all California source income.  If the attorney were to earn $99,000, he would owe no Federal tax, but 50% of the income would be taxed by California at around 9%.  This is why state tax for expats can be so confounding to the uninformed.

Capital gains is another issue you must consider when dealing with state tax for expats.  Let’s say you move out of the United States to Panama.  You move to Panama permanently, obtain residency, file taxes (if applicable), become part of a community there, cut all ties with your home state by selling your home, etc.

However, you leave your bank and brokerage accounts in the U.S. and your state has no idea that you left.  They won’t get notice (Form W-2) from your job in Panama, but they will receive 1099s from your bank and brokerage accounts.  And, these 1099s will reflect only the sales, and not the purchases in that trading account.  This means the state will have a very distorted view of your income… all stock sales and no expenses/purchases.

California will take this information and prepare a return on your behalf, create a tax bill, and attempt to collect.  The first you may hear about this is when they empty out your U.S. bank and brokerage accounts with a tax levy.  Think I am exaggerating?  I have represented too many clients to count over the years in this very situation.  One was a day trader with a net loss on his brokerage account, but $1 million in sales for 2012.  California taxed that $1 million and levied his account for the balance due.  He was left to negotiate, beg, and file a claim for refund.  He had to prove he was not a resident of California, which is an uphill battle… especially after the government has a hold of your cash.

When dealing with state tax for expats, you have two options:  1) move everything out of the reach of your state, or 2) move to a state with no income tax for a year before you go offshore.  Option 1 will protect your assets, but option 2 will protect you AND avoid a confrontation.

Had my client moved his wife and child to Florida or Texas before going to work in London, he would have zero state taxes to pay.  Assuming his income was $99,000 (it was closer to $800,000), he could have also moved them to any state with a matching Foreign Earned Income Exclusion with the same result.

Likewise, you can first relocate to a non-taxing state, file a partial year return with your state referencing the change, and then go offshore without the risk of California coming after you.  This prevents the substitute for return issue, and makes an audit unlikely.  People in the military have been doing this for years.  Expats should take a page from the Navy’s playbook.

However, you must be sure to cut all ties with your original state and become a resident of Florida or Texas before going offshore.  You should sell or rent out any real estate (I am a big believer that selling is better than renting), close any bank and brokerage accounts in California and open new ones in Texas or Florida, get rid of your CA driver’s license, and cut all ties with California.

As you can see, it is important to be proactive when dealing with the state tax for expats issue.  Remember that these state tax problems can come back to bite you years after you move offshore, so dealing with them now will save you in taxes, interest, penalties, and fees to a CPA or Attorney.

Cheap offshore Company

How to Prorate the Foreign Earned Income Exclusion

When you first move offshore, you will need to know how to prorate the foreign earned income exclusion. This is because, you will be using the physical presence test in your first year and, presumably, won’t move abroad on January 1, so you will need to prorate the foreign earned income exclusion.

Let me take a step back. As you probably know, the Foreign Earned Income Exclusion allows you to exclude $99,200 in salary from your US taxes in 2014. To qualify, you must be a resident of a foreign country (residency test) or be out of the United States for 330 out of 365 days (330 day test or physical presence test).

Under the physical presence test you can choose any consecutive 12 month period for your Foreign Earned Income calculation. So, you might have moved abroad on Mach 15, 2014 and begin your new job on April 1, 2014. Therefore, you will probably want to prorate the Foreign Earned Income Exclusion from April 1, 2014 to April 30, 2015.

In this case, you should be out of the U.S. 330 days from April 1, 2014 to April 30, 2015. You could use March 15th as your start date, but that would mean you lose 15 days of the exclusion and these 15 days can’t be recouped when you file your 2015 return.

I note that it is necessary to prorate the Foreign Earned Income Exclusion because most people don’t leave the good ole USA on January 1, so they need to prorate in the year they begin their new lives. Also, to qualify as a resident of a foreign country, you must be out of the US for a full calendar year. Therefore, the physical presence test is common in year one.

In the example above, it would be possible to use the 330 day test to qualify for the FEIE from Aril 1, 2014 to December 31, 2014, and then use the residency test to qualify for the exclusion from January 1, 2015 to December 31, 2015. However, this will not affect your exclusion amount. You will still need to prorate the Foreign Earned Income Exclusion. In other words, there is no financial benefit to converting to the physical presence test, though you will be able to spend more time in the United States. The prorated exclusion amount may not exceed the maximum allowable exclusion.

To prorate the Foreign Earned Income Exclusion, use the number of days you were physically present during the tax year over 365. That is to say, exclusion is calculated by dividing the number of days physically present in the foreign county or countries (numerator) by the number of days in the year (denominator). (See Publication 54, section on part-year exclusion.)

In the example above, your 2014 exclusion is April 1, 2014 to December 31, 2014, or 274 days. Each day is worth $271.78 ($99,200 / 365= $271.78), so you can exclude up to $74,467.72 in 2014. If you earned $100,000 in salary from April 1, 2014 to December 31, 2014, you will owe U.S. tax on about $25,500 ($100,000 – $74,467 = $25,532.28) because of the prorated Foreign Earned Income Exclusion calculation.

Prorating the Foreign Earned Income Exclusion is common in the first year an ExPat moves abroad. It is also possible to prorate if you are forced to leave the country due to civil unrest.

According to the instructions for IRS Form 2555, under Waiver of Time Requirements:
If your tax home was in a foreign country, you reasonably expected to qualify for the Foreign Earned Income Exclusion in that country, but were forced to leave because of war, civil unrest, or similar adverse conditions, the time requirements residency test or the 330 day test may be waived. You must be able to show that you reasonably could have expected to meet the minimum time requirements if you had not been required to leave.

To support this rule, the IRS publishes a list of countries and the dates they qualify for the waiver. If you left one of these countries during the period indicated, you can claim a prorated Foreign Earned Income Exclusion on Form 2555 for the number of days you were a resident of or physically present in the foreign country.

As I wrote above, you must reasonably expect to qualify for the Foreign Earned Income Exclusion in the affected country. This is aimed at contractors moving in to dangerous areas. Basically, if you move to a dangerous area, and then decide to leave or are forced to leave, you don’t get the benefit of this rule. If you move to an area after it is listed in the IRS publication, you are on notice that it is dangerous and don’t get the benefit of this section.

I hope you have found this article helpful. Please post any questions in the comments below and I will respond online. You may also contact me directly at info@premieroffshore.com.

Seize Your IRA

Foreign Earned Income Exclusion 2014

Good news for those American’s living and working abroad. The Foreign Earned Income Exclusion in 2014 has been increased to $99,200. This means that you can exclude up to $99,200 in salary for 2014 on Federal income tax return if you are a resident of another country or are abroad for 330 out of 365 days.

  • This article from 2014 contains some valuable information. For 2015 FEIE numbers, please see: FEIE 2015

If a husband and wife both qualify for the Foreign Earned Income Exclusion in 2014, they each may deduct up to $99,200 this year. That means a husband and wife team may earn up to $198,400 from their offshore corporation.

Unfortunately for retirees and investors, this exclusion only applies to earned income, which is income from a business or a salary. If you are drawing that salary from a corporation formed in the United States, social taxes will still apply. If you are operating a business without a corporation, then Self Employment Tax at 15% will still apply.

  • Note that the exclusion applies to salary from any foreign corporation. It does not matter if you own the company or you work for someone else.

The Foreign Earned Income Exclusion for 2014 does not apply to passive investments or capital gains. If you are an American living and working abroad, the U.S. wants its cut of your investment profits. If pay taxes to another country (such as when you sell foreign real estate for a capital gain) you get a dollar for dollar credit and are not double taxed by America. For more information on foreign real estate transactions, see my article U.S. Tax Breaks for Offshore Real Estate.

This amount of $99,200 is the maximum exclusion you can qualify for. If you earn less than the exclusion, you may not carry forward the unused portion. For example, if your salary is $60,000 in 2014, you may only exclude $60,000. You may not carry over the balance of $39,000 to 2015.

If you earn more than $99,200, you must pay tax on the excess for the right to carry that U.S. passport. So, if you earn $299,200 in 2014, you will pay U.S. tax on $200,000 at about 38%, or $76,000. If you are operating a business through an offshore corporation, you might be able to retain earnings in that company and thereby defer U.S. tax. For more information, see: Eliminate U.S. Tax in 5 Steps with an Offshore Corporation.

Since 2006, the FEIE has been pegged to inflation, so we expect it to increase each year ever so slightly. The Foreign Earned Income Exclusion for 2014 increased by about 1.6% from 2013 and about 2.5% from 2012. So, we might expect an increase of 2% in 2015. Which is to say that the Foreign Earned Income Exclusion for 2015 might be about $101,184.

Here are Foreign Earned Income Exclusion amounts from 2014 back to 1998.

  • Tax year 2014: $99,200
  • Tax year 2013: $97,600
  • Tax year 2012: $95,100
  • Tax year 2011: $92,900
  • Tax year 2010: $91,500
  • Tax year 2009: $91,400
  • Tax year 2008: $87,600
  • Tax year 2007: $85,700
  • Tax year 2006: $82,400
  • Tax years 2002-2005: $80,000
  • Tax year 2001: $78,000
  • Tax year 2000: $76,000
  • Tax year 1999: $74,000
  • Tax year 1998: $72,000

I hope you have found this article helpful. If you would like more information, I suggest you read start with the Tax Benefits of Going Offshore. Feel free to contact me at info@premieroffshore.com with any questions or article requests. As always, you may leave questions in the comment section below and I will respond online.

Offshore IRA Fees

Tax Benefits of Going Offshore

The United States tax code is a hopelessly complex mess with as many loopholes for the wealthy as there are stars in the sky. There are many tax benefits of going offshore, and some of them can great for the “regular guy.”

Multinational corporations and billionaires spend big money on political campaigns and on lobbyists to ensure their interests are protected, and they expect a strong return on these “investments.” For example, a 2009 study found that each dollar put toward lobbying translated into $6 to $20 of tax benefits. Searching through these negotiated tax breaks leads you to a list of tax benefits of going offshore.

Just how ridiculous has the US tax code gotten? According to the IRS, taxpayers spent more than six billion hours in 2011 complying with the tax code – that’s enough to create an annual workforce of 3.4 million people. If that workforce was a city, it would be the third largest city in the United States. If that workforce was a company, it would employ more individuals than Walmart, IBM, and McDonalds, combined.

Even the mighty IRS seems overwhelmed by the complexity of the current tax laws. According to the National Taxpayer Advocate – part of the Internal Revenue Service – the Service cannot meet the needs of taxpayers.

Of the 115 million phone calls the IRS received in fiscal year 2012, it was only able to answer (actually pick-up) 68 percent of the calls. The IRS also failed to respond to almost half of all taxpayer letters within the agency’s own established time frame. And in 2011, the U.S.  Treasury Inspector General’s reported to Congress that most taxpayers who contact the IRS do not receive helpful responses.

Such complexity means that the well informed and well represented have a major advantage over the average citizen. While billionaires can afford hundreds of thousands of dollars a year in legal fees to structure their affairs to minimize tax, diversify their investments, and protect their assets, the average citizen is at a major disadvantage.

With this in mind, I spend my time researching and writing on the various ways the average person might utilize the tools designed for the Googles and Mitt Romneys of the world for their benefit. It is my hope that my website and articles will level the playing field just a bit.

Tax Benefits of Going Offshore

In the world of international tax planning, there are many regulations that can be utilized by anyone living, working, or investing abroad, to reduce your US tax bill. Some will eliminate tax on your salary, or allow you to opt out of the Social Security and Medicare taxes, while others, such as those that apply to IRA LLCs, can allow you to invest in just about anything offshore, with leverage, tax free.

The information provided below on the tax benefits of going offshore is a brief summary of a variety of complex tax rules. It is not meant as a complete analysis of these laws, nor is it tax or legal advice specific to your situation. Please contact me at info@premieroffshore.com or at (619) 483-1708 to discuss your situation in detail.

Foreign Earned Income Exclusion

The key to many of the offshore tax benefits of going offshore is the Foreign Earned Income Exclusion. This section of the tax code allows you to earn up to $97,600 from work, either as a self-employed person or as an employee. To qualify, you must be out of the US for 330 out of 365 days or a qualified resident of another country.

Anyone living and working abroad can qualify for this exclusion, so long as you meet the requirements of the 330 day test or the residency test, you are golden. The exclusion applies to Federal Income Tax, and not Self Employment tax, so additional planning may be required if you are running your own show.

I note that only those living in low tax countries will get much play from this exclusion. If you are based in a place with a tax rate that is about the same, or even higher, than the United States, then the Foreign Tax Credit will step in and prevent double taxation, without the need for the FEIE.

In other words, if your US Federal tax rate is 35%, and your rate in France is 40%, you have no need of the FEIE because you are already paying more in tax than you would in the United States. You can deduct your French tax on your US tax return without concerning yourself with qualifying for the FEIE.

Conversely, if you are living tax fee in Panama, drawing a salary of $100,000, and fail to qualify for the FEIE, then 100% of your income is taxable in the United States. Without the FEIE, there is no benefit to working abroad in a low tax country!

Take Your Retirement Account Offshore

By moving your IRA or other retirement account in to an offshore LLC, you can take control over your savings, invest in foreign real estate or projects, and hold cash outside of the United States in any currency you like. Even better, you can do all of this while maintaining the tax free or tax deferred status these accounts enjoy.

For the sophisticated investor, the tax benefits of going offshore can be enormous! I will list the in order of importance.

First, if your IRA invests in certain hedge funds (typically, the most profitable ones), the income generated is probably taxable to your IRA at the prevailing corporate tax rate, which is currently 15% to 39%. Most investors will pay about 34% on taxable income earned in their retirement account. In addition, you must file IRS Form 990-T to report that income and pay the tax.

–        Note that only very specific types of income, known as Unrelated Business Income (UBI), is taxable in a retirement account. This tax is called UBIT.

By moving your IRA in to an offshore LLC, and investing through a UBIT Blocker Corporation, you can completely eliminate UBIT. Your IRA can invest in a hedge fund, or any other UBI generating venture, and pay zero US tax.

This tax loophole was created for large pension funds, but is available to any tax exempt organization or charity, including offshore IRA LLCs. Hedge funds that wish to attract pension funds, retirement accounts, or non-US investors, must set up an offshore module of their fund (known as a Master/Feeder structure), whereby the tax exempt groups (your IRA) and foreign persons invest in the offshore division, while US persons invest in the US division. Then, these groups are combined in the master fund, from which investments are made and returns generated.

Offshore IRA LLCs have been used by the uber rich for years, and became big news during the previous presidential election. Many news outlets reported that Mr. Romney was able to grow his IRA LLC to over $100 million through the use of this type of international tax planning. To read more about his use of these structures, click here for the NY Times and here for a very partisan article on the Huffington Post.

Likewise, IRA LLCs that wish to invest in an active business will benefit from being offshore. Your IRA LLC can own up to 50% of any active business. The profits generated, especially if that business is structured as a partnership, are often Unrelated Business Income and taxable to the IRA.

If the company is offshore, then it may be operating free of US income tax. If you buy in through a specially designed offshore IRA LLC, profits paid out to you may also be tax free because your offshore structure effectively blocks the US from taxing those profits. For additional information, see the UBIT Blocker section of my website.

Those are the basics of taking your IRA offshore…child’s play, if you will. Here is the monster tax benefit of going offshore: You can eliminate UBIT on leverage by going offshore. Let me explain.

When you borrow money, or leverage up your IRA, the profits generated from that leverage are taxable (under the UBIT rules). So, if you buy a rental property for $100,000 with your IRA, paying $50,000 from your retirement account and get a non-recourse loan of $50,000 for the balance, when you receive rental payments, or sell the home, 50% of the net income will be taxable as UBI.

The same is true with brokerage and forex accounts. Your provider may be willing to give you 10 to 1, 30 to 1 or even 100 to 1 leverage on your deposit. But, if this is an onshore retirement account, the profits generated with that leverage are taxable.

By taking these transactions offshore, through a specialized offshore IRA LLC with UBIT Blocker Corporation, you can eliminate UBIT on borrowing and leverage. Tax free leverage is the key to generating big tax free profits in your retirement account.

For the “asset protection” benefits of moving your retirement account offshore, see my article: Can the Government Seize my IRA? If you are concerned with privacy or protecting your IRA from creditors and government appropriation, moving your IRA offshore, and in to a bank that does not have a branch in the US, is your best and only defense.

Stop Paying Social Taxes

Are you tired of supporting the Obamanation through social and medical taxes? Or, forgetting the political hyperbole, do you want to cut your US taxes? You can opt out of employment and social taxes by moving offshore. If you qualify for the Foreign Earned Income Exclusion, and are an employee of a company based outside of the US, then you need not pay Social Security, Medicare, or any other social taxes on your salary.

However, if you are an independent contractor, or are otherwise self-employed, then you must still pay Self Employment tax, at a rate of around 15%. So, assuming you qualify for the FEIE, on a salary of $97,000 you pay no Federal Income Tax but around $14,000 in SE tax. For a husband and wife, each drawing a salary, the SE tax will doubled to about $28,000.

The same is true if you are an employee of a US corporation while living abroad. You get the benefit of the FEIE, but must pay your share of social taxes (about 7.5%), as must your employer. All Social Security, Medicare, Obamacare, and related taxes still apply to the Expat and his employer, so long as you are employed by a US company.

Like the employee of a foreign company, you can eliminate SE tax by incorporating your business offshore and become an employee of that company. You can incorporate in any tax free country (such as Belize), and it does not matter where you are living or working, it does not matter if you are the owner and sole employee, nor does it matter if all of your clients are in the United States. So long you are living and working abroad, qualify for the FEIE, and are running an active business, you can eliminate SE tax by incorporating offshore. Your corporation should bill your clients and you can draw a salary from the net profits that entity of up to the FEIE amount (currently $97,600).

–        You might combine the offshore company with a US LLC if you wish to open accounts in the US and get paid by check, PayPal, or credit card.

Defer Tax with Offshore Mutual Funds

For the uninitiated, investing in an offshore mutual is a bad idea. Punitive rules (the opposite of loopholes) have been written in to the tax code by the US mutual fund industry which are quite hostile to investing in these types of products offshore.

In most cases, an offshore mutual fund investment is governed by the Passive Foreign Investment Company (PFIC) section of the code. Like a US mutual fund, you only pay tax when you cash out. But, unlike a US fund, the tax man is going to crush your profits. First, when tax is paid, all income and gains are taxed at the highest ordinary income rate (presently 39.6%).  There is no long-term capital gains treatment.  Second, losses are disallowed.  Third, you have to assume that all of the gains are earned ratably over the time the investment was held — even if the fund lost money the first few years and only made its gains in the last year when you cashed out.   Why is that bad?  Because of the final part of the quadruple whammy – interest charges, compounded annually.  Annually compounded interest at the underpayment interest rate (which is set by the Treasury Department each quarter and has been anywhere from 5% to 10% over the last several years) is charged on deferred tax.

And here is the loophole for the offshore professional: If the PFIC meets certain accounting and reporting requirements, a PFIC shareholder can elect to treat the PFIC as a qualified electing fund.  The effect is that the PFIC shares are taxed like U.S. shares.  The owner of a foreign mutual fund treated as a QEF may: 1) elect to pay tax on income as it is accrued in your account, or 2) choose to defer tax until money is received. If both the QEF and deferral elections are made, you pay tax on the profits plus 3% interest per year when you receive a distribution.

If your offshore mutual fund is returning profits greater than your interest rate of 3%, or the fund has profits some years and losses in others, the QEF with deferral elections are major tax benefits. This is especially important for a fund with losses, as these losses do not flow through to your tax return, so deferral can eliminate some quite harsh tax consequences of going offshore.

These elections allow the well-educated investor to access some of the high flying offshore mutual funds without the punitive taxes meant to keep the uninformed in the United States.

Eliminate Tax in Your Country of Residence

While the United States taxes you on your worldwide income, no matter where you live, and no matter where your clients are located, most countries do not charge you for foreign source income…which is to say, you pay no tax on income earned outside of their borders or, the majority of nations tax you only on income earned within their territory.

With this in mind, planning may eliminate tax from your country of residence. For example, if you are living in Panama, selling products or services to customers in the United States, and operating a through corporation in Belize, Panama may not tax you on the net profits of that Belize entity. Conversely, if you are living and working in Panama, operating through a Panama corporation and/or selling to people living in Panama, then Panama wants its cut.

By incorporating your business in a country other than where you reside, you may be able to legally avoid paying any tax to that country. When you combine a tax free country of incorporation (Belize), with a country with a territorial tax system (Panama), and the Foreign Earned Income Exclusion, it is possible to earn a significant amount of money from your business and pay zero income tax to any nation.

In the case of a business with employees and local expenses, you may form a corporation in Panama and bill your Belize corporation from that Panamanian entity. You should only bring in enough money to Panama to pay your bills, but draw your salary from the Belize company. In this way, the Panama company will break-even and no tax will be due.

I am often asked why countries like Panama allow this setup. It is because 1) you will pay employment and other taxes on your employees, and 2) you will spend money and indirectly contribute to the economy by living and basing your business in that country. A business that employees local workers is a major benefit to any efficiently run economy.

Retain Earnings Offshore

For the entrepreneur, qualifying for the FEIE and taking that salary through an offshore corporation is the first line of defense against the IRS. It allows you to take out $97,600 in salary free of Federal Income Tax. If a husband and wife are both involved in the day to day operation of the business, each may qualify for the exclusion, resulting in up to $195,200 in tax free salary.

So, what if your net profit is more than FEIE? If you take more than the Exclusion out of the corporation, you will pay tax on it as earned. If you leave it in the corporation, it will be classified as retained earnings and not taxable in the United States until it is distributed as a dividend or other payment.

–        This assumes you are incorporated in a country, such as Belize, that will not tax your corporate profits or retained earnings.

Two important caveats: 1) interest or capital gains derived from these retained earnings is taxable as earned, and 2) you may not borrow retained earnings from your corporation or use them for your personal benefit. They must remain in the corporation or be used for business expenses and expansion.

You might be wondering why large companies based in the US get offshore exclusions while you must make the drastic step of moving abroad to receive these benefits? In fact, multinationals must follow similar rules to qualify by having an active division with employees outside of the US in order to retain some earnings offshore.

To put it another way, a small business, that is owned and controlled by a US person, must move all of its operations outside of the US to gain these benefits. A large corporation can achieve the same by moving an autonomous division abroad.

For additional information on this topic, see my article: How to Manage Retained Earnings in an Offshore Corporation.

Conclusion

As you can see, there are a number of tax benefits for those offshore. If you are living, working, and/or investing abroad, you should consult with a professional to ensure you are taking advantage of these benefits. For the business owner who has a non-US partner, additional incentives may be available but are outside of the scope of this article.

I will end by pointing out that big tax breaks come with big tax reporting requirements. US tax compliance should be a primary component for anyone considering going abroad and is the foundation of an international tax or business strategy. Be sure to contact a licensed US representative, and do not rely on a foreign provider, whenever incorporating offshore.

Dollar Will Fail

Foreign Earned Income Exclusion Basics

The Foreign Earned Income Exclusion is the Expat’s first, and sometimes only, line of defense against the IRS. It allows you to eliminate up to $97,600 in salary from your US taxable income in 2013, and can provide additional benefits to those living, working, and operating a business abroad.

Just about every tax article on this site is based on the Foreign Earned Income Exclusion in one way or another, so it is imperative that you have a solid understanding of this US tax law. Whether you are planning to move abroad, or you have been out of the US for years, you should become an expert on the inner workings of the Foreign Earned Income Exclusion.

  • Note that the Foreign Earned Income Exclusion applies to salary you earn from your own business or as an employee of someone else. It does not apply to retirement or other investment income. If you are a pensioner with no intention of getting a job or starting a business offshore, this posting is not for you.
  • This article has some very useful information. For updated FEIE numbers, see: Foreign Earned Income Exclusion 2015

An Introduction to the Foreign Earned Income Exclusion

As stated above, the Foreign Earned Income Exclusion allows you to eliminate up to $97,600 in salary from your US taxable income.

For example, if you are an employee of a corporation in Belize or Panama, you qualify for the Foreign Earned Income exclusion, and you earn $65,000 in wages, you will pay no Federal income tax. Likewise, if you earn $200,000 in salary while qualifying for the exclusion, you will pay US tax on the amount over $97,600, or on $102,400.

Foreign Tax Credit: If you are paying tax to your country of residence, then the Foreign Tax Credit will step in and eliminate any double taxation. But, for the balance of this article, let’s assume you pay no local tax, which is the case with the majority of my clients, and leave the Foreign Tax Credit for another time.

Note that I said “no Federal income tax.” It is possible to qualify for the Foreign Earned Income Exclusion and still be considered a resident of a State in the US…especially an aggressive cash starved State like California. If that occurs, you may have to pay State tax on 100% of your salary. You should review your State laws prior to moving abroad to ensure you don’t get hit with a surprise tax bill.

Also, income tax does not include social taxes, such as FICA, Social Security, Medicare, Obamacare, or Self Employment taxes. If you are an employee of a US company while qualifying for the exclusion, you and your employer will pay these taxes. If you are running a business and not incorporated offshore, you will pay about 15% in Self Employment tax which is not reduced by the Foreign Earned Income Exclusion. To avoid this, you or your employer can incorporate a subsidiary offshore from which you will draw a salary.

Finally, the Foreign Earned Income Exclusion is based on United States Dollars earned. If your country’s currency is appreciating vs. the dollar, the value of the exclusion to you is declining. For a summary of these issues, see: Weak Dollar Crushing the Foreign Earned Income Exclusion

Qualifying for the Foreign Earned Income Exclusion

There are two ways to qualify for the Foreign Earned Income Exclusion:

1) The physical presence test, and

2) The residency test.

The first is relatively simple to calculate and does not require you to live anywhere in particular. The second allows you to spend much more time in the United States, but has many conditions and requirements attached to it.

Physical Presence Test

The physical presence test is easy to define. You qualify for the Foreign Earned Income Exclusion if you are out of the United States for 330 out of any 365 day period. It does not require you to be out of the country for 330 days in a calendar year…any 12 month period will do.

So, if you are abroad from April 1 2013 to April 2, 2014, and only spend 10 days in the US visiting family during this time, you qualify for the exclusion. You can exclude up to $97,600 in salary earned from April to April from your US income tax returns.

Because you are using an April to April calendar, your Foreign Earned Income Exclusion will be prorated on your 2013 and 2014 personal income tax returns. If you earn $100,000 in 2013, you will be able to exclude about $73,200 (75% of the $96,700 Foreign Earned Income Exclusion). You will then be able to exclude around $24,400 on your 2014 tax return in salary earned from January 1, 2014 through March 31, 2014.

When you rely on the physical presence test, it does not matter where you are in the world…just that you are out of the US for 330 days out of 365. You can move around as much as you like (see below), are not required to have a home base, and are not required to be in any one country for a certain period of time.

Of course, my favorite clients will always find a way to make a simple matter complicated. Many of you will try and maximize your time in the US, coming up against the 35 day limit.  That means you need to understand the definition of travel days vs. days abroad and take in to account time over international waters. This becomes especially important for those who travel through the US, those who take long flights through multiple time zones, and those who travel by ship. For a detailed review of these issues, see my article: Changes to the Foreign Earned Income Exclusion Physical Presence Test Travel Days

Residency Test

While the physical presence test is relatively simple to calculate, qualifying for the Foreign Earned Income Exclusion using the residency test can be a challenge. First, the residency test requires you to be resident in a country for a full calendar year. This usually means you must utilize the physical presence test your first year abroad, and then step up to the residency test.

Next, you must move to a city and demonstrate that you plan to make it your home.  The key to the test is your intent to move to that place for the forcible future, with no intent to return to the United States. Any time a tax issue is determined by something as fuzzy as intent, you are asking for trouble in an audit. You must compile a great litany of evidence in case your use of the Foreign Earned Income Exclusion is challenged…especially if your intentions change and you return to the US after a few years.

To put it another way, you are required to prove to an IRS examiner that you moved to your particular city permanently and with no intent to return to the States in the forcible future. Yes, I am saying that you have the burden of proving that you qualify for the Foreign Earned Income Exclusion under the residency test. It is up to you to substantiate your case and not up to the IRS to disprove your claim.

Intent to return to the US is often at the heart of the battle in these examinations. One common case is the “short term” work assignment. If you are sent to Panama by your employer on a 3 year assignment, you probably do not qualify for the Foreign Earned Income Exclusion under the residency test. This is because the evidence suggests that you intend to return to the United States at the end of that 3 year contract.

I see this all the time with military contractors and oil well workers. They want to claim they are residents of Iraq or some war torn strip of land, though their families are in the States and they have no ties to the country to which they have been sent. In these cases, the contractor must rely on the physical presence test, as he will never qualify under the residency test.

In contrast, it would be possible to move to Panama with no intent to return to America, following all of the suggestions below, and then being forced back home after two years due to an unforeseen circumstance.

Such a person will likely qualify as a resident of Panama, even though their stay was short. It is therefore conceivable that someone in Panama for two years would qualify under the residency test, while someone in Iraq for five years would not.

At the other end of the spectrum is the perpetual traveler. This is the person who leaves the US and never puts down sufficient roots to be considered a resident of any particular country. I have had a number of clients who spend a month or two in each country and have no home base.

The heart of the residency test is your intent to make a particular place your home. If you never put down roots, you are not a tax resident of any country and you land back on your default tax home, the United States (without passing Go and without collecting $200). Therefore, the perpetual traveler must qualify for the Foreign Earned Income Exclusion using the physical presence test and not the residency test.

  • Tip: If you are a contractor or perpetual traveler with family in the States, have them visit you at a Caribbean Island paradise or somewhere else outside of the US. I guarantee this vacation will be less costly that risking the loss of the Foreign Earned Income Exclusion.

It is possible to travel extensively and still qualify under the residency test. If you are road warrior, then you should always be returning to a home base. If all of your adventures originate from and return to from Medellin, then Colombia is your home port. If you can demonstrate that you have such a home port, and follow the other keys below, then you have a good shot at being considered a resident.

As I have said, the burden of proof is on you, not the IRS, when it comes to the residency test. The evidence required to prove up the Foreign Earned Income Exclusion using the residency test will vary with each case, but here are a few keys:

1) Obtain a residency permit from your new country.

2) It is best if you spend 6 months or more in your country of residence. You are considered a tax resident in most countries if you spend six months out of the year there.

3) Get a work permit or other authorization to operate a business in your country of residence.

4) File tax returns in your country of residence. You can structure a business with an offshore corporation to limit taxes as permitted, but you should file some kind of personal income tax return to show you are a member of that society.

5) Cut as many ties as you can with the United States. It is especially important to sell or rent out on a long term lease any real estate. You should also limit US investments, bank accounts, and any other link you can think of.

6) Make as many connections with your new country and local community as possible. For example, get a driving license, local ID card, open local bank accounts with debit cards, and join a club or two.

In item #1 above, I note that your residency permit should be from your new country. Many clients grab for the easiest authorization available, such as the Belize QRP visa, and have no intention of living in Belize. It is important to at least begin the process of obtaining residency in your new country, and not in a country where you will have no other ties.

It is possible to qualify as a tax resident for US purposes and not have a residency permit from your new country. If you are unable to afford or qualify for residency, then each of the other suggestions above become all the more important. I also suggest you at least begin the application process prior to using the residency test.

Why all the fuss about the residency test? Why spend the time, effort and money to qualify? Because, once you are a tax resident of another country, you can spend a lot more time in the US. You are no longer limited to the 35 days you get with the physical presence test and you no longer need watch the calendar like a school girl hoping for summer.

How much time do you get in the good ole US of A? That is a difficult question. First, you should not be working while here. All work for your employer should be done abroad. Next, you can’t spend six months or more hanging around. Once you are in the US for 6 months, you are considered a tax resident.

Other than these limits, you can spend as much time in the US as you like, keeping in mind that you must be able to convince the IRS in an audit that you are a resident of your “home” country. I like to tell clients that they can spend 60 days here without risk, and 90 days if they have a good reason. Once you exceed these numbers, it becomes quite challenging to prove you are a resident of another country.

Of course, each case is different and I can envision a scenario where four months in the US would pass inspection. I can also imagine a case where 90 days in the US would not be acceptable. It will all depend on the facts and circumstances of your situation and the quality of your connections to your country of residence.

Foreign Earned Income Exclusion – Use it or Lose It

The Foreign Earned Income Exclusion is an all or nothing proposition. If you qualify, you get to deduct $97,600 on your 2013 personal income tax return. If you do not qualify, you get to deduct nothing and all of your income is taxable in the United States so long as you carry a US passport.

It is a very harsh law and the IRS goes in to Tax Court all the time to take the exclusion away from someone who missed qualifying by a day or two, or someone who failed to meet their burden of proof on the residency test. And, remember, a lot of audits cover three or four years, so losing the exclusion could result in a tax bill of well over $100,000 with interest and penalties.

Also, to get the benefit of the Foreign Earned Income Exclusion you must file your US tax returns. If you do not file, and you are chased down by the IRS, you will lose the right to take the exclusion. Yes, even if you spent every day for five years outside of the US, and there would be no question of your qualifying, the IRS has the right to take away the exclusion for your failure to file.

I am not saying you will lose the exclusion simply because you have not filed on time. If the IRS is not on your trail, and you come forward voluntarily, you will be able to take the full Foreign Earned Income Exclusion. It is only those whom are found out, usually through an offshore bank account, a computer generated audit, the government randomly seeking out non-filers, their family or employer being audited, or some other issue that brings them to the attention of the IRS, who lose the exclusion.

Conclusion

As you can see, the Foreign Earned Income Exclusion is fraught with complexity and nuance. Before you start an offshore business, or before going to work outside the US, consult with an expert in this area. Even if you have been living abroad for years, it is in your best interest to have an experienced professional review your prior filings, plan out your next few years, and make sure you are in compliance.

If you have not filed your US tax returns for a few years, it is imperative that you do so to ensure you qualify for the Foreign Earned Income Exclusion. If, in addition to non-filing, you have an unreported offshore account, you should consider joining the current IRS amnesty program. For information on this, see my article: IRS Voluntary Disclosure Program Gives Big Breaks to ExPats. Basically, if you will owe no tax on your late filed returns after taking the Foreign Earned Income Exclusion in to account, then you will also avoid penalties for failing to report your offshore bank account(s).

If you have any questions on the exclusion, or need assistance with planning your international business or preparing your US tax returns, please contact me at (619) 483-1708 or by email to info@premieroffshore.com. We are very experienced in these matters and consultations are confidential.

Offshore Corporation Taxation

Eliminate U.S. Tax in 5 Steps with an Offshore Corporation

Yes, you, the offshore entrepreneur, can eliminate your US tax bill by forming an offshore corporation and following the five steps below.

As you are painfully aware, the United States taxes its citizens on their worldwide income. No matter where you live, or how much you make, America want’s its cut. Using an offshore corporation will level the playing field just a bit.

If you are a salaried employee in a high tax country, such as France or England, then the US tax system can’t get much, if anything, from you. You have already paid more in taxes to your host country than you would have to the US, so the Foreign Tax Credit steps in and prevents double taxation.

In other words, if the US tax rate is 30%, and you, as an American living in London, pay 35% to The Queen, there is nothing left for the US to take.

But, what if you want to structure your affairs to reduce or eliminate your worldwide tax bill? If form an offshore corporation, and you can follow these five steps, you will eradicate host country income tax, eliminate or defer US tax on your business profits and finally get Uncle Sam out of your pocket – legally and without risk.

Step 1 – Form an offshore corporation in a country that is business friendly

There are a number of tax efficient countries where you can structure your offshore company to pay zero local income tax. Most of these business friendly nations will tax only local source income, or sales to locals, and an internet based or international business will not pay tax on its profits.

To facilitate this, you may need to incorporate in an offshore jurisdiction, as well as in your country of residence, and bill your clients through your offshore entity. The offshore corporation is your “sales” unit and the corporation in your country of residence is your “operating” entity.

Cash flows to your sales entity and net profits are held there. Operating overhead, such as office and employees, are run through the operating entity, which bills the sales unit for these expenses. The operating entity should break-even at year end to avoid local taxation.

If you are marketing to the United States, the most business savvy country from which to operate your offshore company is Panama. It offers a well-qualified English speaking workforce at ¼ the cost of the US and is in the same time zone as America, a big benefit. Panama also has an excellent banking and professional sector, as well as decades of experience in shipping, technology, and production.

Where you incorporate your offshore sales unit doesn’t make much difference. So long as 1) it is different from your operating country, 2) does not tax your business, and 3) does not require you to provide annual reports or audited financial statements. In most cases I recommend a sales unit in Belize or Nevis to match up with a Panama operating company.

You might wonder why countries like Panama and Belize offer these types of structures and tax benefits…don’t they need tax revenue? First, these countries are relatively small and have nowhere near the military, spying, social programs, and other expenses related to running a superpower. Second, offering these incentives brings in investment, income from employment taxes, as well as employment, sales taxes, and other benefits. A small and efficient economy based on entrepreneurship can bring in sufficient proceeds to offer most of the benefits and few of the costs of America.

Step 2 – Live and Work Outside of the US

To realize tax benefits from your offshore corporation, you must live and work outside of the United States as well as qualify for the Foreign Earned Income Exclusion. If you do not qualify for the exclusion, all of the income in your offshore corporation will be taxable in the United States.

There are two ways to qualify for the Foreign Earned Income Exclusion:

The first is a simple math – be out of the US for 330 out of 365 days. If you can meet this requirement, known as the Physical Presence Test, you are guaranteed to qualify for the exclusion and should have no problems in an audit.

I also note that you can be out of the US for 330 out of any 365 day period. It does not need to be in a calendar year. For example, if you are out of the US from March 1, 2013 to March 30, 2014, and only visited the US for 20 days during that time, then you qualify for the Foreign Earned Income Exclusion.

If you have questions on the Foreign Earned Income Exclusion and how these days are calculated, please see my article: Changes to the FEIE Physical Presence Test Travel Days

The second is based on your intention to become a resident of another country for the foreseeable future and is more challenging to prove if you are audited. As a test based on your intentions, rather than travel days, it requires you to show you are a resident of a country, that you are a part of the community there, and that you have no intentions of returning to the United States in the foreseeable future.

To qualify as a resident, you must get a residency permit and file taxes in your new nation (hopefully, you will pay very little, if anything, but you must file). Also, you should think about applying for citizenship or securing some other long term work permit or enhanced residency status. Finally, you should break as many ties to the US as possible, including selling real estate, moving with your family or spouse, transferring some of your investments or retirement accounts, and have as few contacts with the US as possible. 

If you can qualify under the Residency Test, rather than the Physical Presence Test, you can spend much more time in the United States. While I don’t recommend spending more than 4 months, it is possible to spend just under 6 months. If you spend 6 months or more in the United States, you are by definition a resident.  Exactly how much time you can spend in your homeland will depend on the specific facts and circumstances of your situation.

I also note that the Residency Test must cover a calendar year. While the Physical Presence test can be used for any 12 month period, the Residency Test is much more rigid and is usually not an option in the first year you move abroad…unless you happen to move on January 1st.

If you are a perpetual traveler, or on a work assignment abroad, you will need to use the Physical Presence Test. This is because the perpetual traveler never puts down roots in a particular city, and so she is not a “resident” of anywhere, at least as defined by the US tax code. Likewise, the person assigned to work for 3 years in Medellin, Colombia by his employer intends to return to the United States at the end of that job assignment (at least, until he learns how much fun the city can be), so he is not a resident of Colombia for US tax purposes.

Once you qualify for the Foreign Earned Income Exclusion, you can earn up to $97,600 in 2013 in salary from your offshore corporation and pay nothing in US Federal Income Tax. If a husband and wife both qualify, then you can earn $195,200 jointly.

If you are operating a business, and your net profits exceed $200,000, read-on, additional planning is required.

Step 3 – If you are self-employed or have a business, form an offshore corporation

If you are operating a business, you must form an offshore corporation. Failure to incorporate will have dire consequences on your US tax situation. Here are a few examples:

If you do not incorporate, you will pay Self Employment tax on your income, which is approximately 15% and is not reduced by the Foreign Earned Income Exclusion. On joint income of $200,000, SE tax is a little less than $30,000 per year – money you could have saved by planning ahead.

If you do not incorporate, your Foreign Earned Income Exclusion will be reduced by your business expenses. This is a complex matter, but I can summarize it as follows: if your business expenses are 50% of your gross, then your FEIE will be reduced by 50%, from $97,600 to $48,800. So, only $48,800 of your salary is tax free under the FEIE.

If you do not incorporate, 100% of your net profit must be reported as salary. If you incorporate and earn more than the Foreign Earned Income Exclusion, you may be able to retain earnings over and above the FEIE and thereby eliminate or defer US tax. 

It is not tax efficient to draw a salary of more than $100,000 single, or more than $200,000 jointly, from a foreign corporation. If your net profits are above these levels, leave the excess in the corporation and defer US tax until the money is distributed.

There are a number of rules to consider when dealing with retained earnings. For additional information on retained earnings in your offshore corporation, read my previous article here.

Step 4 – Gain residency in your new home country

During your first year offshore, I highly recommend you use the Physical Presence Test to qualify for the Foreign Earned Income Exclusion and spend as little time in the United States as possible. Keep in mind that the Residency Test requires a full calendar year and that qualifying as a resident is a challenging and complex matter.

Once year two rolls around, have all of your documents filed, your ties to the US cut, and your roots firmly in to the community. No matter your long term plans, being able to come and go in the US will be a benefit, and being recognized as a resident of your country of operation will  open a number of doors, both in America and abroad.

For example, a resident will have a much easier time opening bank accounts, getting favorable apartment and office leases, and generally conducting business.  As the luster of the American passport diminishes around the world, a residency card becomes more of a necessity.

Step 5 – File your US Tax Returns, Offshore Corporation Returns, and Report your Foreign Assets and Bank Accounts

As an American citizen, you are required to report your income and foreign assets to the US government or face the wrath of the IRS. This includes an interest in an offshore corporation. The penalties for not reporting these resources are intended to be so draconian that failure to comply is simply not worth the risk.

For the international business owner, the Foreign Earned Income Exclusion and a properly structured entity should remove most of the tax cost of compliance, so reporting and running a “clean” operation should be a welcome relief.

Below is a basic review of the expat Entrepreneur’s US filing obligations:

International Bank and Brokerage Accounts

The most critical filing requirements is the Report of Foreign Bank and Financial Accounts. Anyone who is a signor or beneficial owner of a foreign bank or brokerage account with more than $10,000 must disclose these accounts to the U.S. Treasury.

The law imposes a civil penalty for not disclosing an offshore bank account or offshore credit card up to $25,000 or the greatest of 50% of the balance in the account at the time of the violation or $100,000. Criminal penalties for willful failure to file an FBAR can also apply in certain situations. Note that these penalties can be imposed for each year.

In addition to filing the Foreign Bank Account form, the offshore account must be disclosed on your personal income tax return, Form 1040, Schedule B.

Offshore Corporation and Trust Filing Requirements

There are a number of filing requirements for offshore corporations, IBCs and International Trusts. Failure to file the required returns may result in civil and criminal penalties and may extend the statute of limitations for assessment and collection of the related taxes.

            Form 5471 – Information Return of U.S. Persons With Respect to Certain Offshore Corporations must be filed by U.S. persons (which includes individuals, partnerships, corporations, estates and trusts) who owns a certain proportion of the stock of a foreign corporation or are officers, directors or shareholders in Controlled Foreign Corporation (CFC). If you prefer not to be treated as a foreign corporation for U.S. tax reporting, you may be eligible to use Forms 8832 and 8858 below.

            A offshore corporation or limited liability company should review the default classifications in Form 8832, Entity Classification Election and decide whether or not to make an election to be treated as a corporation, partnership, or disregarded entity. Making an election is optional and must be done on or before March 15 (i.e. 75 days after the end of the first taxable year).

            Form 8858 – Information Return of U.S. Persons with Respect to Foreign Disregarded Entities was introduced in 2004 and is to be filed with your personal income tax return if making the election on Form 8832. A $10,000 penalty is imposed for each year this form is not filed.

            Form 5472 – Information Return of a 25% Foreign-Owned U.S. Corporation is required to be filed by a “reporting corporation” that has “reportable transactions” with foreign or domestic related parties. A reporting corporation is either a U.S. corporation that is a 25% foreign-owned or a foreign corporation engaged in a trade or business within the United States. A corporation is 25% foreign-owned if it has at least one direct or indirect 25% foreign shareholder at any time during the tax year.

            Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation is required to be filed by each U.S. person who transfers property to a foreign corporation if, immediately after the transfer, the U.S. person holds directly or indirectly 10% of the voting power or value of the foreign corporation. Generally, this form is required for transfers of property in exchange for stock in the foreign corporation, but there is an assortment of tax code sections that may require the filing of this form. The penalty for failing to file is 10% of the fair market value of the property at the time to transfer.

            Form 8938 – Statement of Foreign Financial Assets was new for tax year 2011 and must be filed by anyone with significant assets outside of the United States. Who must file is complex, but, if you live in the U.S. and have an interest in assets worth more than $50,000, or you live abroad and have assets in excess of $400,000, you probably need to file. If you are a U.S. citizen or resident with assets abroad, you must consult the instructions to Form 8938 for more information. Determining who must file is a complex matter. See http://www.irs.gov/uac/Form-8938,-Statement-of-Foreign-Financial-Assets for additional information.

With proper planning, selecting the best country of operation and formation of your offshore corporation, keeping in compliance, gaining residency, and, most importantly, utilizing the Foreign Earned Income Exclusion, you can operate your business free of both US and local taxes and make the most of your time abroad.

Please contact me directly at info@premieroffshore.com or call (619) 483-1708 for a confidential consultation.

FEIE) physical presence test travel days

Changes to the FEIE Physical Presence Test Travel Days

If you are using the FEIE physical presence test travel days to qualify for the exclusion, watch your calendar closely. As the IRS interprets the FEIE ever more harshly, one day here or there can cause you to lose the exclusion and cost you thousands.

As you know, the FEIE allows an American abroad to exclude up to $97,600 of wage or salary income for 2013 from your U.S. personal income tax return. You can qualify by becoming a resident of a foreign country or by being present in a foreign country or countries for 330 out of 365 days.

In recent years, a battle has raged on the definition of “present in a foreign country or countries” It is now interpreted very literally, and, of course, in favor of the IRS.

In prior years, we explained the FEIE physical presence test travel days like this: You must be out of the U.S. for 330 days out of 365. The 330 days do not need to be in a calendar year…any 12 month period is fine.

But this definition has been modified through a series of tax court cases. Now, we explain the FEIE physical presence test like this: You meet the FEIE physical presence test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months. The 330 days do not need to be in a calendar year…any 12 month period is fine.

This modification may seem minor, but has caused many to lose the benefits of the FEIE altogether, costing them thousands of dollars each year, and bringing millions in to the IRS.

The change in terminology means that, being “present in a foreign country” does not include time in on or over foreign waters. In other words,you are not present in a country while in or over international waters.

Also, a full day is now a period of 24 consecutive hours, beginning at midnight. It no longer includes partial days. Therefore, to meet the FEIE physical presence test travel days you must now spend each of the 330 full days in a foreign country or countries.

When you leave the United States, or return to the United States, the time you spend on or over international waters does not count toward the 330-day total. This means that most travel days to or from the U.S. does not count towards the FEIE physical presence test. Exceptions would include driving or flying to Mexico, or Canada. Travel to South and Central America depend on your flight path or course. However, because you must be present in the foreign country for a full day (24 hours), your path is only relevant if you are traveling at night and on the road at midnight.

Time over international water can be very important to those traveling to Europe or Asia.

  • For example, if you leave the United States for Switzerland by air on March 28, and you arrive in Switzerland at 9:00 a.m. on June 29, your first full day in Switzerland is March 30.

You can take short trips from country to country (not including the United States) without affecting your FEIE physical presence test. However, if any part of your travel is over international waters, and the trip takes 24 hours or more, then you lose those day(s).

These new interpretations can hit perpetual travelers and cruise ship passengers hard.

  • For example, you leave Panama by ship at 10:00 p.m. on February 6 and arrive in Brazil at 11:00 a.m. on February 8. Since your travel is not within a foreign country or countries and the trip takes more than 24 hours, you lose three FEIE physical presence days – February 6, 7, and 8. If you remain in Brazil, your next full day in a foreign country is February 9.

The IRS takes these calculations quite seriously and goes to extreme measures to deny the FEIE physical presence test travel days. For example, I was in the courtroom watching one of the first cases where the government attacked the captain of a small sailing ship. This guy and his wife were just getting by on $55,000 per year as the captain and crew of a millionaire’s yacht, and the FEIE was everything to them.

The government spent a great deal of time going through the ship’s course and even got the U.S. Navy involved to determine exactly when the yacht crossed in to international waters (over 50 times during the year). This endeavor took up hundreds of government man hours and resulted in the captain losing the FEIE physical presence test by three days.

I give you this example to stress the importance of watching your travel days. I guarantee the IRS will do anything to separate you from your money, so you must be even more diligent to protect your rights.

  • A number of special rules apply to international airline pilots and are not considered here. For additional information, see the IRS website or the pilot’s forum.

I will leave you with one last cautionary tale: A friend was traveling with his wife and three children, including their new baby, from Panama to the Cayman Islands. They decided to take the cheaper flight with a stop-over in Miami. Well, it was the most expensive vacation they ever had.

If you are in transit between two points outside the United States and are physically present in the United States for less than 24 hours, you are not treated as present in the United States during the transit. The U.S. airport is considered international space for this purpose. So, if the trip, including the stop-over in the U.S., takes less than 24 hours, you do not lose any FEIE physical presence test days.

Well, U.S. immigration took this opportunity to interview these Expat’s on their time in Panama, their business interests and foreign assets, whether they had filed and paid their U.S. taxes each year, searched their luggage, and, the most damning, let them sit for two hours before beginning the grilling of all members, including the children.

As a result, they missed their flight from Miami to Cayman and had to spend the night in Florida. This meant the trip took more than 24 hours and that they were considered present in the U.S. during their stop-over. Thus, they lost two full FEIE physical presence test days.

Because this was at the end of their 330 day cycle, and they had previously spent some days in the U.S. during the year, they lost the FEIE in its entirety. That stop-over in Florida cost these fine people over $38,600.

I note that you can’t pro-rate the FEIE physical presence test. You either qualify or you don’t. For example, if you do not meet the physical presence test because of illness, family problems, a vacation, or your employer’s orders cause you to be present for less than the required amount of time, the FEIE physical presence test is lost.

There is only one narrow exception to this rule. The minimum time requirement can be waived if you must leave a foreign country because of war, civil unrest, or similar adverse conditions in that country. You must be able to show that you reasonably could have expected to meet the minimum time requirements if not for the adverse conditions, and that you had a tax home in the foreign country and were a bona fide resident of, or physically present in, the foreign country on or before the beginning date of the waiver.

The moral of the story is that you must watch your travel days closely. If you are closing in on your 330 day limit, do not risk a trip through the United States. I guarantee that neither immigration officials nor the IRS will heed your cries for mercy. For additional information on the FEIE physical presence test, see

Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

retained earnings in an offshore corporation

How to Manage Retained Earnings in an Offshore Corporation

The key to maximizing the tax benefits of being offshore is to generate retained earnings in an offshore corporation. Retained earnings in an offshore corporation will allow you to accumulate (basically) unlimited amounts of tax differed dollars in your company.

If you have been reading my postings for a while, you know that anyone operating a business outside of the United States should be using an offshore corporation. You are also aware of the risks associated with these entities if not structured and reported correctly.

Operating a small business through an offshore corporation allows you to draw a salary of up to the Foreign Earned Income Exclusion (FEIE) amount, which is $97,600 for 2013. The offshore corporation also eliminates payroll or self-employment taxes, saving about 15% in most cases.

But, what if your business net profits exceed the FEIE amount? What if you earn $1 million? Must you pay tax on $902,400? The answer is yes; unless you structure your business from day one to provide for retained earnings in your offshore corporation, you will pay U.S. taxes on the income over and above the FEIE amount.

So, how do companies like Google defer tax on $10 billion with a Bermuda offshore structure? Why does Bloomberg claim there is $1.2 Trillion (yes, Trillion, with a capital T) in untaxed profits offshore? These companies spend big money on political lobbying to protect the Active Financing Exception, which can be found in Section 954(h) of the U.S. Tax Code and was recently renewed in the Fiscal Cliff deal.

The Active Financing Exception allows multinationals to create “friendly” offshore banks which actively lend and invest in the controlled group’s international divisions. The profits of this bank can be retained offshore indefinitely, or until the parent decides to repatriate these profits to the United States.

The Active Financing Exception works great for the world’s largest companies, but what about the rest of us? How can we use an offshore corporation to defer U.S. tax on our business profits? We must generate retained earnings in our offshore corporation from an active business.

How to get Retained Earnings in an Offshore Corporation

In order to get tax deferred retained earnings in an offshore corporation, you must first:

1. Be living and working abroad and qualify for the FEIE,

2. Operate through a properly structured and maintained offshore corporation,

3. Generate ordinary / active business income in excess of the FEIE,

4. Pay yourself a salary of up to the FEIE amount,

5. Retain profits in excess of the FEIE in the corporate bank account,

6. Pay tax in the U.S. on those retained earnings in your offshore corporation when you take them out in the form of dividends or other payments.

This first step, to be living and working abroad while qualifying for the FEIE, is covered in great deal on this website. Click here for additional information on the FEIE for 2013.

If you are an American who may generate retained earnings in an offshore corporation, you should begin your business with the proper structure…and that structure should be created by a U.S. international tax expert. Please contact us at (619) 483-1708 or info@premieroffshore.com for a confidential consultation to design your offshore structure.

The basics of a properly structured offshore corporation are these: you must utilize a corporation (not an LLC, Foundation, Partnership, or other pass-through entity), which is incorporated in a country that will not tax your profits. It does not matter where you live, or where you operate your business (unless you provide professional services, see below), you should incorporate in a tax free jurisdiction such as Belize, Panama, or Nevis.

You must report your activities and retained earnings of the offshore corporation on IRS Form 5471, report your foreign bank account, and keep up on all other U.S. reporting requirements. As your profits grow, so do the penalties for failing to properly report your activities. See the list of filing requirements below.

You may generate retained earnings in an offshore corporation from ordinary / active business profits. Ordinary business income is income received from the sale of a product and must be attributable to the normal and recurring operations of the company.

Next, you should pay yourself a monthly salary up to the FEIE amount. If a husband and wife are both operating the business, they can each draw $97,600 for 2013, and leave the rest of the money in the corporation.

The remainder of your net profits is to be held in the corporate bank account and become your tax deferred retained earnings. By creating retained earnings in an offshore corporation, you are deferring U.S. tax on those profits. In most cases, you must pay tax when funds are withdrawn from the corporation.

  • One possible exception would be paying out retained earnings as salary in future years where those salaries benefit from the FEIE. The availability of this option would depend on a number of factors and your bona-fide business must be ongoing (see below).

Four rules that allow you to hold retained earnings in an offshore corporation

Rule 1: Understand the U.S. tax regulations regarding retained earnings in your offshore corporation.

The theory behind an offshore corporation is simple: these are not U.S. entities, so the IRS has no right to tax them. Not to be deterred by such a technicality, the IRS goes after the shareholders, not the entity.

The U.S. claims authority over anyone with a U.S. passport, no matter where they live. Our government has enacted a number of laws controlling how and when U.S. citizens must pay tax on earnings from or retained in offshore corporations.

If you are going to generate retained earnings in your offshore corporation, there are two international tax code sections you should be familiar with:

Controlled Foreign Corporation (CFC): If a U.S. person holds 10% or more of the stock (or voting control) of an offshore corporation, and U.S. persons hold more than 50% of the shares or control of that company, then U.S. persons can defer tax on active income, but not passive income.

In other words, if American(s) control an international business, then that business may defer U.S. tax on retained earnings in an offshore corporation from active / ordinary activities, not from investments. If less than 50% of the business is owned by U.S. citizen(s), then the CFC rules do not apply. For Deloitte’s worldwide CFC guide, click here.

The CFC rules also limit deductions and control how retained earnings are taxed upon distribution:

  • Passive income from interest, dividends, investments, etc. is not active income, thus no U.S. tax deferrals are available. Passive income flows through to the shareholders of a CFC and is taxable on your personal return.
  • When you distribute retained earnings from a CFC, they are taxed at your marginal rate. Long term capital gains rates (currently 20% for 2013) are not available.
  • Losses in a CFC do not flow through to the shareholders. Losses are not deductible until the company is liquidated.
  • If you die holding shares in a CFC, your U.S. heirs do not get a stepped up basis. When they sell the shares, they will pay tax on their value when you acquired them, not when they inherited them.

Passive Foreign Investment Company (PFIC): If you or your offshore corporation generates high levels of passive income, or invest in non-U.S. mutual funds, a complex tax regime may be imposed on those earnings.

Basically, you can elect to pay U.S. tax on the appreciation in your investment account each year, or you can pay U.S. tax on the gain when you sell funds or shares from your account. If you elect to pay tax when you sell, a punitive interest rate is added to the tax due to eliminate any benefit from deferral.

PFIC rules are complex and I consider them in their most basic form here. My intention is to let you know of their existence and warn you that passive income in an offshore corporation is not tax exempt or deferred. If you hold a U.S. passport, America gets a piece of your investment profits. The only major tax benefit available to the offshore entrepreneur is for active business income.

Rule 2: Have a bona-fide offshore business

You must be operating a bona-fide business if you wish to hold tax deferred retained earnings in your offshore corporation. In its most basic form, this means you should be selling something on a regular and continuous basis, you should make a profit in at least 3 of the last 5 years, you should be working at the enterprise full time, and it must be a business and not a hobby.

You should be selling a product, not providing a professional service. A professional service which is performed outside of your country of incorporation and generates income from technical, managerial, engineering, architectural, scientific, skilled, industrial, or commercial activities is not bona-fide ordinary income for U.S. tax purposes.

If you are operating a consulting or professional service business, you may utilize the Foreign Earned Income Exclusion, but you are not allowed to hold retained earnings in your offshore corporation. For additional information, see Section 4.61.24 and 25 of the IRS CFC Audit Guide.

A hobby is an activity you do for entertainment and does not have a significant profit motive. Here are a few factors use to determine if you have a business or a hobby:

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Do you depend on income from the activity?
  • If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
  • Have you changed methods of operation to improve profitability?
  • Do you and your advisors have the knowledge needed to carry on the activity as a successful business?
  • Have you made a profit in similar activities in the past?
  • Do you expect to make a profit in the future from the appreciation of assets used in the activity?

As you can see, the most important component in the hobby vs. business analysis is your profit motive. Your bona-fide business must generate significant profits over a number of years or risk being classified a hobby. This can be an issue for a business with one big year, followed by losses in all subsequent years.

Of course, this bona-fide business must be operated outside of the United States. The U.S. owner and operator must be living and working abroad and qualify for the Foreign Earned Income Exclusion in order to generate retained earnings in their offshore corporation.

An offshore corporation may have shareholders who live in the United States. These shareholders must be passive investors, having no control over the company’s day to day operations. The offshore corporation should not have a U.S. office or employees. Nor should it have any U.S. agents working exclusively to market or distribute its goods in the United States.

NOTE: A bona-fide business rarely includes individuals who trade their own investment accounts. This is the number one question I get at conferences and in emails – though I have had only one client in 12 years who was a professional trader. Unless you are working full time at your trading business, you are not considered a trader in securities. And, unless you are a professional trader, you may not utilize the Foreign Earned Income Exclusion, or generate retained earnings in an offshore corporation from your investment activities.

Rule 3: Keep records as if you were in the United States

Remember that you must file U.S. tax returns and therefore may be audited by the IRS. Your offshore business must maintain records of income and expense in accordance with U.S. accounting principles. If you can’t prove your expenses, they may be denied by the Service.

For additional information on accounting for business expenses, see IRS Pub 535. For a list of small business tax deductions, click here.

Rule 4: Know your reporting requirements

Offshore corporations must file a number of U.S. tax forms. Failure to file can result in some very draconian penalties.

  • A foreign corporation or limited liability company should review the default classifications in Form 8832, Entity Classification Election and decide whether to make an election to be treated as a corporation, partnership, or disregarded entity (http://www.irs.gov/pub/irs-pdf/f8832.pdf).

Conclusion

The risks and rewards are great when doing business offshore and generating retained earnings in an offshore corporation. If the business is properly structured, you may be able to eliminate or defer U.S. tax on 100% of your active income. However, most of these tax rules are “all or nothing.” If you miss qualifying for the FEIE by one day, you lose 100% of the benefit. If you use the wrong type of structure, the ability to retain earnings offshore is gone. If fail to accurately and completely report your activates, you may face enormous penalties from the IRS – possibly hundreds of thousands of dollars.

The U.S. licensed tax experts and international attorneys at Premier Offshore, Inc. give you the best of both worlds – unparalleled offshore know-how combined years of experience in dealing with the IRS. Please contact us at info@premieroffshore.com or (619) 483-1708 for a confidential consultation on any aspect of offshore corporate formation and tax law.

Recent Articles (External Links)

Because of the tough economic times most American’s have experienced in recent years, much ado has been made of multinationals use of offshore tax tools to hold out on Uncle Sam. Here are a few articles on this topic, most of which are quite biased against the entrepreneur.

Older Articles (External Links)

Foreign Earned Income Exclusion

Weak Dollar Crushing the Foreign Earned Income Exclusion

If you are using the Foreign Earned Income Exclusion and are paid in a foreign currency, your U.S. taxes may have tripled in the last few years! This is because the value of the FEIE is falling fast, along with the value of the US dollar. Let me explain.

Editors Note: This post was written in January of 2013. Since then, the dollar has soared and other currencies have faltered. This article is still helpful in understanding how to calculate the FEIE and, like all things, currency valuations are cyclical.

The Foreign Earned Income Exclusion allows you to exclude $97,600 in 2013 from your Federal Income Taxes. This exclusion amount goes up most years and is indexed to inflation. For example, the Foreign Earned Income Exclusion was $91,400 for 2009, $91,500 for 2010, $92,900 for 2011, $95,100 for 2012. For additional information on the FEIE, please see my article on taxation, or click here for About.com.

When you report your foreign salary, you must translate from your local currency into U.S. dollars. If your currency is strong compared to the dollar, as most are, your U.S. tax bill will increase as the dollar weakens.

Here is an example from a group of tax returns I prepared this month:

This client is living and working in Japan and needed to catch up on his delinquent Federal 2009, 2010 and 2011 returns, and file his 2012 return. His salary has remained constant for these years at 12,000,000 Yen.

Using the yearly average charts on the IRS site for 2009, 2010 and 2011, and Oanda for 2012, here are the approximate conversion amounts:

  • ¥12M is $123,250 in 2009, compared to a FEIE of $91,400.
  • ¥12M is $131,370 in 2010, compared to a FEIE of $91,500.
  • ¥12M is $144,400 in 2011, compared to a FEIE of $92,400.
  • ¥12M is $150,500 in 2012, compared to a FEIE of $95,100.

If this client had earned the same salary of 12M Yen in 2006, the conversion to U.S. dollars would have been $97,938 against a Foreign Earned Income Exclusion rate of $82,400.

So, even as the buying power of this client’s salary has done down over the years (no increase for inflation, etc.), his U.S. taxes have skyrocketed. In 2009, his net taxable income (salary in US$ minus FEIE) was $31,850. In 2012, his net taxable income is $55,400. Had this client earned ¥12M in 2006, his net taxable income would have been only $15,500. This means his taxable income has increased by a multiple of 3.5 since 2006!

There are a few planning tools you might use to mitigate these affects. For example, when reporting your salary, there is no exchange rate mandated by the IRS. The only requirement is that you be consistent year to year and use a published rate. If your salary is about the same each month, then a yearly average exchange rate is the most accurate. If you receive a large bonus at the end of the year, or other incentives, you may benefit from a more complex calculation. In that case, I generally recommend www.oanda.com, www.xe.com or www.x-rates.com.

The Foreign Earned Income Exclusion remains the most important tool in the Expat’s tax toolbox, but its value is falling fast, just as your tax rates continue to climb. This means that other tools, such as foreign corporations for the self-employed and the ability to retain earnings offshore are becoming even more important.

Foreign Earned Income Exclusion 2013

Foreign Earned Income Exclusion 2013 Amount

The Foreign Earned Income Exclusion 2013 amount got a little bump up for inflation and managed to avoid the financial cliff. The Foreign Earned Income Exclusion 2013 amount is $97,600, up from $95,100 in 2012.

As an American citizen living overseas, you are subject to the same U.S. tax laws as a United States resident. One of the only personal tax benefits you get for living abroad is the Foreign Earned Income Exclusion. If you are out of the U.S. for 330 days, or are a resident of another country, you can exclude up to $97,600 of earned income from your U.S. personal return using the Foreign Earned Income Exclusion 2013 amount via Form 2555.

Note: My website has a number of resources explaining the Foreign Earned Income Exclusion 2013 amount and use. Please click here for an in-depth article on international taxation for Americans.

Earned income is active income and is defined as wages, salaries, commissions and professional fees. It does not include investment, rental, or other types of passive income.

If you earn more than the Foreign Earned Income Exclusion 2013 amount, you will pay Federal tax on the excess. However, if you are operating a business, or are self-employed, you may be able to eliminate this tax by using an offshore corporation and retaining earnings in the entity over and above the Foreign Earned Income Exclusion 2013 amount.

Note: Yes, the ability to retain earnings offshore also survived the fiscal cliff and will be the topic of a future article. For additional information, check out this article from Bloomberg.

Foreign Earned Income Exclusion 2013 and Prior

Historically, the Foreign Earned Income Exclusion has increased with inflation, with the exception of 2002 through 2005, when it was stuck at $80,000.

  • Tax year 2013: $97,600
  • Tax year 2012: $95,100
  • Tax year 2011: $92,900
  • Tax year 2010: $91,500
  • Tax year 2009: $91,400
  • Tax year 2008: $87,600
  • Tax year 2007: $85,700
  • Tax year 2006: $82,400
  • Tax years 2002-2005: $80,000
  • Tax year 2001: $78,000
  • Tax year 2000: $76,000
  • Tax year 1999: $74,000
  • Tax year 1998: $72,000

Sources: IR-2012-78, Oct. 18, 2012 for the 2013 amount, Revenue Procedure 2011-52 (PDF) for the 2012 amount, Revenue Procedure 2010-40 (PDF) for the 2011 amount, Revenue Procedure 2009-50 (PDF) for the 2010 amount, Revenue Procedure 2008-66 (PDF) for the 2009 amount, Revenue Procedure 2007-66 (PDF) for 2008 amount, Revenue Procedure 2006-53 (PDF) for 2007 amount, Revenue Procedure 2006-51 (PDF) for 2006 amount, Internal Revenue Code Section 911 for the tax law concerning the foreign earned income exclusion.

Remember that the Foreign Earned Income Exclusion is a “use it or lose it” tax break. If you are living abroad, do not file your returns, and are audited, you may lose the Foreign Earned Income exclusion. This means that 100% of your worldwide income will be taxable in the US.

If you are delinquent on your U.S. tax filing obligations, catch up before the IRS gets a hold of you. For information on our Expat tax filing services, please call us at (619) 483-1708 or email info@premieroffshore.com for a confidential consultation.

For the current FEIE amount, see Foreign Earned Income Exclusion 2020