All income that is U.S. source income is taxable in the United States. Income that is not U.S. source income is not taxable. So, planning to ensure your business income is not considered U.S. source income is the only way to keep Uncle Same out of your wallet.
This article will describe U.S. source income and tell you how to avoid it in your offshore company. From here on, I will assume that you are living and working abroad and that you qualify for the Foreign Earned Income Exclusion. If you are not sure you qualify, please check out the various articles on these topics before reading on.
Your offshore company must pay U.S. tax on any U.S. source income, so a quality international tax plan will do everything necessary to ensure you have no U.S. source income. Note that whether your profits are U.S. source income is not determined by where your clients are located. It is based on where you and your company are doing business. If your business is operating from Panama, and all of your customers are in the United States, you probably do not have U.S. source income.
In other words, if your offshore company has minimal contacts with the United States, then it does not have U.S. source income. If your offshore company has significant ties to the U.S. then you probably have U.S. source income (U.S. Tax Code Section 882).
The income earned in your offshore company is U.S. source income, and thus effectively connected to a U.S. business, if you have an office, employees, or other similar connections to the United States. Even if most of your operations are in Panama, and you have an office in California, you will have some U.S. source income (U.S. Tax Code Section 86(c)(1)-(3)).
If you don’t have employees in the U.S., you are not necessarily safe from U.S. source income. There is much planning that goes in to ensuring your offshore company’s contacts with the U.S. don’t rise to the level of being engaged in a business within the United States.
The simplest case is when you have an internet based business in Panama, selling an electronic product, such as a book delivered by email. Assuming all staff and banking is in Panama, you have no U.S. source income.
If we take the same example, but we move banking and credit card processing in to the United States, assuming no other contacts, you still don’t have U.S. source income. An offshore company with bank and merchant accounts in the U.S. is not conducting a business in the U.S. for tax purposes and thus has no U.S. source income.
Keep in mind that it does not matter where your customers are located. Title/ownership of the electronic product passes to the buyer in Panama, where the business is located. Even if 100% of your customers are in the U.S., you are safe.
Add to this a website and IT in the United States and you still do not have U.S. source income. Hosting your internet e-commerce site in the United States does not create sufficient contacts to result in U.S. tax.
Now, let’s change the electronic product to a physical product such as a new miracle vitamin. If you don’t set up a plant that manufactures the vitamin, you will have U.S. source income. If your Panama company contracts with an unrelated/independent fulfillment house, you can avoid this tax issue.
To clarify, the independent fulfillment house must be providing similar services to other companies, and not be controlled by you. If it were, it may be considered a branch of your Panama company.
The safest scenario is a fulfillment house that is manufacturing the same or similar products for many firms, slapping your label on the bottle, and shipping it to your customers. Again, so long as this is an arms length transaction, it will not result in U.S. source income. See IRS Treasury Regulation 1.864-7(d)(3)(i) and 1.864-7(b)(1).
Since we are piling on, let’s now assume you are marketing your business through an affiliate marketing group. For those of you not so tech savvy, an affiliate marketer is someone who advertises your web page through search engines and pay per click to earn a commission on each sale they generate. Leads are tracked by “cookies” that are saved on to your computer each time you click on one of their links.
I believe contracting with an affiliate network is safe and will avoid U.S. source income. In an affiliate network, you pay the network (i.e. management firm) and they pay their agents. If these agents are independent contractors, then the network is responsible for issuing 1099s and U.S. tax issues. See U.S. Treasury Regulation 1.864-7(d)(3)(i).
I strongly recommend working with affiliate networks rather than contracting with individual affiliate marketers. If it was found that your affiliates are employees and not independent contractors, in a payroll tax audit, then some of your income may be deemed U.S. source income. The U.S. would like nothing better than to tax a Panama corporation. The risk of having the marketers reclassified as employees is eliminated with a network.
I will conclude by pointing out that the U.S. source income tax rules are not an “all or nothing” proposition. If it is found that you have both U.S. source and foreign source income, then only that income earned in the U.S. will be taxable in the U.S. Foreign source income will still be eligible to be retained in your offshore company.
In that case, the calculation of what is U.S. source income and what is foreign source income is referred to as transfer pricing. You and the IRS must agree on how much value is being added to the product (your vitamins) by your sales office in the U.S. and how much value is being added by the office in Panama.
If the transfer pricing analysis finds that 50% of the value of the bottle of vitamins is being derived from the work you are doing through your branch in the U.S., and 50% is being created by the parent company in Panama, then half of the net profits from the sale of the product is taxable in the U.S. and half can be attributed to Panama and retained in that offshore company as active business profits.
If you are considering forming a business outside of the United States, proper planning will consider these U.S. source income rules. Please call or email us at firstname.lastname@example.org if you are considering forming an international business. We will be happy to design and incorporate an offshore company that will maximize your tax benefits and keep you in compliance with the U.S. IRS.