U.S. Tax for Business Owners & Self Employed

This section is an introduction to the benefits of an offshore corporation for U.S. citizens living and working abroad. It is not meant for those living abroad on their pension (retirees) or those with passive investment income.

Most Expats know that the U.S. taxes its citizens on their worldwide income and that all U.S. citizens must file a U.S. tax return every year. What most do not know is that a foreign corporation, in a zero tax jurisdiction, can legally and legitimately be used to reduce, defer or eliminate U.S. tax on their business income.

As discussed in Section one, your first line of defense is the Foreign Earned Income Exclusion (FEIE or exclusion). This exclusion was covered in detail in Section One, and can be summarized for our purpose here as follows: The FEIE excludes from your U.S. income tax the first $95,100 for 2012 of wage or self-employment income earned by a U.S. citizen who is a “resident” of another country or who was outside of the U.S. for at least 330 of any 365 day period.

The FEIE can be used to reduce or eliminate U.S. Federal income tax on wages paid to you by a U.S. corporation or a foreign corporation. It does not matter if you are the owner of the corporation…the FEIE still applies as long as you are an employee of that company drawing a salary.

The exclusion can also be used to reduce federal income tax on self-employment income paid to you while you are living and working abroad. “Self-employed” generally refers to someone operating a small business without the protection of a corporation.

Now, that you have become an expert on the FEIE by reading this book, let’s look at the practical applications to the employee and the self-employed person.

Employess

Let’s say you are the employee of a U.S. corporation and live outside of the U.S. You receive a Form W-2, and may have had reduced withholding of your federal income tax, or will file a claim for a refund with the IRS because of the exclusion. However, the exclusion only applies to income tax, thus you still get to pay Medicare, Social Security, and FICA tax…which, for our purposes, I will estimate at about 7.5%, or $6,855 on a salary of $95,100. In addition, your employer is required to match your Medicare, Social Security and FICA contributions, which is a cost to him of about 7.5%. Therefore, the total cost is about 15%. Again, these numbers are rounded off for this example.

Now, let’s say you are an employee of foreign corporation, rather than a U.S. corporation. This foreign corporation can be owned by you, or be a subsidiary of your U.S. employer. In that case, you would not have a Form W-2 sent to the IRS, might not have any U.S. withholding, and may not be required to contribute to the U.S. Medicare, Social Security, or FICA programs (unless the foreign corporation opted in to the U.S. system).

In addition to the benefits to the employee, the employer incorporated offshore is not required to pay in to these U.S. programs, thereby resulting in a total savings of about 15%.

Please note that I have assumed that the foreign entity is incorporated in an offshore jurisdiction that will not tax its income or levy a Social Security tax. Also note that I assume it is a corporation, and not a partnership or Limited Liability Company.

Self-Employed

Now for the self-employed person operating without a corporation: The IRS and the entrepreneur will (or should) receive a Form 1099 from each payment over $500 done for a U.S. company or person. Presumably, there will be no report for work done for non-US businesses, though this does not impact your tax obligations. You then report your business income and expenses on Schedule C and use the foreign earned income exclusion to reduce your federal income tax…and that is where things go horribly wrong.

First, the FEIE does not reduce self-employment tax, which is about 15%, similar to the tax charged to the employee and employer above. Unfortunately for the self-employed person, he must pay the entire tax, rather than only half, as he would as an employee.

Second, the exclusion is reduced in proportion to your Schedule C business expenses. This roughly means that, if your gross income is $182,800, and your business expenses are $95,100, your exclusion is reduced by about 50% to $45,700. Thus you are paying federal income tax on $45,700, or about 50% of your net business income, in addition to paying 15% self-employment tax on $95,100.

Ok, so that is rough, but the IRS is not done with you yet! Since January 1, 2006, when the Tax Increase Prevention and Reconciliation Act of 2005 came into effect, taxpayers claiming the foreign earned income exclusion have been paying tax at the tax rates that would apply had they not claimed the exclusion. That means, instead of having your income taxed starting at the 10% rate, most expatriates are taxed starting at the 25% tax bracket.

Therefore, if you have a Schedule C business operating at a 50% net profit margin with sales of $182,800 your tax bill might be $24,835 ($91,400 x 15% + $45,700 x 25%). This is a very rough, back of the envelope, example, but you get the idea.

If a husband and wife both operate the same business, and sales are doubled, with the same 50% margin, the cost of reporting the business on Schedule C, rather than through a properly structured offshore corporation, could be around $49,000.

Tax Benefits of Incorporating

If you are self-employed and living and working abroad you do have options.

For example, had the same self-employed person above operated through a properly domiciled and structured offshore corporation, he or she may have eliminated just about all of the tax on net active business profits of $95,100…to say nothing of the benefits of limited liability. This is accomplished as follows:

First, form an offshore corporation in a zero tax jurisdiction, open a foreign bank account, and resister that company with the IRS.

Second, draw a salary of up to $95,100 for 2012 from that foreign corporation. As long as you qualify for the FEIE and the company’s income is derived from active, not passive business, there will be no federal income tax on this income.

Third, the properly registered and domiciled foreign corporation is not responsible for Medicare, Social Security, or FICA taxes.

Fourth, you are not considered self-employed; you are an employee of your offshore corporation, and not subject to self-employment tax.

Fifth, the expenses of the offshore corporation do not reduce your foreign earned income exclusion.

Sixth, you might be able to retain some or all of the offshore corporation’s earnings in excess of the exclusion. Careful planning in this area might allow the deferral of U.S. income tax on active business income inside the corporation.

Therefore, the use of an offshore corporation by an international business with net profits of $95,100 and one employee saves about $24,000 in U.S. taxes. If the corporation’s net profits are $190,200, and there are two employees, such as a husband and wife, the total savings might be as high as $48,000.

When planning an international business, be it large or small, you should consult with a qualified U.S. licensed tax attorney experienced in forming and advising international businesses.

 

OVERSEAS TAX FAQ #1: How can an offshore corporation be used to reduce U.S. taxation?

If you live in the United States while you do your work, you will pay U.S. tax on the income you earn. Using a foreign corporation while you are physically present in the U.S. does not affect your U.S. tax situation.

If you retire to a foreign country and your only income is from a pension, investments, Social Security, etc., you will continue to pay tax in the States. There is no tax benefit to retiring abroad.

If you live abroad, work for either a U.S. company or a foreign employer, and meet the foreign earned income exclusion requirements, up to US$95,100 in wage income (for 2012; the amount is adjusted upward each year) will be free of U.S. federal income tax.

If you run a business or are self-employed, live and work abroad, meet the foreign earned income exclusion requirements, and operate through an offshore corporation, you could be able to reduce or even eliminate all U.S. tax on your ordinary income.

If you operate a business from and reside in a country that does not tax foreign-source income, and your clients are outside that country, you could be able to operate free of tax in that country as well, meaning it could be possible for you to live completely income tax free.

OVERSEAS TAX FAQ #2: What if I set up an offshore corporation but continue living in the United States? Could I have foreign clients wire money to my offshore corporation, then pay U.S. tax on that income only when it is brought into the States?

No. This is one of the most common types of tax fraud…a strategy for going to prison.

If you are present in the United States while you work, all income you earn is taxable in the United States when received. When money is sent to an offshore corporation that you own or control, it is deemed received. It does not matter if you use nominee directors or add some other layer of complexity.

Of course, there are legitimate benefits to incorporating offshore. For example, you could have access to better or more diverse investment options, you could enjoy better asset protection than available in a domestic vehicle, and your customers could prefer to do business with a non-U.S. entity.

I am asked this question all the time by people seeking tax advice. Typically, they are looking for honest counsel and have no intention of breaking the law. However, you must understand that, when you call an offshore attorney or an online incorporator, you often receive no guidance and often can be given misleading information.

OVERSEAS TAX FAQ #3: If I retire overseas, will I owe income on my retirement or pension income?

U.S. retirement and pension income was earned while you were working in the United States. In many cases, you were allowed to defer income on the pension component of your wages.

Now that you are ready to take that income, it is taxable in the country where it was earned. The foreign earned income excision and other international tax tools do not apply.

The same is true of most types of investment income. Income from stocks sold, dividends received, rental income, and bank interest does not qualify for the foreign earned income exclusion and is taxed as if you were living in the United States.

OVERSEAS TAX FAQ #4: Living overseas, must I still pay Social Security, Medicare, and FICA?

If you live abroad but work for a U.S. corporation, you qualify for the foreign earned income exclusion and can exclude up to US$95,100 in wage income (for 2012) from federal income tax.

However, you still must pay Social Security, Medicare, and FICA. This usually amounts to 7.5% paid by you and 7.5% paid by your employer. For the purposes of this conversation, I’m ignoring Social Security treaties, which are country-specific.

Also, you could still be required to pay state tax if your spouse is living in the United States while you are working abroad. For example, if your spouse lives in California, which does not have the foreign earned income exclusion, the state would tax 50% of your income under a community property tax rule.

If you are employed by a non-U.S. corporation, the foreign earned income exclusion rules are as I’ve described, but you do not pay U.S. Social Security, Medicare, or FICA taxes. This is the case even if the foreign corporation is a subsidiary of a U.S. company (unless that subsidiary elects into the U.S. social tax system, which is extremely rare).

OVERSEAS TAX FAQ #5: What is my U.S. tax obligation operating a business or being self-employed outside the States?

If you are self-employed or operate a business outside the United States and qualify for the foreign earned income exclusion, you can use that exclusion to reduce the amount of federal income tax you owe. If you operate your business without a corporation or through a single-member LLC that does not file an election with the IRS, you must pay U.S. self-employment tax on your income. This amounts to about 15% tax of your income.

Making things worse, your business is reported to the IRS on the “Schedule C” form, and your business expenses proportionately reduce your foreign earned income exclusion. For example, if your total sales for 2012 were US$300,000 and your expenses were US$150,000, your foreign earned income exclusion is reduced by 50%. Thus, you can reduce your income for the purposes of figuring the tax you owe by only US$95,100 divided by 2, or US$47,550.

Adding insult to injury, you must pay U.S. income tax on the amount over the allowed foreign earned income exclusion. In our example, that is US$150,000 of net income, minus the remaining FEIE of US$47,550 equals US$102,450 of taxable income.

All three of these problems can be managed by operating your business through a foreign corporation.

First, operating this way, you are a non-U.S. corporation and not required to pay Social Security, Medicare, or FICA taxes.

Second, you can draw a salary from your corporation of US$95,100, avoiding the issue of a reduced exclusion because of business expenses.

Third, you may be able to retain net profits in excess of the foreign earned income exclusion and pay U.S. income tax on that money only when you take it out of the corporation.

OVERSEAS TAX FAQ #6: If I operate a business in a foreign jurisdiction (such as Panama), what is my local tax obligation?

Several countries, including Panama, do not tax foreign source income. These jurisdictions tax only domestic income (profits you make by selling to people in that country).

Therefore, you can mitigate income tax in your country of residence if you sell to people or businesses outside that nation. For example, from a base in Panama, you could offer products or services over the Internet to clients in the United States. If you don’t take orders from people in Panama, this is foreign-source income in Panama and not taxable by that country.

Note: Selling to customers in the United States does not affect your foreign earned income exclusion or your ability to retain earnings in your corporation. These tax rules require only that you live outside the United States and otherwise qualify for the foreign earned income exclusion.

As discussed above, you must take a salary from your foreign corporation to maximize the benefits of living and operating a business abroad. If you draw a salary from your Panama corporation while you are living in Panama, you could be subject to Panama’s various income, payroll, and social taxes.

You can comply with your U.S. obligations by selling through a second foreign corporation, such as one incorporated in Cayman or Nevis, drawing a salary from that entity, and then passing funds sufficient to pay business expenses in Panama up to your Panama company.

In this way, you mitigate tax in Panama on your salary, and your domestic (Panamanian) entity breaks even for domestic tax purposes.

As long as you report both entities and all non-U.S. bank accounts to the U.S. government, you remain in compliance with your U.S. tax obligations. If you take a salary less than or equal to the foreign earned income exclusion, and retain the balance in your offshore structure, you could eliminate or defer U.S. tax on up to 100% of your revenues.

Where to Incorporate

Once you have decided to incorporate your business offshore, the next big issue is where. Here are my suggestions.

The first step in the process is to decide if you want to focus on privacy, transparency, or on a country that will make a good impression on those who contract with your business. There are several good choices available for each of these three focal points, but I tend to limit my formations to countries where I have experience, have personal relationships, and where I have spent time researching and debating their business, tax, and privacy laws.

With that said, if the primary component is privacy, I typically suggest a Nevis or Cook Islands corporation or limited liability company (LLC). Both of these countries have exceptional privacy laws, well tested legal systems, and a long history in the asset protection industry. Again, there are other jurisdictions, but these two work well, so I do not see a need to search further.

I expect most readers are familiar with Nevis, so I will say a few words about the Cook Islands (CI). The CI have long been a leader in international asset protection trusts, and just recently passed the “The Cook Islands International Limited Liability Companies Act 2008.” This Act, modeled after Nevis, integrates CI’s long standing trust and creditor laws, and their corresponding lack of a bankruptcy statute, into an LLC statute which maximizes both privacy and asset protection.

Other clients, especially those who are officers or directors of large U.S. based businesses, or who will operate an offshore hedge fund with U.S. investments, require a country that is fully compliant with the U.S. Fyi…compliant generally means that the IRS and SEC can easily find the beneficial owner and gain access the company’s books, records, and foreign bank accounts.

Where transparency is required, I prefer Cayman Islands corporations and licensed hedge funds. This jurisdiction is more expensive than its competitor, the British Virgin Islands, but I believe that the availability of quality legal and accounting professionals on Grand Cayman is worth the cost. Since most clients seeking such transparency are operating significant businesses or investment portfolios, cost should not be a primary factor.

The third category, a country that will make a good impression on those who contract with your business, is harder to define. After all, beauty is in the eye of the beholder. With that in mind, here are three suggestions:

If money is no object, and image is everything, I suggest a Swiss holding company with Cayman or BVI subsidiaries. This generally allows you to operate from Switzerland, hold yourself out as a Swiss company, and contract through offshore subsidiaries, without incurring Swiss tax on international (holding company) profits.

Unfortunately, operating in Switzerland can be expensive. The typical annual maintenance of a Swiss holding company, including a Swiss director, is $10,000+, compared to about $850 for a Nevis IBC or LLC without a foreign director. In addition, a lot of planning and complex structuring is required to work through the dividend withholding section of the Swiss tax code.

For those on a budget, I recommend Hong Kong or Panama. Hong Kong is an excellent place for a holding company, has a wealth of qualified legal and accounting professionals, balances privacy and business image well, allows for nominee directors, and most banks are comfortable with corporations domiciled in Hong Kong.

The drawbacks of Hong Kong are that the directors monitor the company’s activities closely, which results in higher than average annual bills, the time difference with the U.S. often delays communications and transactions by about 24 hours, and you must travel to Honk Kong in order to open a bank account there. If you prefer not to travel, an account can be opened in the Isle of Man. Also, while the directors are active, they are typically well qualified and handle your business in a professional manner.

Finally, I believe Panama is the best jurisdiction for someone who will operate a business outside of the U.S. with employees, an office, and business assets. The Panamanian economy is strong, qualified labor is relatively inexpensive, the costs of firing an employee are minimal compared to Europe, telephone and internet services are cost effective and of a high quality (certainly superior to all Caribbean islands and most Latin American countries), several local banks provide reasonable service and do not have branches in the United States, and Panama’s primary currency is the U.S. dollar, so your Panamanian bank can accept checks from U.S. clients.

In addition to the business benefits above, from a privacy standpoint, Panama allows for nominee directors and shareholders. Also, the shares in a Panama company can be held by a Panama foundation, thereby maximizing asset protection.

Shelf Companies

I am frequently asked about the use of offshore “shelf” corporations in international business. Some claim they are useless, while others market them as the greatest invention since the numbered bank account. I would like to take this opportunity to put my two cents worth in to the debate.

Bottom Line: I believe offshore shelf corporations can be helpful if you are marketing a business because they improve your image. Since this can be accomplished without backdating any documents, or doing anything improper, I support shelf companies.

First, what is a shelf company? It is a corporation formed months or years ago that has been sitting on the incorporator’s shelf, unused. Because it has no history of operation, no bank account, and no creditors, there should be no risk in purchasing a shelf company.

The legitimate benefits of an offshore shelf corporation are:

1. The company is ready to use off the shelf. You do not need to wait for the company to be formed, the name to be approved, or for the directors to be assigned.
2. You can market the name and age of the shelf company. For example, your letterhead and marketing materials can refer to “International Marketing Services (Panama), S.A., Established 2006,” if you bought a corporation by that name formed in Panama in October of 2006.

Of course, the abuses of shelf companies are well documented. Many purchase these entities and then ask the director to sign back dated documents. While you can find some less scrupulous directors who are willing to provide this service, such a practice is obviously improper.

Because of the nature of the industry, it is difficult to find a shelf company older than about 14 months. This is because these companies are usually formed by the incorporator on behalf of a particular client. The client does not pay the incorporation fee, so the entity sits on the shelf to be sold to someone else. After 12 months, the annual dues must be paid, which the incorporator is not willing to do. Around the 14th to 16th month, the company is closed by the government registrar.

The only significant exception that I have found is in Switzerland. There, it is possible to purchase a company formed many years ago, revive that company in the government registry, let it sit on the shelf for about 2 years to eliminate any potential creditors and then file for a tax clearance. The result is a clean shell with the original incorporation date attached.

So, while a shelf company may help in marketing your business, it has no tax benefit.

International Foundations

Many offshore promoters are pushing Liechtenstein Foundations on the very wealthy and Panamanian Foundations on the rest of us.

Note: Foundations are more commonly used in asset protection, but some operate offshore businesses under them, thus their inclusion in this book.

Many are taken in by the term “foundation,” hoping or believing that it makes the structure a charitable foundation which is tax exempt. This is simply not true. For an entity to be tax exempt, it must be registered with the IRS as such, under IRC §501(c)(3)., and this applies to both foreign and domestic entities.

Tax tip: Only donations to charities licensed by the U.S. are deductable on your personal tax return. You can donate money to any charity or group around the world, but, if they do not have the IRS’s blessing, you are not entitled to a deduction.

Adding to the confusion, Foundations typically have multiple levels of nominee directors and boards which allegedly control the Foundation’s assets. Some promoters’ claim that, because you gave up control of your assets, you are not taxed on the interest, dividends, and earnings of the foundation. Again, this is not true. You remain the beneficial owner and have indirect control, which equals ownership in the U.S. tax code.

Most accept that a simple foreign corporation with a nominee director, or an offshore trust with a foreign trustee, does not reduce U.S. tax on earnings. But, change the ending from Inc. to foundation; add a few layers of directors, and many are willing to believe the impossible.

Taking it one step further, some foreign attorneys will issue an option stating that the Foundation is not a grantor trust under the U.S. rules. I do not see anything inherently incorrect in this statement. It seems possible that the Foundation can be classified as something other than a grantor trust. However, these statements are often used to confuse and mislead the U.S. client in to believing that there is some tax benefit to such a classification.

All of the opinions I have read say something like this: “The design and structure of the Foundation is to achieve an entity classification as other than a trust such as a partnership, corporation or disregarded entity for U.S. tax purposes.”

Keeping in mind that the U.S. citizen is taxed on his or her worldwide income, and if we agree that the foundation is not some magical tax exempt structure, the classification does not make a tax difference. Under all options, income to the foundation will be taxed in the U.S. as earned, transfers to the entity will be reportable events, and (most) transfers of appreciated property will be deemed sales.

Some opinions also have the following clause: “Furthermore, there is the option of seeking a private letter ruling from the Internal Revenue Service confirming the proper entity classification of the Foundation.” Such a statement should cause alarm…it means that the IRS has not classified the Panamanian or Lichtenstein Foundation and that U.S. citizens have no certainty regarding when, what, and how to file returns for a foundation.

What would happen if you assumed the foundation was a corporation, filed foreign corporate returns, and then it was classified as a trust? I have no idea, but I would not want to find out! In my opinion, Panamanian and Lichtenstein Foundations are potential options and competitors of the offshore Asset Protection Trust. However, I will not recommend them until the IRS provides some clarity on their status and filing requirements.

I am a big fan of Panama as a country in which to operate an international business and I hope these issues are resolved, and that promoters take a more realistic view of U.S. taxation, so that Panamanian Foundations can become legitimate Asset Protection tools.