The entrepreneurial spirit is hard wired into the American psyche. According to the U.S. Chamber of Commerce, some 400,000 new businesses are started each year in the United States. When American expats relocate to a foreign country, that entrepreneurial spirit comes right along, together with your U.S. tax obligations on that business income.
So, what is the best way to organize that foreign business from a U.S. tax perspective? Let’s look at several choices and examine attributes of each. For the sake of simplicity, we’ll assume a single U.S. citizen owning all of the foreign business.
The simplest method to organize a business venture is as a sole proprietor.
You rent the space and equipment, obtain the appropriate local licenses, hang out a sign and open your dry-cleaning business. The proprietor reports the business activity on her personal return. In most cases, however, the proprietor will seek to limit her personal liability by organizing the business under some form of limited liability structure.
The default treatment by the IRS of any foreign limited liability entity is to call them all foreign corporations. Now we are no longer reporting the business activity on the owner’s personal return, and are instead in the realm of the International Information Return, which carry heavy penalties for non-filing. So we really want to get this right.
Everything from this point forward is stated in greatly simplified form, and should be discussed with your U.S. and local tax advisors before executing any of these strategies.
Individual shareholder of a foreign corporation
This was very much the standard structure until the Tax Cuts and Jobs Act (“TCJA”) of 2017. Business income, apart from passive income, would be retained in the corporation and would be taxed by the U.S. only when that income passed through to the U.S. shareholder in the form of wages or dividends.
It served many American expats as a deferral device to accumulate retirement income pretax. After the TCJA, essentially all the business operating profits pass through to the shareholder, and is included in her personal income for the current year. No deferral. And no credit for the local income tax paid by the foreign corporation because the corporation paid the tax, not the individual (however, see §962 election, below).
Individual shareholder of a foreign corporation in a high-tax country
If the foreign corporation’s income is subjected to a high enough corporate tax rate in the foreign country, then the income is not included in the U.S. income of the U.S. shareholder.
How high is high enough?
That is 18.9 percent (90 percent of highest U.S. corporate rate of 21 percent). That rate of corporate taxation is common in many countries in Europe. No U.S. passthrough means no U.S. income tax. §962 Election shareholder of a foreign corporation takes credit for foreign tax paid by the company. Earlier we said the individual shareholder could not take a tax credit for the income tax paid by the foreign corporation. This remains true, but if the individual shareholder agrees to be taxed as though she were a domestic corporation on her foreign company pass through income, then she can credit 80 percent of the foreign tax paid by the corporation against her U.S. tax on the pass-through income.
But wait! Much like those Ginsu knife commercials in the 1970s, there’s more!
Because the individual shareholder has elected to be taxed as a domestic corporation, she also gets a 50-percent deduction reserved by the TCJA solely for corporations. So instead of applying her individual income tax rate, or even the corporate tax rate of 21 percent, she is taxed at a rate of 10.5 percent on the pass-through income, and can still take the tax credit of 80 percent of the foreign tax paid against the remaining U.S. income tax.
But there is yet another catch to the individual shareholder taking a credit for the foreign tax paid by the corporation. When a §962 election is made, subsequent distribution of earnings which were the subject of the election will be included in the shareholder’s gross income, net of tax previously paid. So, the election is only providing a deferral of tax until the income is actually distributed.
Ownership of a foreign corporation through a U.S. domestic corporation
This is the strategy which benefits most from the TCJA. U.S. individual owns all the shares of a U.S. corporation, which in turn owns all the shares of the foreign corporation.
As with the individual shareholder, the domestic corporation takes the operating income of the foreign subsidiary into its gross income, then takes a deduction for 50 percent of that pass-through income. Applying the corporate tax rate of 21 percent to one-half the income means the effective tax rate is 10.5 percent. The U.S. corporation can then apply 80 percent of the foreign income tax paid by the foreign corporation as a credit against its U.S. corporate tax liability.
Dividends from the domestic corporation to the individual shareholder would be taxed at the lower qualified dividend rate in her personal return. Transferring the shares of an existing company from an individual to a U.S. corporation may have local tax consequences which must be considered before the transfer. On the U.S. side a robust structure of tax-free exchanges statutes can be observed to mitigate any U.S. exposure.
Foreign disregarded entity (FDE)
Finally, we come to a strategy employed by many American expats owning a foreign small business. This strategy treats the foreign corporation as the equivalent of a single member LLC in the U.S. The foreign entity’s business activity is reported on the individual shareholder’s personal return as if she were operating the business as a sole proprietorship.
There is a specific form the shareholder files with the IRS to inform them of her election to treat the foreign corporation as an FDE, and a specific International Information tax return which she attaches to her personal U.S. return to report the activity of the FDE. Since the foreign business entity and the U.S. individual owner are treated as a single taxpayer, the U.S. shareholder may take a U.S. tax credit for the foreign income tax paid by the business.
One complication to FDE treatment is the exposure to U.S. self-employment tax. The individual will incur self-employment tax on the business income unless she participates in the social security system of her resident country, and that country has an agreement with the U.S. to eliminate double social security tax.
Choosing the structure that is best for your business will depend on many factors including the nature of the business and the tax regime of the resident country in which the business is operated.
Again, these are decisions best made in consultation with both your U.S. and local tax advisors.
About the author:
Doug Ralph is a certified public accountant and an expert in U.S. expat taxation. You can read his blog here.
Doug is based in New Mexico. You can reach him for tax advice at: [email protected].
Read more here on Dispatches about taxes and official requirements for expats.
