Expat Businesses: Benefits of Offshore Corporations for American Expat Entrepreneurs

Today guest blogger Chris Rusch, tax attorney specializing in international taxation and foreign corporate formations for US citizens, is going to share an article he wrote about the benefits of 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. Take it away Chris...

Most expatriates know that 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 U.S. tax on their business income.

The expat’s first line of defense is the Foreign Earned Income Exclusion (FEIE or Exclusion). This Exclusion was covered in detail in another article, and can be summarized for our purpose here as follows: The FEIE excludes from your U.S. income tax the first $87,600 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 by either 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.

The Exclusion can also be used to reduce Federal income tax on self employment income paid to the expat living and working abroad. This is typically someone operating a small business outside of the U.S. or who is an independent contractor to a U.S. for foreign corporation that performs his or her work outside of the U.S.

So far, the rules have been pretty strait forward (hopefully). Now, let’s look at the practical applications to the employee and the Self Employed person.

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 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 we can estimate at about 7.5%, or $6,570 on a salary of $87,600. 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%.

The employee of a foreign corporation would probably not have a Form W-2 sent to the IRS, would probably not have any U.S. withholding, and would not be required to contribute to the U.S. Medicare, Social Security, or FICA programs. Also, the employer incorporated offshore is not required to pay in to these U.S. programs, thereby resulting in a total savings of about 15%. This is true even if the employer is a foreign corporation owned by a U.S. person or company. It may not be true if the employer is a partnership or some other type of entity, so planning is important here!

Now for the self employed person operating without a corporation: The IRS and the entrepreneur will (or should) receive a Form 1099s from each job 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 levied against the employee and employer above. Unfortunately for the self employed person, he has the joy of paying 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 $175,200, and your business expenses are $87,600, your Exclusion is reduced by about 50% to $43,800. Thus, you are paying Federal income tax on $43,800, or about 50% of your net business income, in addition to paying 15% Self Employment tax on $87,600.

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.  As you might imagine, I had quite a few irate ExPat tax return clients when they saw their 2006 tax bill!

Therefore, a Schedule C business operating at a 50% net profit margin, with sales of $175,200, your tax bill might be $24,090 ($87,600 x 15% + $43,800 x 25%). This is just a rough example, but you get the idea.

NOTE: If two people work for the corporation, such as a husband and wife, and both qualify for the Exclusion, the total savings might be $48,180.

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

If the same self employed person above operated through a properly domiciled and registered offshore corporation, then he could have eliminated just about all of the tax on net active business profits of $87,600…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 $87,600 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 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 $87,600 and one employee saves about $24,090 in U.S. taxes. If the corporation’s net profits are $175,200, and there are two employees, such as a husband and wife, the total savings might be $48,180.

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.

Thanks Chris for sharing your expertise!

In case you didn't know, Chris Rusch is a California licensed attorney who has represented clients before the IRS in many States. His practice is focused international taxation, foreign corporate formations, and resolving complex tax controversies. To learn more about him, please visit his website: http://www.ruschlaw.com

Comments

[Sharon]

Hi Megan

I love your blog. It is full with so much important information.

I would love to suggest a career option for expats spouses, who follows their partner, but not always able to find a suitable job in their destination country.

Building a website about a passion they have and at the same time earning money. And best of all - there is no need for special tech skills.

I am "trailer" spouse married to a diplomat. Many years I had to compromise my career while following my husband. Even when we came back home for a few years I did not have the time to establish my own career, until I found SBI, which enabled me to follow my passion to build a website about something I love and know, and I even started to earn some money.

My website URL is: http://www.expats-moving-and-relocation-guide.com
and I am using SBI, which for my opinion has all the tools for people who are not hightech, and that want to build a website and earn money.

You can find more details about SBI in the following link
http://passion.sitesell.com/Sharon59.html

Should you think this is a good career option for expats spouses you can contact me and I would love to expand on the subject.

Other than that - One of my website section is about overseas employment. It would be an honor for me to add an interview with you to my site.

Happy holidays
Sharon Gilor

[Chuck]

Thanks for sharing. It's important that people get good legal advice when moving overseas. Our clients have saved thousands.

Keep up the good work...

San Diego Tax Attorney