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Living, Investing and Operating a Business Offshore
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$91,400 in wage income (for 2009; 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 jail.
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$91,400 in wage income (for 2009) 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 a 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 2009 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$91,400 divided by 2, or US$45,700.
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$45,700 equals US$104,300 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$91,400, 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.
Note: Chris Rusch is the author of The Expat Tax Bible 2010, published by International Living. For additional information click here to be taken to IL's website.
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$91,400 in wage income (for 2009; 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 jail.
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$91,400 in wage income (for 2009) 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 a 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 2009 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$91,400 divided by 2, or US$45,700.
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$45,700 equals US$104,300 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$91,400, 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.
Note: Chris Rusch is the author of The Expat Tax Bible 2010, published by International Living. For additional information click here to be taken to IL's website.