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In short, there are many tax and nontax reasons to consider a foreign company.
Problems with Certain USA Business Structures
There are several issues for expats and digital nomads that can severely limit their tax-free benefits when using certain US business structures (a bad thing). We will walk you through each issue and solution:
• 1st Problem- Issues with ‘Self-Employed’ Expats (‘30% Rule’ and the ‘Scale Back Rule;’)
• 2nd Problem- Issues with U.S. “Subchapter S” Corporation structure;
• 3rd Problem- Employment Tax Issues with U.S. Corporation, LLC, and Schedule C structures.
PROBLEM #1 - Issues for ‘Self-Employed’(‘30% Rule’ and the ‘Scale Back Rule;’)
Suppose you’re an independent contractor or operate a business in your own name or through a flow-through entity such as a US LLC or schedule C (collectively “Self-Employed”). In that case, there are two ‘Rules’ that can severely limit your tax-free benefits:
A) Scale Back Rule. Under the US' “Scale Back Rule,” the amount that Self-Employed expats can deduct is reduced to take into account business deductions. And as most businesses also have expenses, Self-Employed expats need to be careful with this rule (note: if you’re one of the few businesses that have no expenses at all, this rule does not apply to you). The idea here is that the FEIE Tax Break applies to the Self-Employed business’s gross income, not the net profits. The bottom-line effect of this first rule for Self-Employed expats is that you still may have to pay US income tax even if your net profit is under the FEIE income caps. It should not be this way, but so it goes with the tax laws sometimes.
Solution: The Scale Back Rule does not apply if you are an employee of your own corporation (US or foreign) – this way, the entire amount of your salary (from your own corporation) is fully eligible to be tax-free under the FEIE Tax-Break (no Scale Back loss of benefit). Thus, it is usually best for self-employed individuals to form and work for their own corporation.
B) 30% Rule. The second punitive rule affects Self-Employed expats who operate a “capital-intensive business.” Capital-intensive means businesses such as (a) manufacturing, (b) companies with inventory, including many Amazon sellers, and (c) others that require a significant capital investment to get started. The bottom line for these Self-Employed expats is that they can only deduct ‘part’ of their income under FEIE Tax Break (The “30% rule”). This rule only applies to businesses where “capital is a material income-producing factor.”
What does this mean? This means that Self-Employed expats with capital-intensive businesses (such as e- Amazon FBA sellers, etc.) are only able to apply 30% of their profits towards the FEIE Tax Break. This is because the remaining 70% of your profits are considered unearned (passive) income—which is not eligible for the FEIE Tax-Break. This is a bad thing, as it severely reduces the benefit of the FEIE Tax Break.
Solution: The 30% Rule does not apply if you operate your capital-intensive business through your own corporation (US or foreign). Here, the entire amount of your salary from your corporation is earned income, which is fully eligible to be tax-free under the FEIE Tax-Break (a good thing).
PROBLEM #2 - Issues with U.S. “Subchapter S” Corporations structures:
Can I use a US ‘Sub-S’ corporation to lower my ‘self-employment tax’?
For expats working on foreign soil, a ‘Sub-S’ corporation can also be problematic. You see, monies received as non-salary dividends (profits above salary) do not qualify for the FEIE Tax Break. This is because profit distributions are considered ‘passive’ income–a ‘no-go’ for the FEIE Tax Break. In contrast, actual wages paid to US expats/digital nomads from a US S-corporation qualifies for FEIE Tax Break.
However, you’ll still owe hefty employment taxes on those wages because you’re working for your own “US” Sub-S employer and thus owe US employment taxes (15% in total on wages).
For these reasons, it’s generally better to operate your business through a non-US corporation to achieve no employment taxes (instead of a Sub-S Corporation). See Chapter Four Tax Break #4 for more details.
Remember, we help our clients achieve little to no taxes on incomes of $140,000 or even higher (per person), so the US-centric Sub S-Corp strategy is less applicable to US expats.
PROBLEM #3 - Employment Tax Issues with U.S. “C”-Corporations, LLCs, and Schedule C
Q) Can I use US business structures like a U.S. Corporation, LLC, or Schedule C while abroad?
A) Yes, BUT you’ll still owe US Employment Taxes
For income tax purposes only, it does not matter whether an American or foreign company employs you. The same is not valid for self-employment taxes, as you’ll save thousands more by being paid through a foreign corporation. This includes forming and working for your own foreign company;
Background: An expat working abroad for a US employer (including your own US corporation) is liable for paying employment taxes. If you’re a self-employed individual working overseas as a freelancer, independent contractor, or sole proprietor (Schedule C or LLC), the same is true. In other words, you’ll still owe employment taxes even if you owe $0 income taxes because of the FEIE Tax Break. Always remember, income tax is different from employment tax.
For example, say, your self-employment income is $100,000 when working on foreign soil, you’ll likely owe no income tax, but you’ll still owe the IRS about $15,000 in self-employment taxes. That’s why it’s called the hidden tax. Even if you work for your own US corporation, you’ll still owe the same $15,000 – it’s just split up where you pay $7,500 personally, and your own corporation pays another $7,500 as the employer.
Here again, it’s generally better to operate your business through a non-US corporation to achieve no employment taxes (instead of in your own name or through a US business structure). To find out more details on eliminating employment taxes click here.
There can be substantial non-tax beneficial purposes in having a foreign corporation. For example:
• More business and investment possibilities;
• A foreign corporation can open the door for permanent residency visas;
• The foreign company can hire low-cost in-office local assistants to help build the business;
• Easier to open foreign bank accounts;
• Easier to manage foreign expenditures;
• Far easier to secure debit cards for employees. Easier to pay foreign vendors;
• Streamlined payroll processing;
• Most US banks are constantly ‘freezing’ credit cards when US expats travel/live in a foreign country;
• Foreign banks are much less likely to ‘freeze’ credit cards when used abroad;
• Reduce the number of high-cost wire fees ($50 or more per international wire);
• Show your business as a more substantial business entity;
• Perform trade secret/patent work overseas through the foreign company to further protect its proprietary nature;
• Avoid the punitive 30% Rule (see Appendix B);
• Avoid the punitive Scale Back Rule (see Appendix B), and more.
Always remember that income taxes are different from employment taxes. You eliminate self-employment taxes by forming your own foreign corporation, then paying your salary through that non-USA corporation, AND work on foreign soil.
For more information on tax-smart strategies and forming foreign corporations, set up a 30-minute consultation here. We’ll show you ways to keep far more of your hard-earned dollars, while keeping the cost and reporting requirements down to a minimum.
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