If you are considering starting a business outside of the US, you must incorporate offshore. This should be the first thing you do, no exceptions.
In the US, one can come up with an idea, get a business name (called a DBA), open a bank account in about 5 minutes, and begin operating. So long as liability is not an initial concern, this works great.
Business income and expense from your new endeavor is reported to the IRS on your personal tax return, Schedule C, with no complex corporate forms required. Then, once the business gets going, you can seek professional advice, incorporate, and get your ducks in a row.
If you are living and working abroad, and plan to qualify for the Foreign Earned Income Exclusion, then this easy road is fraught with trouble. You need to incorporate offshore from day one and here’s why:
In most cases, it is not possible to open an offshore bank account under a business name without forming a corporation or LLC. While you can run your business with a US bank account, or a personal account offshore, doing so will create a nightmare when tax day rolls around. This is because, like the example above, your offshore business will land on your Schedule C and get sliced apart by the tax man faster than you can blink.
Background: The Foreign Earned Income Exclusion allows you to eliminate $97,600 of salary from your personal income tax return. For additional information on the FEIE, see my article on International Taxation. The FEIE is the Expat’s first line of defense and requires that you incorporate offshore.
An offshore business without a corporate structure is reported on Schedule C, while an offshore corporation is reported on Form 5471. When an offshore business is reported on Schedule C, your FEIE is reduced in proportion to your business expenses, thereby increasing your US tax bill.
For example, if your business expenses are 50% of your gross sales, then your FEIE will be cut in half if you report on Schedule C rather than Form 5471. So, if gross income is $200,000, and expenses are $100,000, then net taxable income is $100,000. If you were operating through an offshore corporation, you would deduct $97,600 (the max amount of the FEIE) from this income and pay US tax on only $2,400. Without a corporation, your FEIE is cut down to $48,800 ($97,600 / 2) and you get the joy of paying US tax on the remaining $51,200 ($100,000 – $48,800).
You are probably wondering what the heck I am taking about…this sounds unfair! Well, no one said the US tax code is fair. In this case, it hits the unprepared hard in favor of the properly structured entrepreneur.
Read on, it gets worse.
Next, the Foreign Earned Income Exclusion applies only to Federal Income tax. It does not reduce social taxes, such as Medicare, Social Security or Self Employment. When you report net profits on Schedule C, they are subject to SE tax, which is about 15%. Taking a salary from an offshore corporation eliminates this expense.
So, if you have a net profit of $100,000, SE tax will be around $15,000, even if you qualify for the FEIE. If a husband and wife are joint operators of the business, and the profits are $200,000, you may be paying around $30,000 combined in SE tax.
Note: Actual SE tax paid will be slightly less based on the SE deduction, how you allocate income between spouses, and the fact that SE tax caps out at higher income levels. The section above is for illustrative purposes only.
In to the breach once more!
What if your business is a resounding success and you earn more than the FEIE? God forbid, what if you and your spouse net $400,000? Without an offshore corporation, you will pay US tax on 100% of your net profits in excess of the FEIE. You will be unable to retain earnings in a corporation, thus all net profits are taxable in the year earned.
Let’s assume your business has zero expenses (that would be awesome), and you get to take the full FEIE. Your net profit is $400,000, reduced by the FEIE for both husband and wife, or $195,200. This leaves $204,800 available to the IRS. If you were using a corporation, these earnings may have qualified to be retained by the company and not taxed until distributed. Without a corporation, they are considered salary and taxed by the Feds at around 32%, or $65,280.
Finally, to add insult to injury, this $204,800 is taxed at the highest rate available. Since January 1, 2006, when the Tax Increase Prevention and Reconciliation Act of 2005 came into effect, those claiming the Foreign Earned Income Exclusion have been paying at the tax rates that would apply had they not claimed the exclusion. That means, instead of having your income taxed starting at the lowest rate (around 10%), most expatriates are taxed starting at the 25%+ tax bracket.
If you plan to make a profit in your business, I suggest you read my article on retained earnings for additional information on how to keep those profits away from Uncle Sam.
For more information on forming an offshore corporation, please check out my website or contact me at info@premieroffshore.com. I will be happy to work with you to structure your international business affairs. We have specialized in helping clients incorporate offshore for the last decade, and we can ensure you are tax compliant AND tax efficient.