This article is aimed at US taxpayers (Citizen, Green Card Holder or Resident) and you have, or are considering setting up a business outside of the United States.
In addition to reporting your worldwide income to the IRS and US government, they also require a lot more of your financial information; the value of your non-US bank accounts, monies invested in non-US businesses and details of certain non-US financial assets. This also applies where you set up a business outside the US.
Running that business and paying foreign taxes is stressful enough, you also must worry about the overreaching arm of the US tax system and the associated, excessive reporting requirements. But don’t panic just yet, there are plenty of options available to you which allow you to minimize your US tax exposure and there is help available to assist with filing those extra forms. So, here is everything you need to know.
Where do we start?
This article follows the timeline of your typical business. In most scenarios, this would start as a self-employment and then, as the business becomes more successful, it would consider the benefits of turning into a company. There are certainly tax advantages to this here in the UK and, with some careful planning, this can also be the same in the US (albeit with a few extra forms to file).
I’m self-employed, what do I need to know?
Self-employment is by far the simplest arrangement for a foreign business. All income and expenses of the business are reported annually on a US tax return and there is no deferral or disguising of the income received by the individual. In the tax world we refer to this as “full transparency”.
To alleviate any US tax calculated on these business profits you would need to rely on the Foreign Earned Income Exclusion or Foreign Tax Credits (more information of this can be found here – https://pjdtax.co.uk/updates/to-exclude-or-not-to-exclude/).
The 2017 Tax Reform introduced a new category of foreign income called Foreign Branch. The name would imply that it is for the taxation of Foreign Branches of US corporations, but it actually has nothing to do with this. It covers income from any foreign business which is sufficiently separate (from the taxpayer’s personal activities) that it maintains separate foreign currency accounts. This will catch any foreign business owner and even US partners of foreign partnerships.
Income from Self-Employment fits neatly into the Foreign Branch category. Furthermore, a US Taxpayer who operates a Foreign Branch must file Form 8858 to report certain details of the business, notably the financial statements covering the business’ financial year. There is no tax to pay with this form, but it just adds to the ever-growing list of administrative burdens.
All the above can be handled quite easily by your tax preparer. The only thing that is reliant on you is the timing of your foreign tax payments. To avoid double taxation, you need foreign tax credits to offset the US liability arising from Foreign Branch income. For most taxpayers, foreign tax credits are accounted for on a “paid basis” whereby you are only able to utilize foreign taxes that have been paid in the US tax year. It is therefore important to discuss with your tax preparer a suitable advance tax payment to make before 31st December each year.
What if I incorporate my business?
Under normal circumstances a company is a separate legal entity and has its own tax reporting obligations, whether this be to the IRS or some other foreign governing body. In short, a shareholder of a foreign corporation is entitled to a salary and a share of the business profits that are paid out as a dividend. The US taxation of this company and the sources of income derived from it will differ depending on how your business is treated for US tax purposes.
Certain US shareholders will have additional reporting and US tax to pay. The IRS are particularly interested in Controlled Foreign Corporations (CFC). This is where more than 50% of the voting rights of the foreign company (usually determined by shareholding) is held by US taxpayers. A US taxpayer who owns at least 10% of a CFC will have an on-going filing requirement for Form 5471 which is similar to Form 8858 mentioned previously but has a few more schedules that report various types of income and transactions. Since the Tax Cuts and Jobs Act was introduced in 2017 there are also a few more things to worry about such as Global Intangible Low-Taxed Income (GILTI) and Subpart-F. These avoid US taxpayers deferring taxation of business profits and investment income within a foreign company. More information on GILTI can be found here – https://pjdtax.co.uk/updates/not-gilti-your-honour/.
It is also worth mentioning another particularly nasty piece of US legislation regarding the taxation of Passive Foreign Investment Companies (PFIC). More information on these can be found here – https://pjdtax.co.uk/updates/not-the-pfic-solution-to-your-investment-choices/. Depending on the type of business you are conducting, and the assets held by the company, you may fall foul of the PFIC rules and be subject to prior year tax and interest charges on distributions. For example, if you set up a company to manage the running of your rental property business, the assets and income are considered passive and therefore into PFIC tax.
For a small business owner, the above tax regimes are best to be avoided to save time and money. Certain elections can be made in the early stages of the business that could help you.
What elections are available?
A corporation can make an election to be treated as a corporation, a partnership or disregarded entity for US tax purposes. The Classification Election (more commonly referred to as the “Check-The-Box Election”) is made on Form 8832 and the initial election must be made within 75 days of incorporation. It is possible to claim late election relief within 3 years and 75 days under certain circumstances. Without an eligible election a foreign corporation, by default, will have the following classification:
- A partnership if it has two or more members and at least one member does not have limited liability.
- An association taxable as a corporation if all members have limited liability.
- Disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.
What does this election mean for the taxation of my business profits?
By electing to treat your company as a partnership or foreign disregarded entity, the business becomes fully transparent and the IRS is privy to your share of the businesses income and expenses as they arise. The business profits will be subject to US income taxes on an annual basis and therefore no ability to defer tax on certain types of income. In most cases, this election will be a satisfactory option for sidestepping the GILTI, Subpart-F and PFIC tax regimes.
That’s not to say that it will be the most tax efficient option for everyone. The company will still be a company in its home country and will be subject to corporate tax rates. These are often significantly lower than income tax rates and often means that there are not enough foreign taxes to cover the US liability each year. However, this election also allows you to apply the foreign earned income exclusion against your business profits potentially relieving some, if not all, of the liability.
Can an election be made at any time?
Elections can be made at any time but there are consequences. An election to disregard an established foreign business will mean that there will be a deemed distribution of all retained profits. All of which are taxable on a US tax return. The problem is, this is only a deemed distribution in the US and no foreign taxes are going to be paid therefore leaving the full distribution open to US tax. There are ways to efficiently make this election which you will need to discuss with your tax preparer.
What if I don’t want to make the election?
You will note that only Controlled Foreign Corporations (CFC) attract the GILTI and Subpart-F issues. If you don’t have a CFC, then there is not too much to worry about, just the timing of your foreign tax payments. There may be a Form 5471 filing requirement, but you are not into the complex tax regimes mentioned previously mentioned.
With this in mind, there is some planning that can be done to reduce the shareholding of US taxpayers to 50% or less. This is often an option where the US shareholder has a Non-Resident Alien spouse or business partner. In this same regard, you can also gift shares to reduce the US shareholding to 50% (being careful to avoid Gift Taxes in the meantime).
These options allow you to avoid the complex tax regimes all together but if there is no way of doing so then you need to think about what you can do to reduce your potential tax liability. More information on this can be found here – https://pjdtax.co.uk/updates/not-gilti-your-honour/.
There are endless variations and complexities that make each case unique. An election that may work for one corporate structure, may not work for another. These options need to be discussed in depth with your tax preparer. This article must not be taken as tax advice.