Critical Advice For Any American Running A Business Overseas
If you’re an American considering starting a business outside the United States, here’s my very strong recommendation: Incorporate offshore. This should be the first thing you do, no exceptions.
In the United States, 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 on qualifying for the Foreign Earned Income Exclusion (FEIE), then this easy road is fraught with trouble and simply does not work. 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 could run your business with a U.S. bank account or a personal account offshore, doing so will create a problem when tax day rolls around. This is because, as in 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.
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, it reduces your FEIE proportion to your business expenses, drastically increasing your U.S. tax bill.
For example, if your business expenses are 50% of your gross sales, then your FEIE will be cut in half. So, if gross income is US$200,000, and expenses are US$100,000, then net taxable income is US$100,000. If you were operating through an offshore corporation, you would deduct US$97,600 (the maximum amount of the FEIE) from this income and pay tax on only US$2,400. Without a corporation, your FEIE is cut down to US$48,800 (US$97,600 divided by 2) and you get the joy of paying U.S. taxes on the remaining US$51,200 (US$100,000 minus US$48,800).
But it gets worse.
The Foreign Earned Income Exclusion applies only to Federal Income tax. It does not reduce social taxes, such as Self Employment (SE) tax. 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 US$100,000, Self Employment tax will be around US$15,000, regardless of whether you qualify for the FEIE. If a husband and wife are joint operators of a business, and the profits are US$200,000, you could be paying US$30,000 in combined SE tax.
What if your business is a resounding success and you earn more than the FEIE? What if, say, you and your spouse net US$400,000 in a year? Without an offshore structure, you will pay U.S. tax on the net profits in excess of the FEIE. You will be unable to retain earnings in a corporation, meaning all net profits will be taxable in the year earned.
Let’s assume your business has zero expenses (which would be awesome, right?), and you get to take the full FEIE. Your net profit is US$400,000, reduced by the FEIE for both husband and wife, or US$195,200. This leaves US$204,800 available to the IRS.
If you were using a corporation, however, these earnings could qualify to be retained by the company and not be taxed until distributed. This is a big deal.
Finally, to add insult to injury, that US$204,800 would be taxed at the highest rate available. Since Jan. 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 have applied had they not claimed the exclusion. That means that, instead of having your income taxed starting at the lowest rate (around 10%), most expatriates are taxed starting at the 25%+ tax bracket.
Live and Invest Overseas Editorial Staff
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