U.S. Foreign Residents with Businesses Abroad
U.S. Tax considerations.
by John Ohe (IRS Enrolled Agent).
United States expats are subject to U.S. income taxes regardless of where they live and where they make their income. For those that have their own business, there are special requirements and issues to consider when it comes to tax planning and tax return preparation.
In this article, we answer some of the frequently asked questions.
Can you explain the foreign earned income exclusion, and can I use it to offset business income?
The foreign earned income exclusion (FEIE) is a gift from the IRS. U.S. expats can exclude up to about $100K in foreign earned income on their tax return by exercising the FEIE. For example, a person who earns $100K in wages, conducts all of his/her work abroad, and meets the requirements to qualify for the FEIE, would owe zero income tax on that income.
For business owners, the application of the FEIE is somewhat more complicated than for wage earners. For instance, if one conducts business as a sole proprietor, a proportion of business expenses are disallowed. The result is some taxable income. If a U.S. expat conducts business through a foreign corporation, the best strategy is to pay oneself a salary (up to the FEIE limit, if possible). However, additional reporting requirements kick in when a U.S. person has certain ownership over a foreign entity – see next question.
Am I subject to U.S. employment tax (FICA) if I operate a business abroad?
Self-employment tax (FICA) includes: Social Security and Medicare. Normally, employers and employees split this tax responsibility. However, the self-employed individual (sole proprietor) is both employer and employee, and therefore, is responsible for the entire amount, which is 15.3% of net income. The self-employed cannot find relief from FICA through the foreign earned income exclusion.
There is a legitimate way around paying FICA tax. A person can establish a foreign corporation, and pay oneself a wage. The IRS cannot assess FICA tax on a foreign corporation, and the wages it pays to employees. Of course, the foreign corporation and you (as an individual) may need to pay employment/social security tax to the host country. The establishment of the foreign corporation, however, prevents double taxation.
What reporting requirements are there if I have set up a foreign entity?
Expats with local or cross-border business interests commonly establish foreign entities (e.g., corporations, partnerships). Unfortunately, many U.S. expats are caught off-guard when they learn about the filing requirements associated with ownership stakes in foreign entities. The IRS wants to know how American expats with businesses abroad are deriving their income.
Below, we discuss two types: foreign corporations and foreign disregarded entities.
American expats who own 10% or greater stake in a foreign corporation (or who is an officer or director of a foreign corporation in which a U.S. person owns at least a 10% stake) must file Form 5471 along with their individual income tax return. One of the schedules within Form 5471 requires the filer to identify all other U.S. shareholders of the foreign corporation. This allows the IRS to be able to cross-check names, and identify people that are not compliant.
Important to note: The IRS will likely treat any foreign entity that confers limited liability as a foreign corporation—it does not matter what nomenclature the entity is referred to as in the local country.
The penalties for non-compliance are severe. The IRS can assess a $10,000 penalty for each year that the information is not provided. If the IRS has sent you a notice regarding non-compliance, and you do not respond quickly, additional penalties can reach up to $50,000.
Foreign Disregarded Entities:
A foreign disregarded entity is an entity created outside the U.S. and is “disregarded as an entity separate from its owner for U.S. income tax purposes.” For example, single-member LLCs and sole proprietorships are disregarded (not regarded) as an entity separate from its owner for U.S. income tax purposes. When similar foreign entities are owned by a U.S. person, the IRS requires Form 8858 to be filed. The penalties for non-compliance are similar to as described above (Form 5471).
This article was written by John Ohe (IRS enrolled agent and chartered financial analyst). John is a partner at Hola Expat, which specializes in preparing tax returns for U.S. expats. If you would like to submit a tax-related question, email: firstname.lastname@example.org
Disclaimer: The answers provided in this article are for general information, and should not be construed as personal tax advice.
Tax laws and regulations change frequently, and their application can vary widely based on specific facts and circumstances.