In the age of the “digital nomad,” it has never been easier for Americans to start businesses while living outside the United States. But as long as the U.S. retains the principle of citizenship-based taxation, Americans abroad must pay special attention to the tax, compliance and planning complexities imposed on all U.S. persons abroad running early stage start-ups and mature businesses.
As a result of this entrepreneurial spirit, a U.S. taxable person may own a controlling stake in a foreign business, and a business held by an American abroad outside of the United States is likely a Controlled Foreign Corporation or a CFC for U.S. tax purposes. Frequently, a CFC is subject to complex tax reporting requirements in the United States. At a minimum, the CFC must file U.S. Tax Form 5471 annually. Should a CFC fail to file this form, even if no tax is owed, the IRS can assess large penalties on the CFC.
Given these considerations, Creative Planning International provides five top recommendations that “Expatreneurs” or American expat business owners need to consider to maximize the value of cross-border enterprises and avoid big compliance headaches.
1. Ensure Your Business Is Tax-compliant
The Foreign Account Tax Compliance Act (FATCA) means the IRS has greater transparency on global financial transactions and is therefore able to enforce more rigorously U.S. taxation of non-U.S. transactions than ever before. In particular, enforcement centers around “subpart F income” and “passive foreign investment income” (PFIC) rules. CFCs that derive more than 75% or more of their income from passive sources (such as dividends, capital gains or royalties) become Passive Foreign Investment Companies (PFIC) and are subject to very onerous reporting requirements (Form 8861) and highly punitive U.S. tax rates (see our article on PFICs).
2. Be Aware Of Controlled Foreign Corporation (CFC) And Controlled Foreign Partnership (CFP) Reporting Requirements
As noted above, corporations organized outside the United States, but controlled by U.S. persons, are Controlled Foreign Corporation for U.S. tax purposes. CFCs must report their income on Form 5471. CFC rules result in foreign sourced income being taxed at the level of the individual U.S. shareholder. Controlled Foreign Partnerships (reported in Form 8865) also result in foreign partnership income to be taxed as personal income even where the U.S. person is a minority shareholder. Ultimately, these reporting requirements mean the business (if it has U.S. taxable partners) must prepare financial statements to U.S. standards and submit the detailed statements to the IRS to help determine the U.S. taxable partner’s income tax liability.
3. Pay Attention To Other Tax Reporting Requirements
Where a U.S. partner (or even a U.S. employee) has signing authority over a business related financial account, the business must file a Foreign Bank Account Report (FBAR, also known as FinCen-116) to disclose the account to the U.S. Treasury Department. the business must file a Foreign Bank Account Report (FBAR) to the U.S. Treasury Department every year and failure to properly make FBAR disclosures can result in extraordinarily high U.S. penalties, even when no tax is due.
4. Don’t Overlook Conventional U.S. Retirement Plans
U.S. taxable persons who own a non-U.S. business can generally use standard U.S. qualified retirement plans (Personal Defined Benefit Plans, Solo 401ks or SEPs). For instance, an individual 401(k) and/or a defined benefit pension plan can be used to defer large amounts of foreign sourced income into retirement accounts. U.S. domestic business owners often find such plans of limited use, because so-called “anti-discrimination” rules prevent them from deploying the plans without providing prohibitively expensive retirement to all U.S. employees. However, if the foreign corporation in question has no U.S. employees, anti-discrimination rules will not prevent a U.S. owner from making very large deferrals into a U.S. retirement account. For example, an American entrepreneur abroad with sufficient CFC income reported can defer up to $61,000 (2022) annually into an easy-to-set-up Individual 401(k) plan. If a slightly more complicated defined benefits plan is designed, hundreds of thousands of tax deductible contributions can be made on behalf of the owner.
5. Beware Of Local Taxation And Its Interactions With U.S. Taxation
Depending on the locale, the tax benefits of a U.S. qualified retirement plan can be reduced or eliminated by local taxation. Additionally, bilateral tax treaties can determine the net tax advantage of such plans. Bilateral tax treaties can also effect if Americans abroad must pay the U.S. Self Employment Tax of 15.3% which covers Social Security and Medicare. Social Security Totalization agreements maintained with several other countries may exempt the U.S. taxpayer from this tax if they pay a similar tax in the country of residence. These taxes paid in a foreign country would entitle U.S. taxable business owners to government sponsored retirement benefits from the country where their business is located.
The headaches of being a business owner can be compounded by the multiple additional tax and compliance requirements when operating abroad. With good planning, however, the burden does not have to be excessively onerous and even offers potentially large tax advantages in terms of retirement account investment planning.