Establishing a Business Abroad – US Tax Considerations
Many US expats operate their own business while living abroad. In this article, we discuss the advantages and disadvantages of establishing a business abroad from the standpoint of US taxes. This is a dense topic, therefore we will be highlighting only the main points.
Expat businesses generally fall into two categories:
1. A local business primarily serving residents of the host country;
2. A business that primarily serving US customers or international customers (outside of the host country)
Expats with local businesses often setup a foreign corporation. For example, an S.A. or Sociedad Anonima is a common business entity in Guatemala. The business pays taxes to the local government, and is not subject to US tax laws. However, US persons are individually subject to US taxes on their wage and any dividends received.
Generally speaking, US expats with a local business should take a salary rather than dividends in low tax rate jurisdictions, such as Guatemala. The principal reason is that the foreign earned income exclusion can eliminate up to app. $100K in wages from taxable income. Dividends, however, are 100% taxable by the IRS (although the US tax liability can be offset by foreign taxes paid). If earnings from the business exceed $100K, then it may be beneficial to take $100K in salary first, and either pay the remainder in dividends or retain the earnings within the company (a great option). Retained earnings are not taxable by the IRS until distributed as dividends to US persons.
Expats with businesses that primarily serves US customers or international customers often operate without establishing a foreign corporation. Depending on the size and nature of the business, one may be operating as a sole proprietorship, or through a US entity (e.g., LLC, S-Corp). There are two critical issues operating a business without the use of a foreign corporation. The first is that US expats continue to be subject to FICA (social security and Medicare tax). The second issue has to do with the foreign earned income exclusion (FEIE). The IRS does not allow self-employed individuals (i.e., sole proprietorships and single-member LLCs) to exercise the foreign earned income exclusion on net income. Rather, the FEIE is based on gross income. The calculation is somewhat complex and beyond the scope of this article.
Given the issues mentioned above, an increasing number of US expats are setting up foreign corporations in favorable tax jurisdictions. In the western hemisphere, Belize and Panama are popular destinations because they do not tax non-residents. Therefore, one can establish a corporation in Belize and pay zero taxes to the Belize government (provided the person does not reside or generate income in the country). The US expat can pay him/herself a salary up to the FEIE without owing US income tax. Lastly, there are no FICA taxes owed.
The main disadvantage of a foreign corporation (whether one has a local or international business) is the increased reporting requirements demanded by the US government. For more information, google “Form 5471.” There is a plethora of information online.