The state department estimated that approximately 9 million Americans were living abroad in 2016, and this number is growing. Expats report enjoying life overseas, with many intending to stay abroad permanently. For someone who is opening a business abroad, choosing how to structure your foreign business can be complex with various factors to consider. A common thread to any of these structures is that a US owner (with greater than 50% ownership if a foreign corporation) will face taxation in the US on their income.
Opening a Business Abroad: A Case Study
Let us take an example of Mark, a US citizen residing in Guinea. He is looking to open up a business with himself as a 100% owner; he does not conduct business in the US. As an American expat entrepreneur doing business abroad, setting up a local business entity would be logical. And, trying to open bank accounts and conduct business as a US corporation in Guinea may not be feasible. He sets up a Guinea corporation and pays Guinea income taxes; the IRS will also come knocking on his door to collect US income taxes on his foreign business profits.
Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), American owners of foreign corporations could defer the taxation of their active business income; this income (with some deduction in case of depreciable assets), along with any passive or Subpart F income is now taxable by the US annually. The advent of GILTI (Global Intangible Low-Taxed Income) tax as part of the TCJA has made compliance surrounding reporting income of foreign corporations complex, expensive, and has expanded amounts includible in a US shareholder’s income.
As a result, Mark will be faced with filing a more complicated Form 5471, calculating GILTI taxes and Subpart F income, and reporting the income on his Form 1040. What should he do?
How to Mitigate US Taxes When Opening a Business Abroad
Mark can consider the following options to help him navigate the intricacies of his tax situation better.
- Make an election in the US to treat his foreign corporation as a disregarded entity. This will have the impact of treating his foreign company as a sole proprietorship by the US, with a simple Schedule C reporting versus the complex Form 5471 reporting. Consider self-employment tax impact as well, however.
- File a Delaware Certificate of Domestication to register his foreign corporation as a US entity. Delaware is one of the more favorable states concerning business incorporation. State income taxes don’t apply if no business is done in the state; also, the court system specializes in corporate issues, and there exists greater privacy. By filing a certificate of domestication, the foreign corporation is also treated as a US corporation. Mark would file Form 1120 to report his business activity. He would avail himself of the current 21% tax rate on his profits, and would need to compare this to his individual tax bracket; alternatively, S Corporation status can also be elected. Domesticating a foreign corporation to C Corporation status can bring the benefits of reducing US tax by foreign tax credits, and avail of the FDII (foreign derived intangible income) deduction.
By choosing either one of the two options above, Mark can avoid paying GILTI or Subpart F income taxes when opening his business. In addition, Mark can evaluate other structures and see if he can take advantage of the benefits of an income tax treaty abroad.
In our current tax climate, US expats have a significant number of options to consider when opening a business abroad. Choosing to have a US-based business may be the best course of action for some owners, and carefully evaluating all alternative structures will aid in long-term tax savings.