This is the second in our series on Offshore Tax requirements for US expats by international tax expert, Diane Kennedy. Read part one HERE.
One non-negotiable for US citizens is that we are taxed on worldwide income. If you live in the US, make money overseas and bring the money back into the US, it will be subject to US tax. However, if the income is earned overseas, the business is owned by a foreign entity and the income is not brought back to the US, the income will be subject to taxes in the foreign country and not the US.
There are a number of things that must go right for that to work, however.
- The income must be earned outside the US.
- You have to use a foreign entity that meets all the US rules to avoid inclusion as taxable in the US.
- You don’t bring the money back to the US.
Let’s look at those items in detail now.
The income must be earned outside the US.
The US federal government and states use something called nexus to determine where income is earned and whether it is subject to federal and state tax. Nexus means connection. If you have connection with the US, you have nexus. And that means you have taxable income for the US.
Some of the things that can trigger US tax nexus include an office in the US, employees in the US, sales to US citizens that are consummated on US soil, live US events and more. The simplest way to keep foreign income separate from the US income is to separate out your customer sales. Use a US business structure for your US sales. And use a foreign company for your foreign sales.
This can be fairly easy to do with your online business. You may use just one website and then separate out the sales depending on where the customer lives when they input their payment method. Or you may have an opening page that redirects based on where they input their country of origin is. As long as you’re separating out the income, you’ve probably passed this first test.
You must use a foreign company that meets US criteria.
Foreign corporations are usually the entities used to defer US taxes because the US owners of foreign partnerships or limited liability companies are subject to tax as pass-through entities. But, having a corporation doesn’t necessarily mean you’re home free. First, if a foreign corporation is considered a controlled foreign corporation (CFC), foreign personal holding company (FPHC), passive foreign investment company (PFIC) or foreign investment company (FIC), there may be a tax on the earnings. If the corporation has income that is connected to the US it may be taxed in the US. And finally, if you have US source income of specific types, even if there is no business involved, it may be subject to US tax.
Of these, the most likely to trip up the online business owner is the CFC. A CFC is a foreign corporation whose total combined ownership in voting power by US shareholders is greater than 50%.
This is an area where you need to make sure you’ve got expert US tax advice. Work with a CPA or tax attorney who understand the tax treaties between the US and preferred country of residence and the rules regarding the foreign entity you’re setting up.
You can’t take the money back to the US.
This is simple. Take it back to the US and it’s taxable. That’s why foreign income is often referred to as tax deferred, not tax-free.
The most common use of foreign corporations, foundations or trusts is for asset protection. Asset protection doesn’t always mean tax savings, though. Make sure you know exactly what you’re getting with your business structures.
It’s your money. Keep more of it. You can find more real-life tax busting strategies by Diane Kennedy, CPA/Tax Strategist at her website http://wwwUSTaxAid.com. Diane and her husband lived outside the US for five years and, to this day, continue to run foreign businesses. When it comes to taxes, the more you know, the less you’ll pay.
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