Why Start An Offshore Company?
Companies can be created anywhere and can generally do business anywhere, so why would someone want to create a company outside the United States?
Well, lots of reasons. In some countries, only a domestic company can own property or engage in certain types of business. In other countries, you can acquire residency or nationality preferences by establishing a local company. From the United States’ perspective, the IRS defers taxation in certain limited circumstances. If you meet the proper criteria, you pay tax only when money is repatriated in the form of salaries or dividends. So, what is the proper criteria?
Imagine a quadrant graph in which the vertical axis is divided between foreign and domestic income and the horizontal axis is divided between active and passive income. If your company generates ANY U.S. income, foreign or domestic, then you do not get any tax benefit. If you generate foreign income, but that income is passive, you do not get any U.S. tax benefit.
However, if you generate active foreign income, that is the circumstance under which U.S. income can be legally deferred. Even when a Form 5471 must be submitted because the company is a Controlled Foreign Corporation, or CFC, no tax may be due. Again, if you do not generate foreign income or the foreign income you generate is passive, then you do not need a foreign company. But if you have the opportunity to generate foreign source active income, then a foreign company is the right “cheese” for you.
Practical Advantages Of An Offshore Corporation
There are advantages to having your business based offshore and outside of the United States. Here are a few basic ways that you might find a foreign company useful:
Privacy is the first thing that a foreign corporation offers. In many countries, there are laws that protect the identities of those who own private corporations, and these laws help to keep prying eyes from your business and activities.
Granted, your ownership of a foreign corporation must be reported to the IRS under today’s rules. But having one still provides a layer of privacy and security that can insulate you from those who’d want to interfere with your personal affairs.
Taxes are another good reason to set up an offshore corporation. The tax advantages vary depending on the laws in your country of citizenship and the laws in the jurisdictions where you do business or own property. When considering corporate tax rates on income, inheritance, and capital gains (relative to private individuals), it is often to your advantage to own property or conduct business abroad via a private corporation.
In Uruguay for example, there are situations when the foreign corporate tax rate is less than the domestic rate. There are also advantages to owning a Brazilian property through a corporation from Uruguay.
Inheritance laws are another good reason to use an offshore corporation, specifically when you’re buying property overseas. Inheritance laws in most of Latin America and Europe are quite different from those of the United States. For example, you’re often required to leave your ownership of a property to your children in equal shares…you cannot leave it to your spouse. This can become awkward when either or both of you have children from previous marriages.
On the other hand, passage of ownership of a corporation can be handled within the corporation’s bylaws, bypassing the local inheritance process. This can allow you to leave your property to whomever you choose, by having your heir take control of the corporation privately.
Transfer of property ownership can also be made easier when the property is held by a corporation. Some countries have complex and expensive property transfer processes. (I’ve paid transfer fees in excess of 11%.) Often, if you own the property through a corporation, you can simply pass the corporation on to the next owner rather than transferring the property itself. This is because it’s not necessary to change the name on the deed (because the name on the deed is the name of the corporation).
Limiting liability is a basic benefit of using a corporation of any type for property ownership, as a corporation’s liability is distinct from that of its owners/shareholders. You can even use an offshore corporation to own property in the United States. It’s not likely that this will provide you with any tax advantage, but it may be just what the doctor ordered for privacy issues or to limit your liability from frivolous lawsuits or claims.
When considering buying property with a foreign corporation, check with an attorney in the country where you’re buying to make sure you can do it. In Ecuador, for example, there is no problem buying property with a foreign corporation, while in Honduras, it’s prohibited. Some countries, including Brazil and Uruguay, also place restrictions on buying with a foreign company that don’t apply to individuals.
Four Rules For The Successful Offshore Company
A successful offshore company is one that operates profitably and legally. There are some basic rules that you must know when starting any venture outside of the U.S. in order to stay legal and compliant.
Here are the four things you need to know:
The theory behind an offshore corporation is simple: These are not U.S. entities, so the IRS has no right to tax them. Not to be deterred by such a technicality, the IRS goes after the American shareholders, not the entity.
The United States claims authority over anyone with a U.S. passport, no matter where you live. Our government has enacted a number of laws controlling how and when U.S. citizens must pay tax on earnings from or retained in offshore corporations.
If you have a successful offshore business, there are two international tax code sections you should be familiar with:
Controlled Foreign Corporation (CFC)
If a U.S. person holds 10% or more of the stock (or voting control) of an offshore corporation, and U.S. persons hold more than 50% of the shares or control of that company, then U.S. persons can defer tax on active income, but not passive income.
In other words, if American(s) control an international business, then that business can defer U.S. tax on ordinary (active) profits, but not from investments. If less than 50% of the business is owned by U.S. citizen(s), then the CFC rules do not apply.
The CFC rules also limit deductions and control how retained earnings are taxed upon distribution. Passive income from interest, dividends, investments, etc., is not active income, thus no U.S. tax deferrals are available. Passive income flows through to the shareholders of a CFC and is taxable on your personal return.
When you distribute retained earnings from a CFC, they are taxed at your marginal rate. Long-term capital gains rates (20% for 2013) are not available.
Losses in a CFC do not flow through to the shareholders. Losses are not deductible until the company is liquidated.
If you die holding shares in a CFC, your U.S. heirs do not get a stepped-up basis. When they sell the shares, they will owe tax on their value when you acquired them, not when they inherited them.
Passive Foreign Investment Company (PFIC)
If you or your offshore corporation generates high levels of passive income, or invests in non-U.S. mutual funds, a complex tax regime may be imposed on those earnings.
Basically, you can elect to pay U.S. tax on the appreciation in your investment account each year, or you can pay U.S. tax on the gain when you sell funds or shares from your account. If you elect to pay tax when you sell, a punitive interest rate is added to the tax due to eliminate any benefit from deferral.
The PFIC code sections are complex, and I consider them in their most basic form here. The intention is to let you know of their existence and warn you that passive income in an offshore corporation is not tax-exempt or tax-deferred. If you hold a U.S. passport, Uncle Sam gets a piece of your investment profits. The only major tax benefit available to the offshore entrepreneur is associated with active business income.
est, dividends, investments, etc., is not active income, thus no U.S. tax deferrals are available. Passive income flows through to the shareholders of a CFC and is taxable on your personal return.
When you distribute retained earnings from a CFC, they are taxed at your marginal rate. Long-term capital gains rates (20% for 2013) are not available.
Losses in a CFC do not flow through to the shareholders. Losses are not deductible until the company is liquidated.
If you die holding shares in a CFC, your U.S. heirs do not get a stepped-up basis. When they sell the shares, they will owe tax on their value when you acquired them, not when they inherited them.
Only a bona-fide business can defer tax on profits. In its most basic form, this means you should be selling something on a regular and continuous basis; you should have made a profit in at least three of the last five years; you should be working at the enterprise full time; and it must be a business, and not a hobby.
You should be selling a product, not providing a service. A professional service, which is performed outside of your country of incorporation and generates income from technical, managerial, engineering, architectural, scientific, skilled, industrial, or commercial activities, is not bona-fide ordinary income for U.S. tax purposes. Therefore, your corporation should be from wherever you are resident overseas…which may create a tax liability in the country of incorporation.
Of course, this bona-fide business must be operated outside the United States. The U.S. owner and operator must be living and working abroad and must qualify for the FEIE to be able to generate retained earnings in his or her offshore corporation.
An offshore corporation can have shareholders who live in the United States. These shareholders must be passive investors, having no control over the company’s day-to-day operations. The offshore corporation should not have a U.S. office or employees. Nor should it have any U.S. agents working exclusively to market or distribute its goods in the United States.
Remember that you must file U.S. tax returns and therefore may be audited by the IRS. Your offshore business must maintain records of income and expense in accordance with U.S. accounting principles. If you can’t prove your expenses, they may be denied by the IRS.
Offshore corporations must file a number of U.S. tax forms. Failure to file can result in some very draconian penalties.
Here are IRS tax forms you should be familiar with before incorporating your business offshore:
- Form 5471 —Information Return of U.S. Persons with Respect to Certain Foreign Corporations. This form is filed with your personal tax return.
- Form 926 —Report of Transfer to Foreign Company. This should be filed when you fund the offshore corporation.
- Form FinCEN 114 —Report of Foreign Bank Account(s). If you have more than US$10,000 offshore, this form must be filed online and is due by June 30.
A foreign corporation or LLC should review the default classifications in Form 8832, Entity Classification Election, and decide whether to make an election to be treated as a corporation, a partnership, or a disregarded entity.
- Form 8858 —Information Return of U.S. Persons with Respect to Foreign Disregarded Entities.
- Form 5472 —Information Return of a 25% Foreign-owned U.S. Corporation.
- Form 8938 —Statement of Foreign Financial Assets. Must be filed by anyone with significant assets outside the United States.
Both the risks and rewards are great when doing business offshore. If the business is properly structured, it is possible to eliminate or defer U.S. tax on 100% of your active income. However, most of these tax rules are “all or nothing.” If you miss qualifying for the FEIE by one day, you lose 100% of the benefit. If you use the wrong type of structure, the ability to retain earnings offshore is gone. If you fail to accurately and completely report your activities, you may face enormous penalties from the IRS, possibly hundreds of thousands of dollars.
Bottom line: Understand how to comply…and remain compliant.
An offshore corporation can provide extraordinary tax-planning opportunities for those living and working offshore. However, planned or reported incorrectly, this same structure can blow up in your face.
The best way to show you the potential complications is to share a real-life examples.
A potential client (we’ll call her Ms. Q) got in touch with us recently. By way of background, Ms. Q is living and working in California. She is self-employed, and most of her clients (and revenue) are from Asia. She had been talking with a promoter in Nevis and was convinced she could operate her business through a Nevis corporation and, thereby, not be liable for any tax.
Here is the gist of Ms. Q’s conversation with the promoter, as she relayed it to us:
Q: If my Nevis offshore company earns money from Asia, will I pay any taxes on that money if I don’t bring it in to the United States?
A: No, you will not pay any taxes in Nevis. Your offshore company is not required to file a tax return or pay taxes of any kind.
Q: Do I need to follow certain accounting standards, file accounting reports, or keep records?
A: No, Nevis does not require you to keep business records, provide audited statements, or file any documents. Basically, all you need to do is pay your monthly fee to keep the company in good standing.
Q: Can my offshore corporation retain earnings?
A: Sure, you can retain as much capital in your Nevis corporation as you like. Nevis imposes no requirements on dividends or corporate capital.
Q: When will I need to pay taxes on the money earned by my offshore corporation?
A: In most cases, clients must pay tax on the money they pay themselves in salary. So you may need to pay taxes on your earnings when you take them out of the company.
Q: Is my offshore bank account private?
A: Absolutely. We value your privacy in Nevis and have very strict laws preventing disclosure of your offshore corporation or bank account to anyone.
The client came away from her conversation with the promoter with the belief that her bank account would be secret and that no taxes would be due unless and until she repatriated money from Nevis to the United States. The promoter stuck to the facts, misdirected but did not lie, and gave only one side of the story… that of Nevis… ignoring the client’s obligations in her home country.
In fact, the tax rules for offshore corporations are rather straightforward:
If you are living and/or working in the United States, an offshore corporation or LLC provides no tax benefit. Where your clients are located is irrelevant. Your domicile while performing the work controls.
The offshore corporation will provide unparalleled asset protection, access to international markets, the ability to diversify out of the United States and its currency, and other benefits, but it is tax-neutral for the U.S. resident.
If you are living and operating a business outside of the United States, and qualify for the Foreign Earned Income Exclusion, then doing business through an offshore corporation may reduce or eliminate all U.S. taxes.
(Note: An IRA or other retirement account may achieve significant tax savings by going offshore.)
In other words, if you are living in the United States, an offshore corporation should not increase or decrease your U.S. tax bill. It may require you to file a number of forms with the IRS, but it should be tax-neutral. If you are living outside of the States, then an offshore corporation can be a great tax tool, and you should consult with a U.S. licensed expert to determine whether you could benefit by forming one.
Ms. Q was asking all the right questions but to the wrong person. If you ask a Nevis attorney a tax or legal question, you will get an answer according to the law of Nevis. As a U.S. citizen, it is important that you operate from a tax-free jurisdiction such as Nevis, Belize, or Panama, but the majority of your tax-planning and structuring concerns involve the U.S. tax code. So your offshore corporation must be created and maintained by a U.S. licensed tax expert.
What Type Of Offshore Company Should You Form?
An important part of starting an offshore company is knowing the type of company that accomplishes your goal while keeping you protected. You have several choices available to you, ranging from a corporation to a sole proprietorship. Each option will come with its own unique set of advantages and disadvantages, as well as reporting requirements and qualifications. Only you and your attorney will know which is best for you given the full scope of your situation, but here are some things you should consider:
Setting up an offshore corporation is typically the most tax-efficient approach for the American operating a business outside the United States. Corporations can be an effective choice for holding assets, as well, but other entities are generally better, depending on the specific purpose.
With an offshore corporation, a U.S. person can operate a business outside the United States with two main benefits from a U.S. tax perspective. First, living and working outside the United States as an employee of the offshore company, you can avoid paying Social Security and Medicare taxes in the United States. Being paid by a company outside the United States, your own or someone else’s, means the company (and therefore you, as well) aren’t obliged to pay those taxes.
The second benefit is that all profits in the company from active income are taxdeferred until they are paid out of the company in the form of salary or dividends to you. This allows the company to hold net profits, which can be reinvested in the company, meaning the potential for much faster growth than if the company had to pay taxes on all profits every year.
You need, though, to be careful about the amount of retained earnings. At some point, you could end up with more income from passive activities than is allowed, meaning the company’s net income, or part of it, could be taxable. The passive activity rules are one reason why using another kind of asset-protection entity make sense for holding passive investments.
Shareholders of foreign corporations are required to file an information form (Form 5471) each year. Generally speaking, you are required to file the form if you acquire 10% or more of any foreign corporation or if you acquire additional shares of a corporation in which you already owned shares that put you over the 10% threshold. In either case, you have to file the Form 5471 only for just the year in which the event occurs.
In other words, if you acquire 10% of a foreign corporation, then you file the 5471 with your tax form, but you don’t have to keep filing the 5471 if the corporation isn’t what is called a controlled foreign corporation (CFC), or, more appropriately, a U.S.-controlled foreign corporation.
If the corporation is a CFC, then anyone owning 10% or more of the voting power must file Form 5471 every year in which they retain that level of ownership or more. The instructions for this form are here.
Form 5471 is informational only. No taxes are due with the form.
One of the most commonly used entities for offshore structures and asset protection is an LLC. An offshore LLC is similar to a U.S. LLC in that it limits the liability of the owners… and both are pass-through entities. This is the structure we recommend for holding passive investment portfolios.
You can choose to have a foreign corporation or a foreign LLC treated as though it doesn’t exist for U.S. tax purposes, i.e. a pass-through entity. You do this with Form 8832, and, typically, you’d want to do it for an LLC holding an investment portfolio. A foreign LLC with a single owner can be treated as if it doesn’t exist for U.S. tax purposes… and the “single” owner can be a married couple. (In fact, domestic entities can be elected to be treated this way, as well, using the same form.)
This means that, for tax purposes, you can reduce your filing requirement by electing to have your LLC treated as though it didn’t exist. You simply report the interest, dividends, and capital gains on your 1040.
One thing to remember is that you can’t elect for certain foreign corporations to be disregarded. The instruction section of Form 8832 has the full list.
For disregarded foreign entities, you’ll then have to complete Form 8858 each year. It’s another information form, like the 5471, a simple two pages.
While a foreign LLC puts a layer of protection between your assets and some litigant looking for a payout, if asset protection is your main goal, a foreign LLC isn’t the best choice, though it can be the simplest. For stronger asset protection, an offshore trust may be more appropriate for you. However, it requires a different level of tax reporting for U.S. persons…
If you’re self-employed as the sole proprietor of a business and working and living overseas, you’ll not only pay Social Security and Medicare taxes as you would if you were in the United States (both the employer and employee parts), but you’ll also have your FEIE reduced by your business expenses.
Overall, from a tax point of view, you’re much better off setting up a foreign corporation for your non-U.S. business. The cost to setting up an offshore corporation can run as little as US$1,000. The annual cost to maintain the corporation will run around US$500. Even assuming you use a service to set up the corporation that charges you an excessive fee of US$5,000 to establish a simple offshore entity, you’ll save money in the short- and long-run, if you have only US$33,000 of foreign earned income that can flow through your offshore corporation.
How To Eliminate Self-Employment Tax
We recently received a call from an investment advisor who had read an article by us on international taxation. He came away from that article thinking that an offshore corporation can be used to eliminate self-employment taxes for those living in the United States.
To eliminate self-employment and/or Social Security, Medicare, and FICA taxes through an offshore corporation, you must:
1) Live and work outside of the United States
2) Operate your business through a non-U.S. corporation
3) Qualify for the Foreign Earned Income Exclusion
A U.S. resident may operate his business through an offshore corporation for asset protection or other reasons, but your salary will be fully taxed. Your corporation should issue a W-2 and have proper withholding. If a W-2 is not filed, or a payroll system is not in place, you should report all income from the offshore corporation on your personal return as being subject to self-employment tax.
The moral of the story: If you carry a U.S. passport, your offshore corporation or international asset protection structure must be created and maintained by a U.S. licensed tax expert. Failure to comply with the various tax laws can result in draconian penalties.
Why A Global Franchise Can Make An Ideal Overseas Business
One of the quickest and most straightforward ways to start a business in another country is by investing in a franchise. If you are looking to plant a business flag overseas, we recommend considering this option. A franchise offers proven systems for launching and running a business that, in a new environment and, likely, a new language, can help you reach positive cash flow and profitability more quickly.
U.S. franchises can be found in the fast food halls of malls and shopping centers of most every country in the world. McDonalds is the international king, but Kentucky Fried Chicken and Pizza Hut give it a good run for its money. The known big-box franchises (Costco, for example) are also established in many countries… plus they have a high cost of entry, making them generally unappealing for someone with limited resources looking to establish a foothold business outside his home country. Smaller franchises such as Mail Boxes Etc. and lesser known fast food options can be better choices for going overseas than McDonalds, et al.