The U.S. taxes U.S. persons (U.S. citizens and greencard holders) on their worldwide income regardless of where they live. A U.S. person owning a business abroad will likely have U.S. tax and/or reporting obligations related to the business.
Freelancer, Limited Company, Partnership. What is the best way to structure your business abroad and what are the U.S. tax implications of the structure?
Making the leap to start a business can be intimidating. Realizing that your business abroad has U.S. tax implications, can be terrifying to many. Understanding the U.S. tax implications of the various business structures is vital to making an informed decision.
This article will evaluate various company structures from a U.S. tax perspective. Of course, it is also important to consider the tax and legal liability implications in your resident country, which are outside the scope of this article.
Also called sole-proprietor or self-employed. This is where you operate your business as yourself, with no formal business structure established. This is the least-expensive means of formation. This form of business generally offers no legal protection to the business owner’s personal income and assets. When you operate as a freelancer, you are taxed on the net income
from the business. A Schedule C, Profit or Loss from Business (Sole Proprietorship) is where you will report the gross income received from your freelance work. You are allowed to deduct “ordinary and necessary” expenses related to the business to arrive at net income.
This net income will be subject to income tax AND self-employment tax in the United States. S. Income tax on this income can often be avoided, using either the foreign-earned income exclusion or foreign tax credits. However, U.S. self-employment tax can only be avoided if there is a totalization agreement in place between the United States and your country of residence. If there is no agreement in place, self-employment tax will be owed to the U.S. on your net freelance income. You can read more about the U.S. tax implications of working abroad as a freelancer here.
A legal entity that is established in your resident country and limits your liability will likely be classified as a foreign corporation for U.S. tax purposes. If the limited company is not engaged business in the U.S., the U.S. does not have jurisdiction to tax the income of the limited company. However, a U.S. person with at least a 10% interest in a foreign corporation will have a reporting obligation, Form 5471, with respect to the limited company. In addition, any interactions between the U.S. person and the limited company will likely have U.S. tax implications. For example, if you are paid a wage or dividend from the company, that will be taxable income to you that needs to be reported on your U.S. tax return. You can read more about the U.S. tax implications of owning an interest in foreign corporation here.
This can be an informal agreement or a formalized, registered partnership. While the U.S. will not have jurisdiction to tax the partnership income (assuming it is not doing business in the United States), the U.S. will likely tax the U.S. partner’s distributive share of the partnership income. In addition, the U.S. partner may have a reporting obligation, Form 8865, with respect to the partnership. Partnership income “flows through” to the shareholders of the partnership and they are taxed on their share of the income. For example, if a U.S. person owns a 25% interest in a foreign partnership, then the U.S. person will need to file Form 8865 and also report 25% of the partnership’s net income on his personal return. Depending on the structure of the partnership and the U.S. partner’s “active” involvement with the partnership, the U.S. partner may be subject to self-employment tax on this income, in addition to income tax. You can read more about the U.S. tax implications of foreign partnerships here.
Some countries, such as Australia, utilize trust arrangements to operate businesses. While this structure may be deemed a trust under Australian law, it is important to understand that the IRS will look to the character of the organization and properly classify it as a business entity for U.S. tax purposes. Depending on the liability protection the trust affords and other factors, the business may be classified as a foreign corporation or foreign partnership for U.S. income tax purposes. As such, the depending on the level of U.S. ownership, the additional reporting in #2 or #3 above, may be required for these types of business trusts.
As you can see, the structure of your business can have significant U.S. tax and reporting consequences. In structuring your business, you will want to optimize the liability protection as well as the costs of formation and tax and reporting compliance. We can help in structuring your business. Contact us today to schedule a consultation.
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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult tax, legal and accounting advisors before engaging in any transaction.