It’s beginning to look a lot like . . .
. . . tax reform . . . . Everywhere you go . . .
Move over Rudolph (with your nose so bright). The star of last Christmas season was Donald Trump and his tax reform plan, which was enacted into law while we were decking the halls and donning our gay apparel.
Even though tax reform is heavily covered in the news, very little of that coverage has discussed the impact on expats. The latest article I could find on tax reform for expats was written several months ago.
So, let’s jump in and see how Americans who live outside the US will fair under the new Trump tax plan.
First, the basics
Let’s make sure we’re all on the same page before diving into the details.
As an American citizen or green card holder, you are subject to US tax on your worldwide income no matter where you live. So, simply living outside the US is not a fundamentally different thing to do than living in the US when it comes to US tax–you don’t get to stop thinking about US tax right when you board that outbound plane.
But, even though US tax is still a part of your life, there are several special rules that allow you to reduce your US tax bill. These rules may allow you to pay zero (or very little) US tax while you live outside the US.
For most expats, nothing changes
Maybe we’ve discovered the reason for the lack of tax reform coverage for expats . . . . For most expats, absolutely nothing will change.
Sure, some of the general provisions that apply to everyone will also apply to expats. So, you may lose certain itemized deductions in exchange for the larger standard deduction, and you may benefit from the reduced tax rate on income from pass-through entities.
But, the tax reform bill doesn’t make any changes at all to the mainstay provisions for expats: the foreign earned income exclusion, the foreign housing deduction/exclusion, or the foreign tax credit (as applied generally to individuals).
New to expat tax? Click here to learn how it all works.
Also, the tax reform bill doesn’t completely exempt Americans who live abroad from US tax. There was an earlier bill that would have done that (making the US more like every other country in the world), but it didn’t pass and is not a part of the tax reform bill. (By the way, if something like that ever does pass, please give me a call for all of your Belize real estate needs.)
But for expat entrepreneurs . . .
If you own a business, then the world is currently moving right underneath your feet. Everything you’ve known and loved about US tax and legal structuring for expat entrepreneurs is about to get shaken up; for some of you, it will turn completely on its head.
Under current law, the best legal structure to operate your business through is a non-US corporation (as long as you don’t have people on the ground in the US running your business). A non-US corporation provides two groups of benefits.
On the first $100k of net income from your business, your non-US corporation allows you to pay zero US tax. Your non-US corporation does away with the following three things, which would otherwise cause you to pay US tax on that first $100k:
- The self-employment tax (which is about 15% on the first $118k),
- The scaleback rule (which reduces the effectiveness of the foreign earned income exclusion for a self-employed person with gross income over $100k); and
- If you have a business where “capital is a material income producing factor” (e.g., Amazon FBA), the 30% rule (which allows a self-employed person in these businesses to only treat up to 30% of net income as foreign earned income).
Then, on your non-US corporation’s net income above about $100k, current law allows you to defer US tax by leaving the money in the company. You only pay US tax on these retained earnings when your non-US corporation pays them to you as either (i) a salary in excess of about $100k or (ii) a dividend.
Here’s how the new law would change things:
- On the first $100k of your business’s net income, the new law doesn’t change anything at all. You can still pay zero US tax by operating your business through a non-US corporation. So, your non-US corporation is still necessary and beneficial—-it still allows you to pay zero US tax on the first $100k. It would NOT be better for all expat entrepreneurs to scrap your non-US corporation and instead operate through some other legal entity.
- On everything above $100k, the party’s over basically. Starting in 2018, you’ll be required to pay US tax at standard ordinary income rates on the amount your business makes in excess of your salary (i.e., the amount that was previously the retained earnings of your non-US corporation). The ability to defer paying US tax on this amount by leaving it in your non-US corporation is just over and done with.
- It gets a little worse. As a transition from the old regime to the new regime, you’ll be subject in 2018 to a one-time tax on all of the retained earnings of your non-US corporation.
So, here’s the bottom line after tax reform: Being an expat allows you to operate your business through a non-US corporation, which gets you the first $100k tax-free. However, on the amount above about $100k a year, you would pay US tax just exactly like you lived in the US.
A glimmer of hope for some
The rules discussed above under the new law apply with respect to a “controlled foreign corporation,” which is generally a non-US corporation where US persons own more than 50%. In certain situations, it may be possible to shift ownership of your company in ways to avoid “controlled foreign corporation” status.
For example, if you’re married to a non-resident alien, give them a big kiss and half of your company. Then try to stay on their good side from here on out.
Now, I hesitated adding this section of the article because some people will get really bad ideas here. You can’t just put your uncle Igor’s name on the shareholder register and flip the bird to the IRS–you have to actually shift real beneficial ownership of your business. No shenanigans allowed.
Plan now for the transition . . .
If the bill is enacted into law this year in current form, the one-time inclusion discussed above will occur on 1/1/2018. You still have time to plan here–there may be ways to mitigate the effects or even prevent this one-time inclusion entirely. If you have retained earnings in a non-US corporation, we should talk as soon as possible.
. . . and for the new normal to come
Before tax reform, a non-US corporation was all you needed for US tax purposes (and then of course you would typically have a US limited liability company under your non-US corporation so you can bank in the US). The non-US corporation was the go-to structure for all expats and digital nomads.
After tax reform, a non-US corporation is still clearly the best choice if you’re just starting out. So, if you already live outside the US (or are about to board that outbound plane), and you’re just starting your business, setting up a non-US corporation is still a great idea–that’s the only way to pay zero US tax on the first $100k. To learn more, click here to register for my free webinar.
However, a non-US corporation may not make sense in other situations. For example, if your business makes more than $100k of net income per year, it may be best to include a US C corporation in your structure. Yes, that’s right, tax reform is turning the world upside down–using a US C corporation in your structure may actually be the best way to reduce your worldwide tax bill. Also, in certain other situations, an S corporation may be the best structure.
For new expats who already have a business, especially if it’s making over $100k of net income, there’s no more one-size-fits-all solution. We should talk so I can prescribe the best structure for your particular situation.
Will you be affected by tax reform? Book a call so we can put together your personal tax reform survival plan.