A few house-keeping matters before we dive in:
- This article doesn’t apply to you if you still live in the United States. See this other article instead.
- This article is concerned only with structuring an active business or profession that you operate—we’re not going to discuss passive investments. The US tax rules draw a sharp distinction between the two, and the concepts discussed here don’t apply to passive investments.
- Finally, this article assumes you’re familiar with the basics of the foreign earned income exclusion.
Business v. Profession
An important concept for the structures discussed in this article is the difference between a profession and a business.
A professional sells their own services. So, a lawyer, accountant, IT consultant, web designer, copywriter, graphic designer, software developer, and business advisor would all typically be engaged in a profession—they aren’t selling a product or the services of other people, they’re selling their own time and attention. They’re renting their brain to clients.
However, a business has a life of its own outside the personal efforts of the owner. Imagine a hotel—the front desk is checking people in, maids are cleaning rooms, the kitchen is making meals, and the bartender is making drinks, all while the owner is up in her room taking a nap. That’s a business. Now, imagine a solo practitioner lawyer’s office while the lawyer isn’t in it—there’s no business going on.
How to Structure your Business
Hold through a Non-US Corporation
If you own and operate your own business outside the United States, and your business isn’t a profession, it’s generally most advantageous to hold the business through a non-US entity that’s classified as a corporation for US tax purposes.
And, of course, it would be wise to form this corporation in a low- or no-tax jurisdiction. See this article for a discussion of the best jurisdiction for your non-US corporation.
By holding through a non-US corporation, you can
- take advantage of the foreign earned income exclusion by paying yourself a salary as an employee of the corporation,
- avoid self-employment tax, and
- avoid the rules that limit the use of the foreign earned income exclusion by a self-employed person (the “30% rule” and “scaleback rule,” discussed further below).
By using this structure, you can easily and legally avoid all US tax on the first about $100,000 of net profit from the business by causing your non-US corporation to pay this amount to you as compensation.
Consequences of Holding Business Directly
What if you were to simply hold your business in your own name (or through a passthrough entity) instead of through a corporation? Several bad results:
- You would be subject to self-employment tax on all of your net income from the business, which is 15.3% up to about $118,000 and 2.9% over that. The foreign earned income exclusion only works for purposes of the income tax, not self-employment tax.
- Even worse, for any business other than a service business, you would only be able to use the foreign earned income exclusion to exclude 30% of your income from the business—the remaining 70% would be treated as unearned income and would therefore not be excludable. The reason for this is that a non-service business makes money in part through the owner’s personal efforts and in part through the use of business assets (which is essentially unearned income), so the IRS spit-balled it and came up with 30% as the proportion generated purely by your personal services.
- But wait, it gets even worse: your allowed business deductions are scaled back by the ratio that the foreign earned income exclusion cap bears to your gross income. This is a little complicated, but the basic idea is that you could have net income of less than the foreign earned income exclusion cap but still have to pay US tax because of the magnitude of your gross income and deductions.
Keep Good Records
Holding through a non-US corporation is a fantastic structure, but it does come with complications and considerations. For example, you’ll be required to include IRS Form 5471 with your US tax return to report the activity of your foreign corporation, and you must include a balance sheet and income statement on that form each year. You’ll have other forms to file as well in certain years. So, it’s important that you keep meticulous records of your corporation’s business activity.
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How to Structure your Profession
A profession is a very different beast than a business, so of course it must be structured differently.
Bad News First
Unfortunately, operating a profession through a non-US corporation simply doesn’t work for US tax purposes. The reason for this is that a corporation is a separate person. In a profession, the client is paying to hire the professional. So, the professional must pay tax on that income-the professional can’t simply send that income over to a separate person (a non-US corporation). Doing that would violate the “assignment of income doctrine.”
You’ll find people on the internet who say differently than the above. The reason for that is they aren’t US tax attorneys, they just sell non-US corporations. So of course they think everyone in the world (plus their mother, dog, and parakeet) need a non-US corporation (or 2, or 3!).
Do I Even Need a Legal Structure?
If your profession is pretty much a series of jobs, then not having a legal structure is perfectly OK. So, if you simply hire yourself out for discrete projects that you work on one at a time, and you get paid on a pure hourly basis, then having a legal structure honestly won’t help you all that much.
But once your profession grows beyond those early stages, having a legal structure is absolutely mandatory. Here are the benefits of operating through a legal entity:
- it provides a more professional appearance to clients, banks, and others;
- it protects your personal assets from liabilities generated by your business;
- to a more limited degree, it protects your business assets from liabilities generated outside your business;
- it provides a centralized place to keep business assets; and
- it helps keep business income and expenses separate from personal income and expenses, which can be helpful for tax reporting purposes.
Legal Structure Options for Professionals
First, since you can’t use a non-US corporation, you should simply operate your profession through a limited liability company (an “LLC”) formed under the laws of a US state.
Then, there are two ways for your LLC to be classified for US tax purposes.
- If you don’t make any tax elections, then your LLC will be a “disregarded entity.” This means that it simply does not exist for US tax purposes. The assets and activities of the LLC are simply treated as your assets and activities.
- Under this option, you’re subject to US income tax and US self-employment tax on all income from your profession.
- Of course, if you qualify for the foreign earned income exclusion, you can avoid US income tax on the first $100,000 or so, but you still have to pay self-employment tax on everything you make.
- You could also elect for your LLC to be classified as an “S corporation” for US tax purposes. An S corporation is a separate entity for US tax purposes-it’s a special sort of “pass-through entity.” A pass-through entity doesn’t itself pay tax-it’s owner pays tax on its income.
- Your income would be split into two streams: First, your S corporation would pay you a salary. Then, your S corp would “allocate” its net income above your salary to you.
- The salary portion is “foreign earned income” and can therefore be excluded using the foreign earned income exclusion. The allocation portion, on the other hand, is NOT foreign earned income.
- You would only pay self-employment tax on the salary portion (technically, your S corp pays “employment taxes,” but the amount is the same). So, the benefit of this structure is that you reduce your self-employment tax burden-it only applies to the salary portion, not the allocation portion.
Now again, there are more details and nuances to consider here-the above is just a general outline. For full details on exactly how each of these structures work, plus a step-by-step guide to setting each of them up, see the Tax-Savvy Expat : Freelancer course.
This stuff is complicated.
This article gave you a good introduction to how everything works. However, once you make the leap from “doing some research” to “I’m really seriously thinking about doing this stuff,” you need expert advice on your particular situation.
Unlike many lawyers, I don’t have a minimum number of hours I need to bill before taking on a new client. If you just want to jump on the phone for a half-hour to make sure you understand how everything applies to you, I’m happy to help.
You can easily schedule a call with my easy online calendar system.
Want to know more? The Tax-Savvy Expat courses teach you everything you need to know about expat tax.