Several times a week, I get an email from a business owner living in the US who’s looking to reduce their US tax bill by operating their business through an offshore company. These inquiries aren’t from scofflaws—those types don’t contact tax lawyers before jumping head-first into trouble. Rather, these inquiries are from well-meaning, law-abiding people who are simply trying to implement the same structures and strategies they’ve read about being used by big companies—like Apple, Microsoft, and Google.
However, holding your business through an offshore corporation will not reduce your US tax liability UNLESS you also move yourself offshore with your business. This article explains exactly why.
Basics: US Tax Treatment of US Persons and Foreign Corporations
I want to show you exactly how this all works from the ground up, and to do that I need to cover some technical rules. So, at the risk of putting you to sleep, let’s first cover the ground rules here:
- US persons are subject to US tax on all of their income, no matter where they live or where they earn the income. However, US persons living outside the United States can use the “foreign earned income exclusion” to legally avoid paying US income tax on about $100,000 per year of earned income.
- A foreign corporation is generally subject to US tax only on its US source income and only if it is “engaged in a trade or business in the US.” However, a foreign corporation is also subject to US tax on its foreign source income if the foreign corporation is (i) engaged in a trade or business in the US and (ii) the income is attributable to a US office of the foreign corporation.
- A US person who owns stock of a foreign corporation is generally subject to US tax on the foreign corporation’s earnings only when he or she receives dividends from the foreign corporation. However, under the “Subpart F” rules (so named due to their location in the Internal Revenue Code), a US person who owns at least 10% of a foreign corporation that is majority-owned by US persons must currently pay US tax on any “Subpart F income” earned by the foreign corporation. Subpart F income includes passive income and certain other specifically enumerated types of income.
Example: Offshoring a US-Owned and US-Operated Business
Now that we’ve made it through the technical background, let’s look at the following example:
Jane Doe currently lives in the US and conducts an active online business where she sells products or services to customers who live all over the world. The products she sells could be physical products or digital products (e.g., e-books, access to subscription services, etc.). She holds the business in her own name (i.e. not through an entity).
Jane decides to hold her business through an offshore corporation. Jane forms Jane Doe Enterprises, Ltd (“JDE Ltd”) in a tax haven jurisdiction (e.g., Cayman Islands, Panama, Belize), contributes all of the assets of the business to JDE Ltd, and thereafter operates in the name of JDE Ltd and otherwise observes all corporate formalities.
Treatment After Transferring the Business to an Offshore Corporation
While she held the business directly, Jane was clearly subject to US federal income tax (and self-employment taxes) on 100% of her net earnings. What has this new structure done for Jane’s US tax situation?
JDE Ltd is clearly engaged in a US trade or business (because the only employee of JDE Ltd resides and works in the US). So, JDE Ltd would itself be subject to US tax and would be required to file a US tax return each year. Even worse, JDE Ltd would also be subject to the “branch profits tax” at a rate of 30% on the amount of its US earnings after payment of US federal income tax (for a combined US tax rate on JDE Ltd’s U.S. business of 54.5% (i.e., 35% plus 30% on the remaining 65%)).
With respect to JDE Ltd’s foreign customers, JDE Ltd’s income is foreign source income that is subject to US tax (because it is attributable to a US office of JDE Ltd, which is wherever Jane Doe is located). So, JDE Ltd is also subject to US tax on this income.
Therefore, moving her business to JDE Ltd has worsened Jane Doe’s US tax situation considerably. Instead of simply paying US federal income tax and self-employment taxes of 15.3%, Jane will now effectively pay:
- US federal income tax plus branch profits tax at 30% and
- tax on dividends received from JDE Ltd at ordinary income rates.
Also, if JDE Ltd generates any passive income (e.g., interest on business savings, or dividends or rent from investment property), then Jane must pay US tax on such income even if such amount is not distributed to her (but she won’t have to pay US tax again once such amount is distributed).
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Then Why Does Offshoring Work for Apple, etc.?
Apple and the like make profits outside the United States without paying US tax because, unlike Jane in our example, those companies have actual boots-on-the-ground businesses that are operated by people who live and work outside the United States. They therefore do not pay US tax until they cause their foreign subsidiaries to pay the offshore earnings to the US parent company as dividends.
Now, of course there are other “tips and tricks” here that these companies use to further reduce their US taxable income. However, this simple deferral provided by the use of offshore companies to hold active foreign businesses is what provides the bulk of their US tax savings.
Treatment if Business Owner Moves as Well
Jane can take advantage of this deferral opportunity herself by transforming her business from a US-operated business to an active business that is operated from outside the US. If Jane moves outside the United States, depending on her specific facts, it is most likely possible to structure her business so that
- JDE Ltd itself does not pay any US tax,
- Jane does not pay any US tax on the first $100,000 or so of salary she receives from JDE Ltd, and
- Jane does not pay US tax on JDE Ltd’s earnings above such amount until she causes JDE Ltd to pay such earnings to her in the form of dividends.
So, here’s the bottom line: Moving just your business offshore doesn’t work to reduce your US tax liability, but moving you and your business offshore most certainly does (as long as it’s structured and reported properly).
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