I just got off a call with a new client.
She had just started her first foray into life as a digital nomad, so she’d been doing some internet research on the tax-saving opportunities. Before the call she sent a list of conclusions she’d made and questions based on those conclusions, and the biggest conclusion was that she would form a non-US corporation structure to hold her business going forward.
Unfortunately, given the client’s particular circumstances, using a non-US corporation doesn’t work for her. This article discusses why that’s the case and why this client was perfectly happy to hear this.
When does a non-US corporation work?
You can hold your business through a non-US corporation only when you meet all three of the following requirements (which I call the “Big Three”):
- You live outside the US more-or-less full time (i.e., you qualify for the foreign earned income exclusion);
- You’re engaged in a business (as opposed to a profession); and
- Your non-US corporation would not be “engaged in a trade or business in the United States.”
These are the baseline requirements to hold your business through a non-US corporation structure. If any of these three essential ingredients are missing, you’re going to have problems of one kind or another.
why can’t I operate a “profession” through a non-US corporation?
A profession is an activity where you sell your own time and attention to clients. A business, on the other hand, is where you sell something else, such as other peoples’ time and attention, a physical product, access to software, etc.
So, in my role as a US tax attorney, I’m engaged in a profession. The same is true for people who operate consulting-type businesses or who work as freelancers.
In a case called “Lucas v. Earl,” the US Supreme Court announced that the person who earns income must take into account the tax considerations of that income. The earner can’t “assign” that income over to another person.
If you were to operate a profession through a non-US corporation, that’s exactly what you’d be doing—you’d be the one earning the income, but you’d be sending that income to a non-US corporation (a separate person), and you’d want the non-US corporation (not you personally) to deal with the tax consequences. That just doesn’t work.
Why do I and my team have to be outside the US?
A non-US corporation that is “engaged in a trade or business in the United States” (or “ETBUS” for short) is subject to US tax on its income. And the amount of that tax is higher than a US individual is required to pay.
So, one part of operating through a non-US corporation is that you only want to do so in a situation where the non-US corporation would not be ETBUS (so that the non-US corporation would not be subject to US tax.)
A non-US corporation is ETBUS when two things are true:
- It has at least one employee or other “dependent agent” in the US (as opposed to a third party engaging in its own business, which would be an “independent agent”), and
- The dependent agent in the US does something substantial to further the non-Us corporation’s business (as opposed to something that’s purely administrative or ministerial).
So, if you were to run your business while living in the US (i.e., you didn’t satisfy the first of the Big Three), then you’d be the dependent agent in the US who makes your non-US corporation ETBUS.
Similarly, if you live outside the US, you want to make sure that everyone else who operates your business is outside the US as well. (An interesting result of this rule is that it helps to keep the US expat and digital nomad community together. If you want to hire an American, then hire one that lives outside the US.)
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What were the issues in this client’s situation
Without going into too much detail, my client had problems with two out of the big three:
- The first requirement isn’t a problem: she lives full-time outside the US. However, there’s a timing element here that does actually raise additional concerns (more on this below).
- For the profession v. business requirement, my client’s situation definitely had some hair on it. She operates a consulting business, and she’s the only brains behind the operation. However, when she gets a contract for a new project, she does hire people (on an independent contractor project-by-project basis) to help her execute. So, she falls somewhere in the middle of having a business (i.e., selling other peoples’ services) and having a profession (i.e., selling her own time and attention, albeit by using other peoples’ services as a force multiplier).
- Finally, the “avoid being ETBUS” requirement is murky as well because several of the independent contractors she uses are located in the US (and really need to be given her client base). And note that these last two requirements sort of cut against each other. If we get satisfied that she has a business (i.e., she’s selling other people’s services), then this third requirement is even more of a problem (because those people are providing those services in the US).
Also, as mentioned above, there’s a timing element as well. The client wasn’t sure how long she’d spend outside the US.
Contributing an on-going business to a non-US corporation is generally a taxable transaction. Then, if the client were to move back to the US, she’d have to pull the business out of the non-US corporation, which would also be a taxable transaction.
So, a non-US corporation is really a viable structure for an ongoing business only if you plan to be outside the US for long enough (or you plan to sell the business while still outside the US).
Why was this client still happy?
Well, maybe “happy” is too strong of a word . . . But she at least was satisfied with the advice I provided for several reasons:
- I saved her from using a structure that simply wouldn’t work in her situation. If she had just gone ahead with putting the structure together, she would have cost herself much more tax than she would have saved (or, if she didn’t actually pay more tax, she may have gotten involved in a tough conversation with the IRS).
- I saved her from hours of additional research trying to figure out how all the above issues apply to her situation. US tax is really complicated stuff, and the international tax aspects are probably its most complicated part. So, a one-hour call with me freed up her time to actually focus on operating her business and enjoying her new life outside the US.
- Finally, she was happy I was able to simply tell her how this all works instead of trying to sell her a structure just to line my own pockets. Before talking with me, she had spoken with an “offshore guru” type who didn’t mention any of the stuff above. The offshore guru just presented a big number for the amount he would charge to set up a structure.
So what’s the best legal structure here
Even though a non-US corporation won’t work here, that doesn’t mean that having absolutely no legal structure is a good idea.
Instead, the best legal structure to use is simply a limited liability company, or LLC. My client would be the sole member of the LLC, which means that the LLC would be a “disregarded entity” for US tax purposes. That simply means that the LLC is not treated as a separate person–it’s just treated as an extension of its sole member.
Operating through an LLC has a lot of benefits:
- A more professional appearance,
- Separation of business and personal assets, and
- Some degree of limited liability.
I created Tax-Savvy Expat: Freelancer to make setting up an LLC totally easy and hassle-free. Click here to read more about Tax-Savvy Expat: Freelancer.
Will a non-US corporation work for me?
It sure might. And it sure might not. It all depends on your particular situation and your plans for the future.
I’d be happy to have a conversation with you so we can figure it out. Click here to read more about how I do expat and international tax consultations.
Ready to become an expert on this stuff? Click here to take the US Tax Masterclass for Americans Abroad (absolutely free).