April 15, the infamous deadline for filing U.S. Income tax returns, actually slipped back three days this year to April 18, a boon to procrastinators everywhere. Those of us living abroad are eligible for an automatic two-month extension, however. So this may be an opportune time to discuss some special tax considerations for Americans living abroad, in particular those affecting the many business owners here on the Bay Islands.
U.S. citizens and permanent residents are subject to U.S. income taxes regardless of where they live and where they earn their income. However, they may exclude about $100,000 of their overseas earnings from U.S. taxes through the foreign earned income exclusion (FEIE). For example, a person who earns $100,000 in wages, all of it earned from work conducted outside the United States, and meets the requirements to qualify for the FEIE, would owe zero U.S. income tax on that income.
The situation is a little more complicated for business owners than for wage earners. If you are a sole proprietor of an overseas business, a proportion of your overseas business expenses may be disallowed on your U.S. tax return, and you may end up with some taxable overseas income. If you are conducting business overseas through a foreign corporation, the best strategy is to pay yourself a salary up to the FEIE limit. However, additional reporting requirements kick in when a U.S. person has certain ownership over a foreign entity – see below.
Self-employed U.S. citizens and residents living abroad are also responsible for making self-employment contributions to Social Security and Medicare (FICA). Normally, employers and employees each pay half of these payroll taxes. However, a self-employed person (sole proprietor) is both employer and employee, and therefore is responsible for the entire amount, which is 15.3 percent of net income. This tax applies even to income that is excludable under the foreign earned income exclusion. However, part of it may be deductible from income taxes you are required to pay on your non-excluded income.
There is a legitimate way around paying FICA tax. You can establish a foreign corporation and pay yourself a wage. The IRS cannot assess FICA tax on a foreign corporation or on the wages it pays to its employees. Of course, the foreign corporation and you (as an individual) may need to pay employment/social security tax to the country where you are working. But by establishing a foreign corporation, you can at least avoid double taxation.
Unfortunately, many U.S. expats are caught off-guard when they learn about the filing requirements associated with having an ownership stake in a foreign corporation or partnership. The IRS wants to know how American expats with businesses abroad are deriving their income.
A U.S. citizen or resident who owns a 10 percent or greater stake in a foreign corporation (or who is an officer or director of a foreign corporation in which a U.S. person owns at least a 10 percent stake) must file Form 5471. One of the schedules within Form 5471 requires the filer to identify all other U.S. shareholders of the foreign corporation. This allows the IRS to be able to cross-check names and identify people who are not complying with the filing requirement.
It is important to note that the IRS will likely treat any foreign entity that confers limited liability as a foreign corporation – regardless of local nomenclature, such as Sociedad Anónima (S.A.) vs. Sociedad de Responsabilidad Limitada (S. de R.L.) in the Honduran case.
The penalties for non-compliance are severe. The IRS can assess a $10,000 penalty for each year that the information is not provided. If the IRS has sent you a notice regarding non-compliance and you do not respond quickly, additional penalties can reach up to $50,000.
If your business here is essentially a one-person show, then regardless of its legal status under Honduran law, it may be considered as a “disregarded entity” by the IRS, in which case you need not file Form 5471. For example, the IRS does not regard a single-member LLC or a sole proprietorship as an entity separate from its owner for U.S. income tax purposes. When similar foreign entities are owned by a U.S. person, the IRS requires Form 8858 to be filed. The penalties for non-compliance are similar to those described above for Form 5471.
John Ohe is an IRS enrolled agent, chartered financial analyst and partner at Hola Expat, a firm based in Belize that specializes in preparing tax returns for U.S. expats. He may be reached at email@example.com. This article is for general information only and should not be construed as personal tax advice.